Top fund manager Alex Wright has said UK stocks remain ‘cheap and unloved’ as investors pull £1.33billion from the sector, but suggests more opportunity may lie ahead in what has been a sluggish market.
The FTSE All Share index has returned 13 per cent this year but investors have generally been deterred from the domestic market because of the double blow of Brexit taking effect and pandemic uncertainty.
Wright, who manages the £3billion Fidelity Special Situations and £935million Fidelity Special Values, is confident 2022 may present an opportunity for the ‘significantly undervalued’ UK stock market which is ‘reasonably valued in absolute terms’ now the headwinds have largely passed.
UK stocks are ‘cheap and unloved’ but they may offer value opportunities in 2022
Indeed, Liberum analysts recently noted: ‘It is rare to find a market that is both cheap and fast growing, yet when we look at global equity markets right now, the UK stock market offers just that.’
Wright thinks this is largely because of the faster than anticipated recovery and significant uptick in M&A activity which has been a ‘key contributor to performance’.
‘We are likely to see more bids if valuation discounts compared to overseas companies do not close.’
Fidelity Special Solutions and Fidelity Special Values both focus on long term capital through investment in UK listed companies.
We look at the possible tail and headwinds for the UK market and Wright’s top picks for 2022.
Supply constraints hit construction
Alex Wright manages Fidelity Special Situations and Fidelity Special Values
While the UK is likely to shrug off the worst of the pandemic by 2022, the emergence of the Omicron variant has jolted markets leading some to believe it could stymie growth.
But it will be the issues of supply chains and inflation that are likely to dominate in 2022, particularly for construction.
Fidelity Special Situations has minimal exposure to the industry – around 3 per cent of the portfolio according to Hargreaves Lansdown – and that is likely to be cut further as costs rise.
‘This is a key topic in our conversations with companies, as we try to assess how they are affected and their ability to pass the extra costs onto their customers. We favour companies with strong supply chains and those well positioned to capitalise on the shortages in areas such as building materials and car distribution and hire,’ says Wright.
‘We have reduced our exposure to areas faced with meaningful rises in input costs, such as UK housebuilders.’
As activity surged once restrictions had been lifted, so too did demand for construction materials. Trade barriers as a result of Brexit have led to price increases as well as increased supply chain lead times.
The industry is also reportedly struggling to cope as migrant worker numbers fall by 8.3 per cent, according to the Construction Industry Training Body.
Wright highlights Travis Perkins’ latest update in which it said costs of building materials had risen 11 per cent in the third quarter alone.
However the fund manager is bullish on other industries that are facing supply issues, notably car dealership company Inchcape – one of the fund’s top 10 holdings – and Halfords.
‘We believe [they] are well positioned to take advantage of supply constraints in cars and bikes (given superior supply chains), as is vehicle rental business Save Northgate.
‘We also have exposure to building materials in short supply such as bricks through brick distributor Brickability and also own Norcros, which makes showers and tiles.’
Other consumer-facing businesses may have a harder time given the recent rise in the cost of living.
Fidelity Special Situations recently sold its small position in Wagamama owner the Restaurant Group as ‘consumers have not been out as much as expected.
‘The company is likely to struggle to pass on rising cost pressures in a lower demand environment.’
‘Our preference is for specialist distributors operating in areas where supply has shrunk, as they can capitalise on rising prices but are less affected by rising input costs.
‘Conversely, we remain meaningfully underweight consumer staples, which remain expensively valued, and global mining stocks, many of which trade on peak earnings amid deteriorating supply/demand dynamics.’
Inflation may boost financial stocks
Having suffered since 2009 from rock-bottom interest rates and tight monetary policy, banks and other financial services companies are looking forward to rejuvenated economies and the possibility of rising rates.
For banks, low rates reduce the margins to be made on lending and uncertain job markets bring the prospect of bad loans being written off. For financial services, customers confident in their finances are more likely to purchase savings, investment and insurance products.
The MSCI World Financials Index is up 22.62 per cent in total return terms year-to-date, outperforming the MSCI World Index which has delivered 16.82 per cent.
Fidelity Special Situations is already well weighted towards financial stocks; Legal & General, Aviva and Phoenix Group are among its top 10 holdings.
‘Our largest sector exposure is to life insurers, which remain cheaply valued, despite strong balance sheets, positive earnings outlooks (thanks to a healthy demand for protection products, bulk annuities and pension de-risking) and attractive dividends,’ says Wright.
Away from immediate supply constraints and inflation, the pandemic has accelerated change in most sectors, not least where competitors have exited.
‘The lockdowns have allowed faster restructuring as companies have used the downtime to accelerate changes (e.g. refurbishing of premises, or digitalisation of their business) and realised cost savings,’ says Wright.
‘A reduction in the number of competitors in areas such as specialist retailers, travel and leisure, banking in Ireland and drink distribution should be reflected in improved profitability in future.
‘Our holdings in M&S, Ryanair, AIB and C&C should benefit directly from these capacity exits.’
SPECIAL SITUATION FUNDS
|Fidelity Special Situations
|Jupiter UK Special Situations
|Blackrock UK Special Situations
|Liontrust Special Situations
|Artemis UK Special Situations
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