UK-focused fund managers have repeatedly trumpeted the value available in domestically focused parts of the FTSE over the past few months, and Fidelity’s Alex Wright (pictured) is no different
.
The FE Alpha Manager, who runs the £2.9bn Fidelity Special Situations fund, said the deeply unpopular status of this area of the market has created an “exceptionally fertile period” for contrarian stockpicking.
“I am struck by the sheer number of stocks across different sectors whose valuations suggest significant asymmetry of risk and reward over the next two to three years,” he added.
“I believe my investment style is well-suited to this environment and I have backed this belief by making a large personal investment into my funds at the end of 2018.”
Wright said that opportunities can be found across the market, in both international and domestic businesses. However, following further deterioration in sentiment towards the UK in Q4, he increased exposure to domestic stocks, primarily recycling capital from US-facing companies.
As a result, the portfolio derives 37 per cent of its revenues from the UK, a 7 per cent overweight relative to the FTSE All Share.
“I don’t have a differentiated view on the UK political or macroeconomic outlook,” said Wright, admitting that while there are risks in domestic companies, he believes they are worth taking if they satisfy the following criteria:
• A low valuation that reflects a worst-case outlook. “It is not difficult to find stocks that meet this criteria,” the manager said.
• Structurally sound markets. “It can sometimes be difficult to distinguish a short-term cyclical downturn from a long-term structural weakness,” he continued. “A low valuation will not provide much of a margin of safety to shareholders if cashflows are being gradually lost to new competitors.”
• A self-help story independent of UK macro. A permanent feature of Wright’s investment process is looking for companies that can help themselves without relying on a rising macroeconomic tide. He typically avoids companies where margins are at historic highs.
With this in mind, here are the domestic sectors the manager is currently buying – and avoiding.
Housebuilders
Wright continues to avoid UK housebuilders, pointing out that most have all-time high profit margins, which gives them significant operational leverage to any deterioration in demand for new houses.
Performance of housebuilders since June 2016
Source: FE Analytics
Instead he prefers the two Irish builders Cairn and Glenveagh.
“These enjoy significantly better industry fundamentals, rising returns, and lower valuations,” he said.
“An Irish recession caused by Brexit remains a risk, though given most of Ireland’s trade with the UK is in agricultural products, the Irish economy may prove more resilient in the face of Brexit than many seem to think.”
Retailers
Wright continues to tread cautiously among the retailers, where he said low valuations offer no comfort if he feels the business is structurally compromised. Just 2 per cent of the fund is invested in this sector, and this is across a number of small positions in companies which are relatively insulated, or benefit from, the shift online.
The manager added that protection from disruption could be provided by a cost advantage, or the provision of an ‘in person’ service in the shops.
“Some clients seem to expect me, as a contrarian, to have a higher weighting to this sector,” he said.
“However, with such a wealth of valuation opportunities across the market, there is no need to buy structurally compromised businesses – there are much more attractive opportunities elsewhere.”
Financials
Wright owns three UK life insurers – Phoenix Group, Aviva and L&G – where the average dividend yield for 2019 is more than 7 per cent.
He noted this is well above historic averages, reflecting the market’s concerns around asset quality and the effect of widening credit spreads on balance sheets.
“The work done by Fidelity’s insurance specialist suggests that the assets held by UK life insurers are significantly higher quality and more internationally diversified than the market is discounting,” said Wright.
“The dividends should be payable even in a downturn, and the long-term growth opportunities for the life insurance sector remain attractive, both in terms of organic growth and consolidation.”
The manager also continues to hold UK banks, saying that position sizes reflect the fact that while trading at attractive valuations, they are cyclical and have been in a relatively benign environment for loan loss provisions.
His preferred choice in this area may raise some eyebrows, however.
“With a lower loan-to-deposit ratio of 85 per cent, I now believe RBS has the most attractive balance of risk and reward in the sector,” he said.
Performance of stock since pre-financial crisis peak
Source: FE Analytics
“It trades at a P/B of under 1 and has a core tier 1 capital ratio of 17, meaning it holds significant excess capital which would provide a buffer in the event of any future losses. I don’t hold any challenger banks, where balance sheets are weaker and risk appetite seems to have been higher.”
Data from FE Analytics shows Fidelity Special Situations has made 39.84 per cent since Wright took charge at the start of 2014 compared with 31.15 per cent from the FTSE All Share and 27.22 per cent from the IA UK All Companies sector.
Performance of fund vs sector and index under manager tenure
Source: FE Analytics
The £2.7bn fund has ongoing charges of 0.91 per cent.