Jeremy Podger, Portfolio Manager, Fidelity Global Special Situations Fund
As the growth vs value debate rumbles on and markets become increasingly polarised, Jeremy Podger outlines the importance of taking a more pragmatic and balanced view. He discusses value traps – and opportunities – and reveals how this is influencing the Fidelity Global Special Situations Fund.
Within the framework of the Fidelity Global Special Situations Fund – which invests in corporate change, exceptional value and unique businesses – we try to build a balanced portfolio with stylistic flexibility. That has enabled the fund to deliver good performance, not just when ‘growth’ (i.e. companies with high expected profit growth, regardless of valuation) has appealed most in a low growth world, but also when markets have anticipated a rise in inflation and ‘value’ (i.e. cheaply rated stocks, regardless of expected earnings growth) has rebounded as we saw in the second half of 2016.
Exceptional value stocks continue to form the core of our portfolio, accounting for around 40% of investments. In this category, we typically look for companies which are cheap because they are underachieving versus their profit potential but where our research has identified a catalyst for turnaround in profitability that the rest of the market is ignoring. Stocks included for consideration offer a potential upside of at least 50% over a three-year period from a double impact of valuation re-rating and earnings improvement.
A polarised market
As things stand, in 2018 we have seen markets become increasingly polarised, where the valuation spreads between global growth and value indices are now around the widest we have seen since 2001. Sentiment towards certain types of growth names remains buoyant despite relatively stretched valuations.
In many areas the earnings trajectory of value stocks has been stronger than that of growth stocks, but at a time of technological disruption and geopolitical uncertainty, investors appear to be unwilling to commit to a view that says economic growth will stay strong. This has meant that the historical relationships between growth and value, which have typically been positively influenced by factors such as inflation and interest rates, are being overridden.
It is difficult to have a clear view on how far this can go. On a fundamental basis there is no clear and immediate catalyst for profit margins of growth companies to get squeezed down even with rising wage and input cost pressures.
Also, the simple mean reversion in the relationship between growth and value that many expect may not happen in a linear way, given that technology is now effectively removing links in value chains across all sorts of industries. In fact, if we look at valuation spreads that existed during the dotcom bubble, the other most recent period of disruption, then we could have further to go. The key from a portfolio point of view is to be pragmatic, be vigilant for changes and stick to a sound process in bottom-up stock selection.
So where can we find the most promising value stocks? At a headline level, following years of improving macroeconomic and corporate data as well as return on equity across regions and sectors, it has become more difficult to identify candidates that are clearly underachieving versus their long run potential profitability. While the obvious areas that stand out include Japan, energy, banking, automobiles, retail and more recently industrials, our constant focus remains not just on value but the catalyst that may release that value. This is where fundamental analysis becomes key.
Ongoing disruption calls for a holistic approach to company analysis over a mechanical (“quant”) one that is based on limited indicators. This can lead one to invest in extreme outliers that are likely to be full of anomalies and traps. Close company and management relationships, constant channel checks and a deep knowledge of changing industry dynamics are crucial in distinguishing between viable candidates (good management track record, stable earnings growth, visibility of cash flows, pricing power and market positioning) and bad ones.
The stand out areas
Over the last six years, we have been rewarded by our decision to use Japan as a hunting ground for exceptional value. Over this period, across the Japanese market as a whole, net profit margins have approximately doubled (though are still below those in Europe and the US). Here we have found opportunities such as KDDI, one of the cheapest telecoms businesses in the world at the time which has delivered and remains in the portfolio.
While profitability has moved sharply higher in Japan, there has been a genuine shift in corporate attitudes towards shareholders. Furthermore, PM Shinzo Abe’s policies and a prolonged economic recovery has resulted in real wage growth. Trade and political uncertainty aside, these could bring about further interesting opportunities and we expect to continue to tap this market in the coming period.
At a sector level, energy stocks, where earnings recovery has lagged other sectors, also present a compelling picture. Despite rising oil prices, many oil stocks continue to appear to price in a scenario of under US$60 oil prices. Demand-supply dynamics remain supportive given factors such as the strength in the global economy and geopolitical tensions between the US and Iran. At the same time, businesses continue to focus on cost and capital reinvestment to improve efficiency.
Elsewhere, the banking sector, with strengthened capital and the prospect of widening interest margins also looks interesting – albeit very selectively – in an environment of policy normalisation. We remain somewhat more wary of other areas of apparent value, such as automobiles and traditional brick & mortar retailers.
Both of these industries are in the throes of disruption and it is not immediately clear who will survive and thrive in the emerging era. Whilst having limited exposure to both areas, our portfolio has not been immune to such pressures, with auto components holdings underperforming at a time of uncertainty and some consumer-focused names being weighed down by margin pressures and increased competition from new entrants empowered by technology.
Looking around the world today, we remain cautiously optimistic about the prospects for equities overall. If we see indications of trade-related issues abating, we could see investors focus back on factors the factors like growth, inflation and bond yields that have been the historical drivers of value outperformance.
However, at this point, given that investor enthusiasm and market leadership is more focused on growth, we have been concentrating our efforts on ensuring a balanced style profile, with exposure to both value and growth while at the same time making sure that the average valuation of stocks held in the whole portfolio is attractive compared to the wider market. This way, portfolio risk will be determined more by stock-specific factors. This flexible approach has worked well in the past six years and we believe it can continue to deliver for our investors.
This article is for investment professionals and should not be relied upon by private investors.
No statements or representations made in this article are legally binding on Fidelity or the recipient. The views expressed may no longer be current and may have already been acted upon by Fidelity. The ideas and conclusions featured are the author’s own and do not necessarily reflect views being actively implemented in Fidelity’s range of investment products and solutions. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security. The value of investments can go down as well as up and clients may get back less than they invest. Changes in currency exchange rates may affect the value of an investment in overseas markets. This fund invests in emerging markets which can be more volatile than other more developed markets. The Fidelity Global Special Situations Fund can use financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments in Fidelity funds should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document, current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbols are trademarks of FIL Limited. UKM1018/22716/SSO/NA