Value investing had a tremendous year in 2016 and there remains a big dispersion between sector valuations, says Fidelity manager Alex Wright.
The FE Alpha Manager, whose Fidelity Special Situations fund returned 14.42 per cent in 2016, says investors focused on value stocks can benefit in 2017.
“Growth stocks remain on very high valuations while value stocks are very low and even within sectors certain companies are at very different levels,” the manager said.
As the below graph shows, this is despite value stocks outperforming their growth counterparts by 17.22 percentage points.
Performance of value vs growth indices in 2016
Source: FE Analytics
While value investing has become more popular in recent months, the style still has more investors to win over from growth-focused strategies.
Indeed, mean reversion suggests that value stocks may make a more compelling argument for investment in the near term.
The FE Alpha Manager says there are three sectors he is buying broadly as part of his value-based approach and three specific stocks in highly valued sectors that he believes are undervalued.
The banking sector is one of the sectors Wright prefers despite the negative headlines and poor returns from the sector since the financial crisis.
Over the past decade, the FTSE 350 Banks index has fallen by 44.60 per cent, yet Wright’s Fidelity Special Situations fund has a weighting to the sector of around 11 per cent.
“We have a very large position in Citigroup – about 6 per cent – about 3 per cent in Lloyds, 2.5 per cent in Bank of Ireland and 0.5 per cent in Paragon,” he explained.
“Valuations are still extremely low and in the middle of last year got back to the relative lows of the financial crisis when in fact there has been a lot of improvement in the banking sector since then.”
“Most importantly balance sheets are far better capitalised than they were previously and there’s been no excess landing so you have very clean loan books.”
“There’s been a lot of consolidation in the banking sector where some small aggressive players have exited and some large players have consolidated away and you’ve seen earnings recoveries in these banks.”
“So even at the low interest rates that we are seeing today these banks are earning reasonable ROEs (return on equity) between 9 and 13 per cent – clearly lower than history but reasonable.”
“So this isn’t an expectation of earnings to improve dramatically from here – these earnings have already improved just the market is not paying up for these earnings which I think are now in more solid businesses than they were historically with certainly less risk.”
Wright also favours the construction sector, which the fund has a 10 per cent weighting, including an investment in building materials firm CRH which makes up 5.5 per cent of the portfolio.
“It is an area that has been performing strongly recently as politicians – particularly Donald Trump – talk more about infrastructure spending but what’s important to know is that this is coming from a very low level in Western markets,” Wright said.
“The average age of US infrastructure has never been older. There is a genuine underspend and need to spend here.”
“When you look at these names there is also benefit from margins to increase because there is spare capacity while spending has been low.”
He adds that other names in the fund including Speedy, Balfour Beatty and SIG, have had management changes while CRH made the acquisition of assets from the Lafarge-Holcim merger.
The oil sector is the last of Wright’s three favourites and makes up around 11 per cent of the fund’s portfolio holdings including Shell, a 7 per cent weighting in the fund.
The oil sector has struggled over the past five years but picked up significantly in 2016 as oil prices rose to more than $50 per barrel last year, after a challenging time for the producers.
Performance of FTSE 350 Oil & Gas Producers index over 5yrs
Source: FE Analytics
FTSE 350 oil stocks have had a rough ride over the past five years but moved into positive territory in 2016 for the first time since 2014.
“Why I like oil is the responsiveness of the supply side to a change in the pricing environment,” Wright said.
“As soon as you don’t spend money on an oilfield you start to see declines so globally you’ve seen four to five per cent per annum declines and in some areas in the US have up to 70 per cent declines.” 
“So therefore the big reductions in capital expenditure we’ve seen since late 2014 has already fed in to quite dramatic falls in non-OPEC production and that is correcting the global oversupply situation.”
“Obviously the recent OPEC deal will further increase the speed of that supply and demand imbalance being worked off – but that was not something that was core to our thesis which was based on the non-OPEC supply – but that is clearly also helpful.”
On a stock specific basis, Wright says there are a number of companies in overvalued sectors that investors have fallen out of love with.
“While the vast majority of the staples and defensive space is expensive, there have been some selective names that are starting to look interesting where there is also some change happening,” he said.
“We have initiated a position in Scandinavian Tobacco – one of these non-UK ideas – which is a spinout from Swedish Match.”
“It has had a big change in the management team and a big cost-cutting and working capital improvement drive which I think can be done better as a standalone company.”
In the UK sector, Wright highlights BT, a long-term holding but one in which he has dramatically increased over the past six months making it a top five position in the Special Situations fund.
“I think people have been overly concerned by the pension deficit which clearly with rising bond yields is shrinking not growing,” he said.
“Also a lot of the talk about splitting up the business and spinning out Openreach is very unlikely to happen.”
“And at its core BT is a very strong franchise, it’s something everybody needs, they have a very strong converged position now in terms of having a mobile business with the purchase of EE as well as the fixed infrastructure and TV – so that’s quite a strong consumer proposition.”
Elsewhere, Wright says healthcare company Shire is a big name that investors have forgotten about in favour of the larger peers such as AstraZeneca and GlaxoSmithKline.
“Big change to the business there with the Baxalta acquisition – I think that diversifies the business which reduces risk and the company is very cheap compared to its healthcare peers and therefore quite attractive,” he said.
“Again this is a new position over the last year and is a top 10 position at just under 4 per cent of the fund.”