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The Contrarian value in UK Large-Caps

The consensus view is that domestically-focused UK small and mid-caps are deeply out of favour relative to larger and more international FTSE 100 stocks. But is this correct? Alex Wright, portfolio manager of the Fidelity Special Situations Fund and Fidelity Special Values PLC, challenges this narrative and reveals why he is increasingly finding value opportunities among UK large-caps.


A recurring question in recent client meetings has been whether I am finding opportunities among apparently unloved UK small and mid-caps. This reflects a strong consensus belief, reinforced by fund manager surveys and press coverage, that UK mid and small-caps are deeply out of favour and under-owned compared to their larger and more international cousins in the FTSE 100. Looking at performance and valuation data since June 2016, we see a different perspective on this one-sided narrative. In reality, small and mid-caps have outperformed the FTSE 100 since June 2016, continuing the trend of previous years. And although all of the market has de-rated, the FTSE 100 is now 10% cheaper on forward earnings estimates than the more domestic FTSE 250.

My process targets unloved stocks which are undergoing positive change that has not yet been recognised by the market. Given the sheer number of small and medium sized companies, and lower levels of scrutiny among other investors, I expect that the Fidelity Special Situations Fund and Fidelity Special Values PLC will always have a significant weighting to small and mid-caps.

However, at the margin, weightings are likely to be influenced by relative valuations between different size categories, as well as the outlook for different industries and companies. In this regard, I have incrementally been finding more interesting new ideas in large-caps. For the Fidelity Special Situations Fund, this has now increased to around 60% of the portfolio – the highest level since I started managing the fund at the beginning of 2014.

LARGE-CAP HIGHLIGHTS

OIL MAJORS

Shell has been a long-standing position in the portfolio, and earlier this year, BP joined it in the top 10. Our positions in the sector do not rely on further rises in the oil price, but do assume that downside to current prices is limited. Fidelity’s models suggest that a US$60 mid-cycle price will be needed to cover the five year supply-gap that emerged as a result of significant capex cuts that the sector saw in 2015 and 2016.

We will be watching BP and Shell closely for capital discipline. Assuming this can be maintained, free cash flow coverage of dividends could rise to between 1 and 1.5x, which would facilitate returns of capital to shareholders and meaningful upside to the 5.5% dividend yield both stocks trade on today.

BANKS

Earlier in the summer, the Fidelity team held a full day of meetings with divisional heads of UK retail banks, primarily focussed on the UK mortgage market. The meetings suggested that although this is a low growth market, fundamentals are evolving in favour of the larger banks with lower funding costs – especially as the Bank of England’s ‘Funding for Lending’ scheme ends. The profitability of these banks is not reflected in the stock’s valuations, many of which continue to trade not far from book value.

DEFENSIVES

Whereas our positions in the oil and banking sectors rest on a combination of stock-specific changes and industry change, our positions in defensive sectors are more stock-specific. We remain underweight in consumer staples, although following the dramatic sell-off in tobacco, we have bought a 1% position in Imperial Brands, which currently trades on a 7% dividend yield (comfortably covered by free cash flow).

This is unlikely to become a large position for the fund given the negative structural trends in tobacco and high levels of leverage. However, weak sentiment and a low valuation suggests an attractive risk-reward for the stock today. I have also added to our position in Irish brewer C&C group following its acquisition of distributor Matthew Clark, which we believe transforms their previously struggling UK business.

In healthcare, I have bought a small position in Sanofi, which trades on an attractive valuation and has a strong balance sheet. The market seems unwilling to give it much credit for what looks like a considerable growth opportunity from new product lines. There are lingering concerns around pricing and competitive threats, but the market could easily change its view and become more interested in the growth story. We also continue to own a large position in Shire, whose shares trade at a discount to the acquisition price agreed with Takeda.

In addition, we continue to own a number of hidden defensives, stocks such as Pearson, Bunzl, DCC and Ultra Electronics, which are not classified in traditional defensive sectors but which should show resilience in a weaker economic environment.


Important information: This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The Fidelity Special Situations Fund and Fidelity Special Values PLC use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. They also invest more than other funds in smaller companies, which can carry a higher risk because the share prices may be more volatile than those of larger companies. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document and annual and semi-annual reports, free of charge on request by calling 0800 368 1732. Issued by Financial Administration Services Limited and FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbols are trademarks of FIL Limited.

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