09 Sep 2021
By Jonathan Winton
While the UK market has looked cheap for some time, the key difference in 2021 is that fundamentals are now improving. Jonathan Winton, lead portfolio manager of Fidelity UK Smaller Companies and co-portfolio manager of Fidelity Special Situations & Fidelity Special Values PLC, discusses how this backdrop is driving a spate of M&A bids which could act as effective catalysts to close long-standing valuation discounts.
The near-term economic outlook for the UK is encouraging with Brexit now behind us, most remaining restrictions related to Covid-19 now lifted and real time data suggesting a continued rebound in economic activity. Consequently, the UK is predicted to grow at the fastest pace of the major developed economies, providing a good backdrop for UK corporates.
This bright outlook is reflected in the number of M&A bids we are currently seeing by private equity groups and other corporates in the broader UK equity market. Our focus on undervalued companies with sound or improving fundamentals means that it is not unusual for our portfolio holdings to be the subject of bids. In fact, over the past year, 10 of our holdings in Fidelity Special Values PLC were the subject of bids.
These bids highlight how attractive UK companies’ valuations are both in an absolute sense and relative to other geographies. While the UK market has looked cheap over the past five years, the major difference in 2021 is that fundamentals on-the-ground look very good.
From a portfolio perspective, this backdrop has helped us find attractively valued companies of better quality than would normally be the case, reflected, for example, in the continued elevated gearing level of Fidelity Special Values PLC.
The attractive valuations might reflect the fact that a particular company or business has experienced internal issues or been impacted by headwinds in its sector or the wider economy. The key is that we feel these issues are temporary and our due diligence gives us the conviction that the business will positively change over the medium-term. This uncertainty and the resulting impact on valuation creates an opportunity for acquirers who typically take a longer-term view.
Many UK listed companies are market leaders in their industries with attractive growth potential, and with Brexit in the rear-view mirror, companies and acquirers are more willing to commit to making new investments in the country. These dynamics, along with the current availability of capital, means we are likely to see more bids if the valuation discrepancy remains in place.
We welcome bids by private equity groups and other corporate acquirers if they recognise the true value of individual businesses and are willing to pay a fair price. These acquirers typically tend to take a longer-term view than market participants who can at times be overly pre-occupied by near-term uncertainty.
We are equally happy to take a public stance and vote against a bid if we think the offer undervalues the business, as we recently did with Spire Healthcare. We don’t see M&A as a threat - the UK is a large market so we are never short of new investment ideas and have had no issues putting to work the cash released from recent bids.
Overall, we believe the portfolio is well positioned to benefit from an improving economic backdrop and we remain excited about the opportunity set on offer. 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 combined with the more positive outlook give us confidence that we can continue to deliver attractive returns to investors from here.
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 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.