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Fidelity’s Karunathilake: Time to focus on high quality

05 May 2017

Aruna Karunathilake, manager of the Fidelity UK Select fund, explains why his portfolio underperformed in 2016 and how he has positioned for the year ahead.

By Rob Langston,

News editor, FE Trustnet

The heavy rotation away from quality growth companies last year left some fund managers reeling as investors piled into value stocks but Fidelity’s Aruna Karunathilake says investors shouldn’t get too far ahead of themselves.

Value stocks found favour as optimism over global growth grew prompting investors to seek out companies set to rise for the first time in years.

Indeed, the FTSE World Value UK index rose by 29.63 per cent during 2016, while its FTSE World Growth UK counterpart increased by just 8.4 per cent.

One fund affected by the rotation was Karunathilake’s five crown-rated Fidelity UK Select, which returned 8.8 per cent compared with a 10.82 per cent gain for the average IA UK All Companies sector fund and a 16.75 per cent rise in the FTSE All Share index – the first year it has underperformed both since 2012.

Performance of fund vs sector & benchmark in 2016

 

Source: FE Analytics

“2016 was a challenging year for the fund and quality [growth] investing in general,” explained Karunathilake, who has managed the fund since 2007. “In my view, the main reason was an increase in global growth expectations through the second half of last year.

“Initially the impact of massive Chinese fiscal stimulus washing through the global economy led to a pick-up in economic growth indicators.

“Later in the year the election of Donald Trump led to an expectation that growth-friendly policies such as tax reform and infrastructure programmes would be implemented.

“The stock market reacted by selling higher quality growth stocks and moving into lower quality value stocks, which it often does when growth picks up.

“At the same time there was a sharp upward move in cyclical stocks relative to defensive stocks.“

“Following this in my view a lot of improvement in growth has been priced in and there is a risk of disappointment if the pick-up is not sustained.”


Added to that, Karunathilake says major economies have failed to get to grips with debt since the financial crisis with no reduction in debt-to-GDP since the financial crisis.

The Fidelity manager says high levels of indebtedness are likely to act as a headwind to long-term growth despite better short-term indicators.

He said: “It is a good time to focus on high quality [stocks] that can do well even in tougher times especially since they’ve been out of favour of late.”

During the first quarter of the year, Karunathilake made several changes to the portfolio reducing exposure to cyclical holdings in the commodities sector that performed well. He also capped exposure to stocks such as engineer Weir Group and construction-related companies like Wolsey.

New additions to the portfolio included Sage and London Stock Exchange Group, “strong franchises that we have owned in the past and know well”.

“Both were left behind in last year’s rally which left valuations looking attractive and provided opportunity to buy back into these stocks,” said Karunathilake.

Performance of bought equities over 1yr

 

Source: FE Analytics

Another new addition to the portfolio was Essentra, FTSE 250-listed plastic and fibre products provider, which Karunathilake describes as a restructuring story.

“It’s a fundamentally good business but suffered a large drop in profits after being poorly run by the previous management team,” he said. “I think there’s now scope for recovery under a new CEO with a good reputation for turning around performance with what should be a solid business in the long run.”

Looking ahead, Karunathilake says the snap UK election in June is likely to have a positive impact on markets as it creates greater certainty around Brexit negotiations.

“We’re generally positive for chances of the UK securing a more favourable exit from the EU,” he said. “The government will be in a more comfortable negotiation position knowing they don’t have to face the electorate in 2020, just a year after the formal end of the Article 50 process.”


He added: “Brexit itself is very much a known unknown, it’s very difficult to predict the likely outcome and allow it to influence investment decisions too much.

“In any case, the UK stock market is very international: roughly two-thirds of earnings come in from overseas. Brexit is not going to be a dominant factor driving market returns.”

“As we progress through the Article 50 process we’ll continue to see swings in market sentiment toward domestic companies that will throw up opportunities to buy into good businesses at attractive valuations.”

Karunathilake says he currently has a moderately high exposure to domestic earnings but expects that to reduce as more investment opportunities present themselves.

“My investment approach through Brexit is to stick to my process of identifying strong franchises whether domestic-focused or international and invest in them when valuations are attractive.”

Over 10 years the fund is up by 104.74 per cent compared with a 76.17 per cent gain for the average sector fund and a 71.64 per cent gain for the index.

Performance of the fund vs sector & benchmark over 10yrs

 

Source: FE Analytics

The fund had an ongoing charge figure (OCF) of 0.95 per cent for the year-ending 29 February 2016.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.