26 Oct 2021
Alex Wright, portfolio manager of Fidelity Special Situations & Fidelity Special Values PLC, outlines why he remains excited by the opportunities on offer in the UK despite recent market volatility. Within this, he highlights the improving outlook for corporate earnings and profits, particularly among domestic stocks and sectors that were hit disproportionately hard by Brexit and the pandemic.
After a strong rally this year, UK equities recently declined amid signs of a slowdown in the pace of the global economic recovery, as well as concerns over central bank tapering, tax increases and supply chain disruptions. But despite the recent volatility, our outlook for UK equities is bright and we remain excited about the opportunities of offer.
In valuation terms, the UK is one of the cheapest major markets with the exception of Italy and Korea. Moreover, the UK market has also shone brightly when it comes to earnings recovery. While the UK was particularly badly hit by Covid-19, the rebound in earnings has been stronger than any of the major markets. In fact, UK earnings have rebounded circa 50% this year, compared to 25% in the US and 35% in Europe.
Given this positive backdrop and the number of opportunities on offer in the UK market, particularly value parts of the market, we have used the recent market weakness to add to some of our most attractively valued holdings, increasing the gearing level back to the upper end of our historical range.
Accelerated changes
The strong earnings performance has been reflected in individual companies and sectors that have been transformed as a result of the pandemic. Covid-19 and lockdowns have effectively increased the pace of change both at individual companies, but also within industries where some competitors have exited. Lockdowns have allowed for faster restructuring as companies have used the downtime to accelerate changes, including, for example, refurbishing premises or digitising their business. Companies have also realised cost savings from reduced travel, employees working from home, reduced office footprint and online sales.
Private equity groups and other corporates are recognising the value on offer in the UK market, with a meaningful uptick in M&A bids this year. We are likely to see more bids if valuation discounts relative to overseas peers do not close. We are happy to accept fairly-valued bids but equally happy to take a public stance if we think the offer undervalues the business.
Navigating rising inflation and supply chain disruptions
One of the key reasons as to why we are very positive is due to the UK consumer who is in good shape. Throughout the lockdowns, the UK consumer saved significantly, and this gives us confidence. Therefore, we believe the expenditure that we have seen come through in the consumption area of the UK market, which is by far the biggest part of GDP, has further to go and can deal with some of the price rises that we’re inevitably seeing because of inflation.
Against a backdrop of rising inflationary pressures and supply chain shortages, our focus is on businesses with pricing power where companies can pass on cost increases. This is particularly the case in areas where there are shortages, such as the motor supply chain where we own car distributor Inchcape whose profit margins are benefiting from car shortages. We are seeing similar shortages with bikes, where Halfords is well positioned to capitalise given it has more robust supply chains than smaller competitors.
Similarly, the large listed housebuilders tend to have the best supply relationships and long-term contracts with suppliers, so should disproportionally benefit from industry shortages restricting the construction of new houses. We also have exposure to building materials in short supply through brick distributor Brickability and Norcros, which makes showers and tiles. Another area well placed to benefit from inflation and higher interest rates is financials, where we have maintained meaningful exposure to life insurers and banks.
Strong potential for future upside
Despite trading on cheaper multiples, the portfolio is anticipated to see stronger profits growth in 2022 and 2023, superior returns on capital and our holdings have less debt than the broader market. Overall, we remain very optimistic about the UK market and see strong potential for upside given the prospect of a multi-year economic recovery, the higher quality profile of our portfolios and their domestic/small-cap bias - the latter being areas that have been most impacted by years of Brexit uncertainty and more recently by the pandemic.
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. Changes in currency exchange rates may affect the value of investments in overseas markets. 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. 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.