Fidelity: Is UK value back?

Key points

• The outlook for UK equities looks bright as the Brexit overhang lifts and the continued strong progress on the vaccination front eases the path to reopening.
• Another reason for optimism is the recent results season which showed that UK company earnings are in much better shape than expected.
• Value-related areas have started to outperform, but the market remains bifurcated and we remain excited about the opportunity set.

We remain excited about the opportunity set on offer as UK equities remain significantly undervalued compared to their peers, trading at a 40% discount versus US equities and a 20% discount to European stocks as at April 9, 2021.

The value on offer is evident from the growing number of M&A bids, notably from private equity and overseas corporates - in the last 12 months, we have seen six bids for fund holdings.

UK value stocks remain particularly cheap. There has been a rotation into value stocks and cyclicals as investors contemplate the implications of an economic recovery - supported by unprecedented fiscal and monetary stimulus. But the dispersion in returns between growth and value stocks since 2006 remains unprecedented. This leads us to believe that, should investors shift their focus, the degree of outperformance could be very substantial given how bifurcated the market continues to be.

More broadly, the outlook for UK equities looks bright as the Brexit overhang lifts and the continued strong progress on the vaccination front eases the path to reopening, alleviating the disproportionate impact of the pandemic on the UK economy. We expect to see strong pent-up demand from consumers and corporates, given the unusually high consumer savings rate and delayed corporate investments due to Brexit uncertainty - estimated at around five years of under-investment from UK companies.

Consensus is growing that we could witness an uptick in inflation later this year due to this pent-up demand and constrained supply in some areas. Indeed, many companies we talk to are increasingly highlighting these challenges, particularly within supply chains. There is still an enormous amount of US fiscal stimulus ahead of us, which could stoke things further, and create a very different environment to the one we saw after the financial crisis.

Nearer-term, the ability for businesses to pass on these cost pressures will be increasingly in focus and is a key topic of conversation in our company meetings. An environment with higher inflation and rising bond yields has tended to favour value stocks. If discount rates rise, then some of the very highly priced stocks/sectors could de-rate, which we have begun to see, whereas value stocks’ moderate valuations should benefit from a normalisation of economic and market conditions.

Resilience in adversity

Another reason for optimism is the recent result season which showed that company earnings are in much better shape than expected, with only one out of over 100 holdings disappointing in recent results. This is partly due to cautious starting guidance, but also on account of cost savings and accelerated restructuring as a result of the pandemic.

For instance, in firms like Brickability, which is a supplier to the construction industry, sales representatives needed company cars to visit customers prior to the pandemic - but then had to switch their communications to phone/video during the pandemic. The company is now considering continuing with this model even after the pandemic as well as further expanding their online offering.

Elsewhere, UK specialist retailers such as Halfords, Dixons and Frasers have re-oriented their business online and shown customers they can still deliver. Investments in digitisation should help them grow market share over time.

There are expectations that non-food retailers will revert to pre-crisis volumes and margins, but we believe the changes triggered by the pandemic such as remote working, online orders and generally more efficient operating models are likely to be structural.

Attractively valued

Overall, we believe the portfolio is well positioned to benefit from an improving economic backdrop both in the UK and overseas. Our holdings continue to trade at a meaningful discount to the broader UK market, despite resilient earnings, superior returns on capital and relatively low levels of debt. This quality profile gives us confidence that we can continue to deliver attractive returns to investors over the course of the year.

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 can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments in smaller companies can carry a higher risk because their share prices may be more volatile than those of larger companies. The shares in the investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Changes in currency exchange rates may affect the value of investments in overseas markets. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.