The UK could end up being one of the best-performing markets of 2019 despite Brexit, according to FE Alpha Manager Alex Wright, but investors should not wait around until the rest of the market catches onto this. 
It’s no secret that UK equities have been unloved since the country voted to depart the EU.
Research such as the Bank of America Merrill Lynch Fund Global Managers Survey have consistently shown that the UK is one of global asset allocators’ least favourite markets.
On the domestic front, figures from the Investment Association – which are illustrated in the chart below – show how UK-based investors have been fleeing the domestic market since the Brexit referendum was announced in 2015 by selling IA UK All Companies funds.
IA UK All Companies fund flows as % of total sector assets
Source: Fidelity, Investment Association as at 31 Aug 2018
But Wright – who runs the £3.2bn Fidelity Special Situations and £375m Fidelity UK Smaller Companies funds – said: “The unrelenting negativity that investors are demonstrating towards UK equities is making me feel more and more positive on their prospects for 2019.
“It might be counterintuitive to think that the UK market could be among the top performers globally in the year that we leave the EU (if indeed we do). But markets have a way of confounding expectations and surprising the consensus.”
The manager does not have a view on whether the UK will have a ‘hard’ or ‘soft’ Brexit, but his optimism is not based on either outcome.
Some 32 per cent of the fund’s underlying revenues come from the UK roughly in line with the 30 per cent for the FTSE All Share, so the portfolio is not tilted towards a particular Brexit outcome.
Instead, he argued that some certainty on the country’s relationship with the EU – whatever form it takes – will be enough to prompt asset allocators to take another look at the “cheap” UK market.
But Wright said that waiting for the rest of the market to return to the UK, adding that it is “an exciting environment” to be a contrarian investor.
“One thing I have learned from investing in unloved companies is that you shouldn’t necessarily wait for good news to become obvious before investing,” he said. “By investing when all the bad news is ‘in the price’ and no good news is expected at all, you put the odds in your favour. I think this is a situation we are in in the UK at the moment.”
The UK market is currently trading at 12x earnings; this compares with 14x for Europe ex-UK and 17x for the US. However, the manager finds it more insightful to compare like-for-like stocks, rather than focusing on market averages.
2019 P/E ratios
Source: Fidelity estimates, Thomson Reuters, Nov 2018
The chart above shows valuations of four Fidelity Special Situations holdings alongside one of the European or US counterparts. Lloyds, for example, “languishes” on a 7x P/E multiple while Belgian bank KBC – which has very similar characteristics and long-term growth prospects – is on a 40 per cent premium at 10x.
However, Wright said that a selective approach remains important as not all UK equities are equally attractive.
The manager said some domestic businesses are being unfairly ignored but others are “structurally compromised or financially unsound and therefore best avoided”. He will only buy unloved domestic stocks if he can see a balance sheet that can withstand a period of economic weakness and valuation that gives some margin of safety.
“Attractive valuations can be found across the market, in large and small companies, both international and domestic-facing,” the manager concluded. “My process rests on identifying unloved companies with the potential for positive change.
“And the number of unloved companies available to choose from now makes me think 2019 could turn into a surprisingly positive year for investors brave enough to buy UK equities before the good news.”
Wright has managed the four FE Crown-rated Fidelity Special Situations fund since 1 January 2014, over which time it has generated a first-quartile total return of 36.21 per cent. This ranks the fund 41st out of 238 IA UK All Companies members.
Performance of fund vs sector and index under Wright
Source: FE Analytics
He has also managed the Fidelity UK Smaller Companies fund since its launch in February 2008. Over this time the fund has made 402.79 per cent, which is the highest return in the IA UK Smaller Companies sector over this time frame.
Fidelity Special Situations has an ongoing charges figure (OCF) of 0.91 per cent while Fidelity UK Smaller Companies’ OCF is 0.92 per cent.