The FTSE 100 reached an all-time high this month, breaching its May 2018 record of 7,903 points. However, the latest Q4 GDP estimate did not reflect this optimism. A recession may have been avoided so far, but UK economic growth is flat with data showing no growth in the final quarter of 2022.1
Against this backdrop of clear disparity between the domestic economy and the UK blue-chip index, Alex Wright, Portfolio Manager of Fidelity Special Situations Fund and Fidelity Special Values PLC, explains why the FTSE 100 performance does not present a full picture of UK equities and outlines the opportunities available for value-focused investors.
“The UK’s blue-chip index reaching a new all-time high comes on the back of a resilient 2022 performance relative to other global indices, returning 5% including dividends versus an 8% fall for the S&P 500 and a 25% drop for the Nasdaq (in pounds)2. Positive performance of the index has been largely driven by sectors such as energy, mining and banks which have benefited from the macroeconomic backdrop of rising energy prices and higher inflation.
“However, if you dig a little deeper, you’ll notice a huge discrepancy in returns, with mid and small cap companies in particular lagging significantly. In fact, 2022 saw only a very small proportion of the FTSE 350 constituents outperform (c. 20%) – the lowest number on record since 1990, according to research by Berenberg.3
“While the near-term outlook is uncertain, attractive valuations and the large divergence in performance between different parts of the market create good opportunities for attractive returns from UK stocks in the next three to five years.
“History suggests that value tends to outperform in a higher rate environment given higher discount rates and a reversion to mean and, factoring in the dividends available in the UK market, there are tailwinds that should support UK equities.“
Financials look exciting
“With interest rates higher than we have seen for a long time, I favour financials, especially banks, where profits have been boosted by these rate rises. While banks have struggled to make a return on the costs of running current accounts as rates remained low over the last decade, the reversal in rate levels in the last 12 months has led to strong performance as banks are beginning to earn decent returns on equity again.
“NatWest, for instance, is now forecasting a return on equity for 2023 of around 15%, yet it is trading on about 6x those earnings. So, while this is now a higher quality than average company within the market, it is still trading on a dramatic discount. Banks will also be more resilient to a downturn as a result of these higher profits and, while they may experience some defaults on loans, their higher profitability provides them with a bigger buffer.
“Aside from NatWest, we also have holdings in the likes of Barclays, whose capital position has improved over the years now allowing for increasingly attractive distributions, as well as Irish market leader AIB Group, which is well placed to take advantage of the consolidation of the Irish banking industry from 5 banking groups into 3.
“The backdrop is also positive for life insurers, whose earnings have proved resilient during the pandemic and should continue to benefit from an acceleration in the pace of pension fund re-risking. The market may view the insurance space as quite cyclical, but as we saw through the Covid pandemic most UK life insurers continued to pay dividends and their earnings remained largely unaffected. We believe they are resilient businesses, with attractive dividends and strong balance sheets.“
Resilience and dividends
“Further resilience can be found in the likes of Serco, the government outsourcer and another top ten holding in our funds, which has been able to weather the inflationary environment given it benefits from a degree of inflation protection in its contracts. It is a non-cyclical, relatively defensive, business which benefits from a stable demand environment, like consumer staples, but for which we are only paying 11x earnings.
“The UK market traditionally pays higher dividends compared to most markets and should continue to do so going forward, with the portfolio well positioned to benefit. When considering a stock’s return potential, dividends can be an important contributor especially when the likes of NatWest, Imperial Brands, Phoenix Group, Aviva, Legal & General and Austrian oil & gas producer OMV all yield in excess of 7%.“
Mid and small cap opportunities
“The smaller end of the market cap spectrum is rich in investment opportunities given the lack of research coverage, so this has always been a big structural overweight for us, although we look for investment opportunities across the investment universe.
“Our funds currently have about 60% exposure to mid- and small caps, which compares to only about 20% of the FTSE All Share. Small caps have suffered particularly sharp deratings over the past year as they are seen as more cyclical, and therefore more vulnerable to an economic slowdown or recession. But in our view, some of the share price declines have been excessive.
“Take TT Electronics, a stock we bought in the second and third quarter last year, around half of its revenues come from the healthcare sector, which is pretty much a-cyclical, and the aerospace/defence industry, which is going through a recovery post-Covid. The market underappreciates its transformation and increased focus towards higher quality end-markets which command higher margins.“
Mergers and acquisitions to continue
“Merger & acquisition (M&A) activity has been unprecedented over the past couple of years mostly involving private equity players and US-based corporates willing to pay prices based on US valuations. While rising rates have dulled the ability of private equity groups to borrow, we are likely to continue to see bids from US and North American corporates, whilst most private equity funds have still got cash to invest and need to put it to work.”
