There are multiple signs that the severe relative underperformance of value funds is about to reverse, according to FE Alpha Manager Alex Wright, who says this will benefit his Fidelity Special Situations, Fidelity UK Smaller Companies and Fidelity Special Values funds. 
Despite the uptick in bearish sentiment and some large headline market losses, investors have still been able to find decent gains from parts of the equity market over the medium term.
That being said, it has certainly been an odd period for risk assets. Indeed, thanks to trends such as huge levels of intervention from central banks and a continued sense of nervousness among investors, it has been more defensive areas of the market that have led global stock indices.
These have tended to be high quality ‘growth’ companies with low levels of debt, cash heavy balance sheets and earnings that are not dependent on a raging global economy.
On the other hand, ‘value’ stocks, or those which tend to be more cyclical, have been hit hard thanks to issues such as China’s economic woes and falling commodity prices. This trend is highlighted in the graph below, which illustrates the relative underperformance of the MSCI AC World Value index against the MSCI AC World Growth index over the past seven years.
Relative performance of indices over 7yrs
Source: FE Analytics
With nervousness still plaguing markets, investors could be forgiven for thinking funds that focus on high quality growth stocks – CF Lindsell Train UK Equity, Fundsmith Equity and Stewart Investors Asia Pacific Leaders to name just a few – will continue to rule their respective sectors and that value funds will remain at the beck and call of global market volatility.
However, Wright – who is one of the UK’s top-performing managers despite his clear value/contrarian approach – argues that this trend is about to reverse.
“Labels such as ‘quality’ and ‘defensive growth’ are used to describe companies where the market perceives a high degree of stability in their earnings and dividends. Although it intuitively seems sensible to invest in quality stocks in the face of a somewhat uncertain macroeconomic outlook, the last two years have seen a magnitude of outperformance which is usually associated with times of extreme economic stress, rather than modest recovery,” Wright (pictured) said.
“The prices you are asked to pay for these companies today leave little margin for error.”
“Many investors seem to be positioned for this trend to continue indefinitely. While it is easy to take comfort from a successful period of outperformance, complacency can leave you dangerously exposed if patterns of market leadership evolve.”
“The last few weeks have offered early signs that a change in leadership could be underway, and in many cases, investor’s positioning over the past two years will have left them ill-prepared for this.”
As Wright points out, value stocks have seen somewhat of a revival so far this year with the MSCI AC World Value index slightly outperforming its growth rival in 2016 with a 3.79 per cent gain, as some of last year’s worst hit areas have enjoyed a sharp relief rally.
However, though Wright is a contrarian investor, his funds haven’t fared too badly over recent years while other value-orientated strategies have struggled – such as Schroder Recovery, M&G Recovery and Investec UK Special Situations.
His Fidelity UK Smaller Companies fund, which he has managed since its launch in February 2008, has comfortably beaten its IA UK Smaller Companies sector and Numis Smaller Companies ex IT benchmark over three years while his Fidelity Special Values Trust is also well ahead of the IT UK All Companies sector and the FTSE All Share over that period.
While he has only managed the flagship £2.6bn Fidelity Special Situations fund – which carries five FE Crowns – since January 2014, it too is outperforming since he has been at the helm.
Performance of fund versus sector and index under Wright
Source: FE Analytics
However, most of Wright’s recent relative outperformance has been due to his bias towards smaller companies, an area that has beaten FTSE 100 stocks due to an improving UK economy and pro-business government.
Nevertheless, he is now finding more opportunities at the top end of the market-cap spectrum.
“My clients will know me as a contrarian bottom-up investor, and usually I am keen to reduce as far as possible any macro or thematic biases to the fund,” he said.
“However, in the current environment, a contrarian investor cannot help but be attracted to those parts of the market that don’t fit the quality perception, and where a wider range of investment outcomes is possible. Many of these ‘value’ categories have some exposure to the economic cycle.”
“Using broad brush strokes; banks, oil and construction stand out to me as areas that seem to be pricing in a recession.”
Of course, there have been many other industry experts who believe 2016 will be the year that value funds start outperforming again.
The likes of Psigma’s Tom Becket, Premier’s Simon Evan-Cook and City Financial’s Peter Toogood have all told FE Trustnet that they are upping their exposure to value strategies over recent months.
“Experience teaches us that fear and panic bring cheap valuations and a happy hunting ground for those who are willing to focus on the long-term potential that lowly valuations can bring,” Becket said.
“This is absolutely the approach we are taking with our investment strategy and we are sticking wholeheartedly to our philosophy that the only key to long-term investment success is to buy cheap assets and hold them until they become less cheap.”
The consensual argument as to why value should now about outperform is two-fold. Firstly, if global growth improves then more cyclical areas will prosper and, secondly, if financial markets do collapse then value will about beat growth stocks from a relative perspective as they are far less expensive.
Wright, who has beaten his peer group composite by more than two times over since he began running funds, says it is confident the former outcome will take place.
Performance of Wright versus peer group composite
Source: FE Analytics
“There is a good deal to be worried about in the global economy (when isn’t there?). But based on the many conversations I and our team are having with company management, I believe the chances of a ‘muddle-through’ scenario are much better than the market expects.”
“So far, it seems that the adjustment underway in industrial sectors can occur without a severe hit to confidence in the all-important service and consumer sectors. Unemployment in the US and UK continues to fall and incomes are showing solid growth.”
“Outside of some industrial and emerging-market facing sectors, we are not currently facing a recessionary scenario.”
As such, he thinks 2016 will prove to be supportive for his investment strategy.
“If this more benign macroeconomic picture endures, I believe the market will re-appraise the prospects of the stocks currently in the reject bin and the gulf of valuations will have to narrow. Could 2016 finally be the year for value investors?”
He concluded: “In my experience, when the risk premium is so high, it can help to focus on the fact that the price you pay for the stock more than fairly compensates you for the uncertainty of the outcome.”
