Refusing to hold popular ‘expensive defensives’ such as tobacco and utility stocks has contributed significantly to Fidelity Special Situation’s underperformance so far this year, according to Alex Wright (pictured). 
The FE Alpha Manager, who has been at the helm of the fund since 2014, says these areas of the market are too fully-valued and continues to like oil & gas and financial stocks despite the fact they are unloved by investors.
Another area of the market that he believes is a rich hunting ground, given its lack of popularity, is the stocks that have substantial pension deficits but nevertheless offer strong bottom-up credentials.
“With the safe, defensive companies which I think are at high valuations such as BAT and GlaxoSmithKline, I think that not owning those versus those that do in the index has been a detractor from performance,” he said.
“With those types of stocks, that perceived safety of earnings has continued to re-rate within the market, with many participants scared of taking on stocks where there is uncertainty which is very much my process.”
“I’m looking for companies where the outlook is uncertain but where I think our work and due diligence can allow us to get an edge on what may happen in terms of positive change going forwards. If that actually comes through, that’s where the outperformance in the fund comes from.”
Year-to-date, Fidelity Special Situations is in the third quartile, having returned 6.56 per cent compared to its sector average’s return of 6.9 per cent and its FTSE All Share benchmark’s return of 11.62 per cent.
It also has a bottom-quartile annualised volatility and maximum drawdown (which measures the most potential money lost if bought and sold at the worst possible times) over the same time frame.
Performance of fund vs sector and benchmark in 2016
Source: FE Analytics
That said, Wright adopts a long-term approach to stock selection, given the value mandate of the fund. Over his tenure, the fund has outperformed its sector average and benchmark by 5.79 and 4.57 percentage points respectively with a total return of 18.62 per cent.
“Going on to look at factors over the last three years, the market has very much been very much bifurcated,” he explained.
“There are some very expensive companies out there and I would suggest that sectors such as tobacco, staples and utilities all look very expensive versus history and therefore overall, the market looks to be at a reasonably high valuation versus history.”
“But, there are some very cheap companies out there – the likes of banks, energy companies and companies with pension deficits have been in the news recently as well.”
“People are steering clear of the stocks that are often hard to analyse where things have maybe not been going so well recently and people are shying away from them. I think within those sectors there are some definite value opportunities – I’ve been taking advantage of some of those and own a number of companies across those types of stocks.”
Fidelity Special Situations currently has an 8.6 per cent weighting in oil & gas stocks, which is actually a 2.5 percentage point underweight versus its FTSE All Share benchmark.
However, many investors have been steering clear of the oil & gas space altogether, given the volatility of the oil price over the last 18 months and concerns that some companies in the sector are paying their dividend yields out of debt.
Performance of crude oil price over 18months
Source: FE Analytics
“By far and away our biggest position is Shell at 6.5 per cent, then we own a basket of other oil-producing companies,” Wright said.
“This is very much based on analysis of the supply side. Clearly oil prices have fallen dramatically since late 2014, returns and profits have fallen significantly as well so those companies do look expensive on current earnings.”
“But actually, when you look at what’s happening to the market here, in oil there’s a very quick supply response to lower prices.”
“As soon as you stop spending on capex, oil fields start to decline by between 3 and 5 per cent - much more than that if you look at some areas such as US shale which can decline by between 50 and 70 per cent per annum without new capex.”
As such, he points out that the drop in oil price already means the global supply is falling dramatically year-on-year, which is beginning to clear some of the excess inventories and rebalance supply and demand.
“Shell is now yielding more than 7 per cent and I think that dividend is secure if oil moves into the mid-50s [dollars per barrel] and is very much payable from cash at that point over the next couple of years. I think that’s quite an attractive total return shareholder story with more capital upside from some of those smaller [exploration & production] names,” he added.
One of the biggest sector overweights in Wright’s fund though is financials, which accounts for 35.2 per cent of the portfolio and is a 10 percentage point overweight versus the benchmark.
Of these, approximately 10 per cent are banks – an area of the market that has been avoided by many due to its vulnerability in the current low interest rate environment and its susceptibility to heavy fines.
Fidelity Special Situations’ largest individual weighting is Citigroup at 5.6 per cent, followed by Lloyds Group at 2.5 per cent and the Bank of Ireland at 2 per cent. He also holds smaller positions in Barclays and Paragon.
Performance of UK stocks over 3yrs
Source: FE Analytics
“Each of these names have some stock specific drivers, but also when you look at the banking sector as a whole I think it’s a very unloved sector,” Wright said.
“Banks’ relative price-to-book valuation versus the market and history shows we are basically back at 2008 lows, which is an incredibly low valuation.”
“I think what’s been happening in the banking sector since 2008 is this dramatic improvement in both the balance sheets of these companies and the potential earnings of these companies. We’ve already seen earnings go up dramatically since the trough of 2008, yet valuations haven’t moved.”
The manager adds that capital has been rebuilt to more comfortable levels across many companies in the sector, with Lloyds now returning excess capital in the form of dividends and Citigroup executing a share buyback scheme.
He also says that there are reasonable returns on equity across the sector and, with valuation pricing in at around eight times current earnings in some cases, cheap asset prices allow further scope for earnings to recover.
“I think there’s a lot of value in banks and also across the general financial space. In fact, when you look at my financial weighting, it continues to be very high. Most of it is actually outside of the banks across insurance companies, also in real estate and some market structure names which I think are attractive,” he continued.
Spanning across sectors, Wright says that some companies with pension deficits are also attractive ‘buy’ options at the moment, given that it is a complicated area which investors tend to shy away from.
While he says that some companies do harbour pension deficits which are problematic (the manager recently sold out of BAE for this reason), he points out that there are still opportunities in this area as long as thorough research into each company is conducted.
“I think if you do the deep analytical work across the sector, you can get into what is going on with the pensions and see whether this is supportable by the company and whether that is actually baked into valuations,” he explained.
Examples of stocks the manager holds that have pension deficits include BT, sewing thread manufacturer company Coats and Royal Mail.