Fidelity Special Values (FSV) has announced its annual results for the year ended 31 August 2022. Its manager, Alex Wright, marked his ten-year anniversary of managing the Company on 1 September 2022, having produced a cumulative NAV and share price total returns of 183.3% and 208.9%, respectively, over the decade. These are both well ahead of the 92.7% achieved by FSV’s benchmark during the period that Alex has been at the helm. However, during the last financial year, FSV has lagged its All-Share Benchmark with an NAV total return of -4.4% and a share price total return of -13.5%, both markedly behind the benchmark which returned +1.0%. However, both the NAV and share price performance over three, five and ten years remain ahead of the Index.
FSV’s chairman, Andy Irvine, comments that the trust is run with a contrarian, value-style approach and, by looking for ‘special situations’, predominantly in UK companies, with a well-diversified portfolio across sectors, including small and mid-cap companies, this provides ample opportunity for the many research ideas employed to bear fruit over time as others in the market come to recognise the value of previously unloved stocks.
FSV’s portfolio manager, Alex Wright, believes that UK equities are attractively valued relative to other international markets and sees great potential in unloved stocks and sectors. Though the environment is uncertain, he believes that these markets will provide attractive investment opportunities. For example, the current environment of higher inflation and interest rates is beneficial for banks and he has been adding to names in the sector where positive earnings have bucked wider trends.
Dividend – 16.2% growth year-on-year
FSV’s board is recommending a final dividend of 5.45p that, together with the interim dividend payment of 2.30p per share, provides a total dividend of 7.75p for the year, which represents an increase of 16.2% over the dividend of 6.67p paid for the prior year.
Manager’s review
The portfolio manager’s review has been provided in the form of a Q&A. Rather than try and dissect this, we have reproduced it in full below.
QUESTION: It has now been 10 years since you took on stewardship of the Company, delivering impressive returns for shareholders. What has stood out to you during that time?
ANSWER: The past decade has been a highly unusual one, both from a political and an economic perspective. Few would have predicted the UK leaving the EU, Donald Trump becoming US president or the COVID-19 pandemic and subsequent lockdowns; all events that had substantial effects on the stock markets in which your Company invests. The past decade has also proved to be historically unusual, in sofaras we have experienced a prolonged period of very subdued inflation, low interest rates and modest and volatile economic growth. This environment has very much favoured growth companies, at the expense of the attractively valued companies with lower downside potential in which we seek to invest. Despite this challenging environment, over the last ten years the Company recorded a NAV total return of +183.3%, and a share price total return of +208.9%, which compares to a total return of +92.7% for the FTSE All Share Index (the Company’s Benchmark Index).
Stock selection rather than any big sector or top-down decisions has been the key driver of performance. By targeting unloved stocks on depressed valuations and leveraging Fidelity International’s (“Fidelity”) research resources, we have managed to unearth investments that have generated outsized gains, while limiting losses when turnarounds have not worked out. Investors tend to dislike companies where something has gone wrong and those going through a period of uncertainty, but things are never quite as black or white as they appear. Our analysts use their sector expertise and wide networks to conduct thorough due diligence and assess the likelihood of a recovery. Even small changes can have a very big positive effect on the share prices of such companies.
Meanwhile, by maintaining a broadly diversified portfolio across sectors and holdings, we have been able to be patient and wait for these recoveries to come through, slowly adding to our positions as our conviction increased, and recycling capital into new investment opportunities as the positive change narrative became more widely recognised. We have also used the Company’s flexible and low-cost gearing to take advantage of what have been surprisingly frequent periods of high volatility, buying when others were selling because of unusual political or economic events. Over time, this contrarian mindset has been handsomely rewarded in the Company’s performance.
QUESTION: How has the Company performed in the period under review?
ANSWER: Despite outperformance in the second half of the period, the Company recorded a NAV total return of -4.4% overall, lagging the Benchmark Index return of +1.0%. The period was marked by increased market volatility, as investors attempted to come to terms with mounting inflationary pressures, interest rate rises and the increased likelihood of a recession, factors that added significant uncertainty to the outlook at both the macro and micro level. The macro economic uncertainty was also reflected in a significant widening in discounts across the Company’s peer group and investment trusts generally, which saw the Company’s shares trade at a discount to its NAV from April onwards and was reflected in a disappointing share price total return of -13.5% for the reporting year.
In an environment of rising living costs, the overweight exposure to the consumer discretionary sector, which we have reduced materially, hurt relative returns. Motoring and cycling specialist Halfords Group featured among the key detractors, as it warned of the effects of rising inflation and declining consumer confidence. Nevertheless, we have been encouraged by the strength of its car servicing business which continues to gain market share and should prove resilient as cash strapped customers opt for cheaper repair and maintenance providers. The small position in Studio Retail Group also hurt returns after the online catalogue company experienced supply chain and working capital issues, and failed to secure an emergency £25 million loan from lenders forcing the company into administration. In an environment of sharply rising oil and gas prices, our underweight exposure to the energy sector detracted. While we remain sceptical that oil prices will remain at these levels longer term, we have a much more positive view on the prospects for gas prices. As a result, we have deliberately skewed our portfolio towards gas producers such as OMV and Energean in preference over BP and Shell whose forays into renewables could result in significantly lower future returns on capital. As defensive stocks performed better against a backdrop of increasing volatility, the underweight stance in large-cap names in consumer staples and health care also held back relative performance.
On a more positive note, our largest holding, outsourcing group Serco Group, upgraded its profit forecasts reflecting robust revenues generation and a healthy contract pipeline supported by stronger demand for immigration services from governments in the UK and Australia. Imperial Brands, whose latest results suggested progress in its repositioning strategy, was another notable contributor. We added to both positions in March 2022 when these defensive holdings had sold-off heavily despite having little or no exposure to the war in Ukraine. These trades show the benefit of an active strategy and an analyst team that can highlight opportunities fast. Merger and acquisition (“M&A”) activity continued to be a major driver of performance, with both power generation company ContourGlobal and consultancy firm RPS Group among the top contributors. The former agreed to be acquired by US private equity group Kohlberg Kravis Roberts (KKR) and the latter recently received a takeover bid from Canadian engineering group WSP Global.
QUESTION: The Company performed exceptionally well last year. Why has this year been more difficult to navigate?
ANSWER: As is well documented, the near-term outlook is very uncertain as economies worldwide grapple with sharply rising prices and slowing growth prospects. At the same time, elevated levels of inflation make it more difficult for central banks to react as they have previously, with many continuing to highlight the need for interest rate rises. This narrative has driven sentiment to depressed levels with many expecting this policy response to lead to a recession, while conversely a few sectors have been boosted by the prevailing constrained supply/demand conditions.
This has caused a huge divergence in performance between different parts of the market. So, in a market that has risen modestly in absolute terms, some companies have lost a lot of value whereas others, such as oil and gas producers, utilities and banks have gained meaningfully. In this risk-off environment, sectors seen as the most at risk such as housebuilders, leisure companies and retailers have seen sharp and often indiscriminate sell-offs. Our bias to small and mid-caps, areas typically less well covered and thus richer in opportunities, has been a meaningful headwind. Whilst a cyclical downturn is likely to result in earnings downgrades, many stocks have already sold-off heavily and reflect very pessimistic scenarios. While the Company has lagged its Benchmark Index, it has proved significantly more resilient than its peer group, thanks to its value bias.
QUESTION: What level of M&A activity are you seeing on the portfolio compared to last year?
ANSWER: Despite the increased volatility, the value in the UK market continues to be recognised by both private equity and trade acquirers. Unlike IPOs which have all but stopped, bids have continued unabated this year. The differential in valuations between UK stocks and global peers, especially US companies, has been a key factor driving this trend. While US valuations have come down of late, so have UK valuations, with sterling’s recent weakness making those valuations even more attractive to overseas acquirers. Against this backdrop, nine of our holdings have been the subject of bids over the past twelve months. The largest holding to be bid for was ContourGlobal, an international power producer, which received an all-cash offer at a 36% premium to the prevailing share price. Three of the bids – aerospace equipment supplier Meggitt, property development company U+I Group and consultancy firm RPS Group – have involved premiums in excess of 70%, highlighting the value on offer. These holdings have either been through temporary difficulties or were not on investors’ radars for various reasons but had good franchises, and medium to long-term growth potential, making them attractive to acquirers.
QUESTION: Inflation continues to soar, both in the UK and globally. How are you positioning the portfolio to protect it from rising inflation?
ANSWER: As we did during the COVID pandemic, when the outlook was highly uncertain, we are continuing to spend a lot of time meeting the companies we invest in to understand how the inflationary environment is affecting them, how flexible they can be with cost, and how resilient their balance sheets are. We are also drawing on the wider Fidelity network, both globally and across industries, to see how some of the wider trends could impact the portfolio. As highlighted, many stocks have sold-off significantly, and our valuation work is helping us to get a sense of how much pessimism is already being priced in. This work has given us the conviction to increase our positions in some stocks, but also sell ones where we see the risk of disappointment.
An area that we have trimmed is our consumer exposure. We reduced our exposure to housebuilders on concerns that momentum in the residential market will slow. We have also cut our exposure to areas more susceptible to demand slowdown such as big-ticket items and advertising. Overall, we are now significantly less overweight consumer discretionary stocks, with a preference for less economically sensitive areas, smaller ticket items and self-help stories.
On the flip side, there are areas that should prove more resilient in an environment of rising inflation and slowing economic growth. Take the Company’s largest holding, outsourcer Serco Group; their work for governments around the world is highly resilient as they proved during the COVID pandemic when they won new contracts. Recent trading upgrades have been strong and highlighted their growing and defensive and inflation protected cashflows.
Sector wise, our largest exposure is to financials, where banks and insurers make up respectively around 14% and 11% of the Company. Over the period, we have meaningfully added to banks, a move partly funded by a small reduction in the life insurance exposure which remains a large overweight position. There has been a small increase in the non-life insurance exposure where the pricing cycle looks very interesting, and stocks were attractively valued. The higher interest rate environment is a boon to the banking sector (and also the insurance sector) and profits from banks are now materially larger than they were in 2019. Take NatWest Group, now a top ten holding; its earnings estimates for 2023 have more than doubled over the last two years and are still being upgraded. This is a compelling story in an environment where markets are seeing earnings downgrades and fears of more to come. While markets are concerned about an increase in provisions, we believe the ability of banks to weather the downturn is much higher and both corporate and consumer balance sheets are stronger than they would be in a typical recession. We also added to AIB Group, which is well-placed to capitalise on the consolidation of the Irish banking industry; Barclays, which was trading at crisis-like levels; and Close Brothers Group, a conservative, well-managed, returns-focused niche lender. While the latter will not benefit from rising rates (as it has no current account business), the stock had underperformed and was trading below book value. Both Barclays and Close Brothers also benefit from some counter-cyclical revenues (i.e., revenues are strongest when there is high volatility) – the former through its investment banking business and the latter through its retail brokerage arm.
Anecdotally, we have also been selectively adding to staples (still a meaningful underweight position) as some key raw materials such as palm oil have started to come off. This should start to alleviate the big margin problem staples have been suffering from. Indeed, more generally, we are looking for companies that have been punished because they have not passed on cost increases, but where we believe they can over time.
QUESTION: Where do you see UK valuations heading compared to the US and Europe?
ANSWER: UK equities are very attractively valued both on a standalone basis and compared to other markets. They trade at meaningful discounts to European, and especially US equities, and these discounts remain particularly wide in an historical context. This has not only been reflected in continually strong M&A activity by private equity and corporate acquirers, but we have also seen more companies buying back their own shares, a reflection that companies themselves believe their shares offer good value and this is a good use of cash. We estimate that a little under half of the portfolio is made up of companies that are either buying back their shares or considering doing so.
While the near term outlook is uncertain, these valuation levels and the large divergence in performance between different parts of the market creates good opportunities to make attractive returns from UK stocks in the next three to five years. In our opinion, the UK market with its higher dividends offers a better prospective return than from many other asset classes, including global equities.
Question: Could the next decade be a better environment for value strategies?
Answer: The last decade has been marked by consistently low interest rates, subdued inflation and moderate growth. With a low cost of capital and low discount rates, some growth companies had reached astronomical valuations compared to where they had historically traded. This backdrop has been a strong headwind for value style investing which focuses on lower rated companies where cash flows and earnings are much shorter dated. The current environment of higher, likely stickier, inflation, rising interest rates and economic volatility is more representative of the longer term pattern seen over the last 100 years. It may feel uncomfortable for many investors who have only really experienced low interest rates, but looking through history, this is what one should expect. In such an environment, investors need to be valuation sensitive, agile and constantly looking for new ideas, which does favour the value style of investing.
Question: Since early September 2022, we have had multiple changes at the top of the UK Government, both in personnel and policy, which has resulted in an extremely volatile UK pound and gilt market. What can Shareholders expect over the next twelve months?
Answer: The September mini-budget underscored the Government’s priority of countering slowing economic activity and rising inflation with increased spending and tax cutting measures designed to boost growth. The initial reaction from markets was sceptical, with concerns about the cost of these latest measures further weighing on bond yields and the pound. With various U-turns and uncertainty in these policies causing further confusion and nervousness among market participants, the emphasis from the Government has shifted to appeasing nervous market participants, given the effects on household mortgage bills, for example. In the meantime, despite the Government’s intervention to limit household fuel bills, the near term economic outlook is uncertain. Many indicators point to a slowdown particularly for the consumer as inflation takes its toll. The unpredictable demand picture combined with continued supply chain pressures are adding to the volatility, and we are starting to see that emerge in company earnings.
Whilst this sounds relatively bleak, many of the most affected areas of the market have sold-off heavily and some stocks are starting to look interesting. After years of being relatively unloved, the UK market started the year looking to be good value, and now looks even cheaper. Meanwhile, portfolio holdings trade on even cheaper valuations for businesses that have healthy balance sheets and can grow and generate good returns. A cyclical downturn would affect some of these businesses, but we think a degree of negativity is being priced in and over time that should lead to attractive returns. Despite the volatility, the value in the UK market continues to be recognised by both private equity and trade acquirers.
When uncertainty is rife, this typically results in more opportunities to pick up very attractively valued stocks. Companies that can hold up well in a recessionary environment should prove to be good investments. In this environment, we need to be agile and constantly look for new ideas, and this certainly plays to Fidelity’s strengths in fundamental research. The Company is well diversified with over 100 holdings spread across different market caps and sectors, with exposure to both cyclical and defensive businesses. While the Company has a larger weight than the Benchmark Index in stocks that earn their revenues in sterling, nearly two-thirds of the portfolio’s earnings are in other currencies, which gives a good hedge against potential further moves in sterling.
While we are on the lookout for such opportunities, we are proceeding cautiously, and the Company’s gearing is relatively low at around 4% when netting out holdings that have received cash bids where we have a high conviction that these bids will go through. This leaves us with plenty of dry powder to reinvest should more opportunities arise.
Alex Wright
Portfolio Manager
3 November 2022