19 Jun 2024
Across the globe, despite a brief comeback, many value stocks and sectors are languishing at historical lows relative to their growth counterparts. Against this backdrop, our value-oriented portfolio managers review the landscape facing investors in the world’s key economies, highlighting the opportunities we’re seeing in mispriced stocks and the potential catalysts for a value revival more broadly.
The ideas and conclusions here do not necessarily reflect the views of Fidelity’s portfolio managers and are for general interest only. The value of investments can go down as well as up, so your clients may not get back what they invest.
2023 was dominated by the Magnificent Seven, which in recent months dwindled to the Magnificent Four and, more recently, to the Magnificent One of Nvidia. Following the popularity of the Magnificent Seven, other groups of stocks have gained popularity such as the Granolas, highlighting Europe’s leading stocks.
More recently, Gavekal Research coined the term “S Club 7” which includes Safran, Saint-Gobain, Sanofi, SAP, Schneider Electric, Siemens and Stellantis. It noted these stocks had in fact performed better than the Magnificent Seven, highlighting that if you group certain stocks in a specific way, you can get great performance over a certain period of time.
Importantly, although the S Club 7 companies are European, they are global in nature and exposed to the global cycle. Their strong performance indicates that the market is discounting a turn in the economic cycle, potentially signalling a shift in where investment returns will come from. From my perspective, the US remains an exceptional market, and I believe the worst of the market uncertainty may be behind us and we could see a positive turn in the cycle.
Against this backdrop, we have already started to see signs of the market broadening. For investors looking to construct a portfolio with exceptional stocks, there is life beyond the Magnificent Seven. If we take two metrics - companies with return on invested capital above 25% and companies with earnings per share growth in 2024/25 of over 25% - there are a number of high-quality companies with these attributes. For instance, our largest sector position is held within health care, where we own core positions in health care providers and services. These are defensive, quality businesses that are backed by long duration demographic tailwinds. Meanwhile, our financials holdings are characterised as higher quality assets trading below their intrinsic value, such as countercyclical investment business Berkshire Hathaway.
At a certain point in 2023, we saw growth go from expensive to very expensive and value move from reasonably cheap to incredibly cheap. As a result, the dispersion in returns between value and growth was at an extreme. But what is interesting is that over a 20-year average, there is a still a fundamental reason to be exposed to value stocks. This is mainly because there are still robust but undervalued businesses across sectors that are exposed to the fundamental strength of the US domestic economy.
The benefit of our US value strategy is that you have the value tilt, with a concentrated portfolio of companies that have great opportunities over the future offering free-cash flow profiles that are even higher than the S&P 500 index.
In contrast to the US, the market environment in Asia is very different. Most investors generally look to Asia for growth. So why look at value in Asia? The answer is simple - to make money. If you look at returns over the long-term, Asia has by far been the best place to invest for small-cap value stocks. Interestingly, small-cap value stocks have grown earnings faster than their small-cap growth and large-cap growth counterparts.
However, over the last 10 years, value investing in Asia has felt like swimming against the tide. Growth has rerated enormously versus value, to the point where the divergence is more extreme than it was during the dot.com bubble. And this is despite value companies growing earnings faster than growth companies. Despite this challenging environment, we have still managed to perform well, and when the tide turns in our favour - and I have no doubt that it will - we believe our portfolios will perform even better.
China, of course, remains a key driver of investor sentiment towards the broader region. It is undoubtedly going through a cyclical downturn, where profit margins are at 20-year lows. But it’s also true that China is the world’s second largest economy with an incredible entrepreneurial culture.
We are finding companies in China where the market capitalisation is half the cash on the balance sheet. For instance, we bought a port, which has been in existence for 130 years, with a net cash balance sheet on four times earnings. I just cannot see how this port will cease to exist in four years’ time.
I think the current degree of pessimism relating to China is immense. When it comes to catalysts for a rerating, I think it will be earnings. We appear to be very close to the bottom, and when things start to recover, we will see sentiment improve.
Elsewhere in Asia, we see opportunities in Indonesia. I don’t see value in India, which I think is in bubble territory. We are also heavily underweight Taiwan.
In comparison to other major markets, the UK is not only cheap on a relative basis, but also on an absolute basis. It trades around 12 times earnings, versus the US at around 22 times and Europe around 15 times.
It is also worth reiterating that the UK stock market is not the UK economy. For instance, in our UK Smaller Companies strategy, around half of the revenues of the companies come from geographies outside the UK. So, you can buy internationally diversified businesses in the UK at very low valuations.
The valuation opportunity exists across the market capitalisation spectrum, with small caps in particular trading at an even greater discount. Historically, the snap-back in small caps tends to be very quick and often before there is full clarity around the outlook for the economy.
Notably, as corporate earnings hold up better than expected more recently, and the soft/no landing narrative becomes consensus, we are increasingly seeing corporates take part in M&A. Whereas previously bid activity was more driven by private equity. Two companies in our UK Smaller Companies portfolio - Wincanton and Spirent - have been subject to corporate bidding wars, and more recently another holding Tyman has also been bid for. It’s worth noting that the bidders have largely been from abroad, which highlights the attractive valuations on offer in the UK. Whilst that discount persists, and absent any significant economic challenges, I would expect this trend to continue, to the benefit of investors.
What’s also fascinating about the current period is that, as UK value investors, we don’t have to sacrifice on quality when buying cheap companies, which hasn’t always been the case. Value investors today can benefit from the UK being out of favour, value being out of favour, and small caps performing poorly.
This dynamic cannot endure forever, but it is tough to say what the catalyst to a potential rerating could be. The US economy could overheat, or we could see some fundamental issues amongst some of the large-cap tech companies. Or it could simply be that we develop better relations with Europe, which reduces investors’ concerns as Brexit was one of the reasons for the UK’s relative de-rating. Whatever the reason, from my perspective, current low valuations offer great opportunities for value investors in the UK.
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. Fidelity's range of equity funds 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. Some of our funds have the potential of having high volatility either due to their composition or portfolio management techniques. 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 investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. 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.