Fidelity Special Values — Sell-off providing wide-ranging opportunities

Lead portfolio manager Wright has a contrarian and value-based approach to investing, which differentiates FSV from its peers. He says the market sell-off, as a result of the coronavirus, and the significant decline in the oil price have created very interesting opportunities, with the UK market looking particularly attractive versus other developed markets. However, the manager notes that due to the significant outperformance of growth versus value stocks in recent years, there are still many higher-valued companies whose share prices could be at greater risk in volatile markets. When investing, Wright looks for downside protection as well as the potential for capital appreciation. He looks at analogies from the past to see what one could expect from company earnings in different environments. The manager analyses company balance sheets to ensure that he is not taking undue financial risk in FSV’s portfolio, and believes that investing at low valuations can afford a degree of downside protection. He also considers potential catalysts to determine what may cause companies to re-rate in an improving economic environment. Wright believes that his stock-specific, bottom-up approach, coupled with the ability to draw on the significant resources of Fidelity’s investment team, provides a competitive advantage. He says that FSV’s portfolio typically has asymmetric risk, with unsuccessful positions losing less than the gains achieved from successful investments. Having recently adjusted his upside/downside analysis of individual holdings to reflect recent developments and calls with company managements, the manager estimates a weighted aggregated portfolio upside potential of 65%, with only a 15% downside risk.

In recent weeks, Wright, along with the rest of the Fidelity analyst team, has been undertaking hundreds of company meetings to understand what is happening on the ground. His view is that beyond the initial lockdowns, there will be a global recession that has the potential to be worse than that experienced during the global financial crisis. Fidelity economists suggest that the global economy could contract by between 10% and 25% in Q220, a much larger fall than the worst quarterly c 8% decline during the financial crisis in Q408. In addition, government support measures will mean significantly higher government debt-to-GDP ratios for countries that have had to lock down, many of which are already highly indebted. While it is difficult to assess the duration of any recession, Wright says that significant and wide-ranging dividend cuts are inevitable.

At end-February 2020, FSV’s top 10 positions made up 36.5% of the portfolio, modestly higher than 35.7% a year earlier; they are a mix of financials, resources, other GDP-sensitive companies and defensive businesses.

In the 12 months to end-February 2020, in terms of sector exposure, FSV’s weightings to consumer goods (+4.9pp) and industrials (+3.6pp) have risen, with lower exposure to financials (-4.6pp) and oil & gas (-2.4pp). The trust retains a meaningful overweight to the industrial sector (+14.4pp).

While Wright says it is a good time to buy UK equities, he is not an indiscriminate purchaser; however, he increased FSV’s gearing from c 2% to c 12% in recent months. The trust has its highest ever defensive weighting, typified by companies such as Imperial Brands, which is trading on a single-digit forward P/E multiple and offers a c 13% dividend yield, but Wright is also finding interesting opportunities in a variety of areas including GDP-sensitive stocks. He has added an unloved telecom operator to the portfolio (name withheld) that is growing revenues and reducing costs, and has increased the holding in Ericsson (communication equipment), which entered the portfolio early in Q120 in anticipation of an increase in telecom-related capex. The manager has initiated positions in two small-cap gold miners, whose share prices had halved despite a rising gold price, thereby increasing the fund’s exposure to gold-linked equities to c 3%. He has reduced FSV’s exposure to major oil companies BP and Shell given the significant fall in the oil price, as, at these levels, the companies cannot cover their high dividend payments.

Wright has also been working through the portfolio to assess where a deep recession and/or the current lockdown will likely cause company balance sheet problems, looking to sell those businesses where he believes there is a real bankruptcy risk. However, the manager explains that this is not straightforward, as some sectors are experiencing such significant revenue declines that even companies with net cash positions could burn through these reserves very quickly. It is also important to monitor the levels of government support and responses from the banking sector, which remain in a state of flux.

The manager sold FSV’s modest airline holdings once it was evident that the coronavirus had spread outside of China. He made a substantial gain in Dart Group, despite only having held the position since last autumn, and a small loss on the Wizz Air holding, which he was in the process of building up. Fundamentals in the airline industry were looking positive with the Boeing 737 Max out of action; however, this thesis is now broken due to the collapse in demand as a result of the pandemic. Wright says that looking out to 2021, if the effects of the virus are washed through the system – which is his base case – there will be ‘an awful lot’ of 737 Max planes delivered, so the airline industry would need a significant increase in demand to soak up the extra capacity.

Life insurance is an area that the manager has been adding to, and it now represents around 12% of the portfolio. Holdings include Aviva, Legal & General and Phoenix, which are all trading on very reasonable valuations. Business is robust, helped by demand for bulk-purchase annuities, there is limited new competition, and these companies’ balance sheets are strong, unlike during the global financial crisis.

Wright has added to CRH (construction materials), which is now the largest position in the fund. The company has a significant exposure to US infrastructure and there is a clear political desire from both sides of Congress to spend more money in this area. CRH’s largest input costs are oil-based bitumen and diesel, so oil price weakness should be positive for the firm’s margins. The manager thinks that the company offers good value, and it also has self-help measures in place to support earnings growth.

FSV also has a position in McCarthy & Stone, which is a developer and manager of retirement communities. Wright generally does not own UK house builders as he finds their valuations unappealing, but says McCarthy & Stone is more attractively valued. The manager points out that the company dominates its niche, with a 70% share in retirement living, and demand is strong; in the UK c 5% of the population live in retirement homes, much lower than 10–15% in other countries such as the US and Australia. There has been a decline in secondary transactions for UK retirement homes, but the manager believes this is a short-term issue. McCarthy & Stone can also adapt its business model to emphasise its rental operations, which could generate higher margins. Meanwhile, the company has net cash on its balance sheet.

Pearson remains in FSV’s portfolio, and has outperformed during the recent market turmoil. Wright says the company is countercyclical, generally performing better when the economy does badly. It is a stock-specific turnaround story, as around a quarter of its business is in the US higher education market, which has been under significant pressure. However, the company also has a growing digital business with recurring revenues. Wright reduced the Pearson position in H219 to 1.5% of the fund (although it is now larger due to recent outperformance), following changes in the senior management team, as he believes the new CEO and CFO will take time to bed in.

FSV’s relative returns are shown in Exhibit 6, and underline that it has had a tricky period of performance over the last year. However, it has outperformed the broad UK market in both NAV and share price terms over the last 10 years, while its share price has also outperformed over the last five years. It is notable that the bull market in recent years has been led by growth rather than value stocks and the divergence between these asset classes has grown wider over the last 18 months, which has proved a headwind to FSV’s relative performance.

Wright explains that as the coronavirus crisis broke, he believed that FSV’s portfolio had its highest-ever defensive exposure. However, some of the names that he considered to fit in this category have been disproportionately affected by the lockdown, such as C&C (a drinks distributor and brewer) and Photo-Me (ID photos and laundry machines). In addition, some other businesses that are not particularly affected by the virus have also been indiscriminately sold down by investors, including Babcock (engineering services), ContourGlobal (power generation), Imperial Brands (tobacco), Mylan (generic and speciality pharmaceuticals) and Serco (provider of public services). The manager considers these share price moves to be an overreaction, and has been topping up the trust’s positions in the latter group. FSV’s overweight exposure to mid- and small-cap companies has also been a headwind to performance, as these firms’ shares tend to underperform those of larger corporates in periods of stock market weakness.

Similar to many investment trusts, FSV’s valuation has been volatile since the coronavirus outbreak. The current 3.9% premium to cum-income NAV compares with the range of a 4.1% premium to a 10.8% discount over the last 12 months. Over the last one, three, five and 10 years, FSV has traded at an average premium of 0.7% and average discounts of 0.9%, 2.5% and 6.0% respectively. The trust’s board seeks a single-digit discount or a small premium to NAV in normal market conditions. Renewed annually, it has authority to purchase up to 14.99% and allot up to 10% of FSV’s issued share capital. In FY19, c 9.6m shares (c 3.6% of the end-FY18 share base) were issued, raising c £24.2m. As shown in Exhibit 1, allotments have continued at an accelerated pace in FY20; so far, a further c 13.9m shares (c 5.0% of the end-FY19 share base) have been issued, raising c £35.2m.

FSV is the second largest fund of the 12-strong AIC UK All Companies sector; the peers follow a variety of investment approaches. The trust’s NAV total returns are below average over the periods shown, ranking 11th over one year, 11th over three years, ninth over five years and eighth over 10 years. FSV is the only fund currently trading at a premium and it has a higher-than-average ongoing charge, although no performance fee is payable. The trust’s level of gearing is above the mean and, unsurprisingly given its focus on capital growth rather than income, it has a below-average dividend yield.