A guide to Fidelity Special Values Trust

When you look at the numbers, the attitude towards UK equities is befuddling to a certain degree. Despite economic challenges, the FTSE All Share has proven resilient, returning almost 20% in the past three years*. That’s more than any other major market, barring the US, with attractive opportunities across companies of all sizes.

The FTSE All Share rose almost 11% last year alone, beating the likes of Europe and Emerging Market returns**. But momentum and sentiment appear unchanged, as UK-focused stocks suffered their worst year on record in 2024, with investors pulling almost £10bn from the market***. It’s the continuation of a long-term trend, with assets being pulled consistently since Brexit in 2016, and the economy dealing with a number of challenges thereafter.

What we have now is a disconnect between share price performance and valuations. Take the FTSE 100 for example. Many companies have recovered since Covid – it reached its all-time high in May 2024 and is consistently above 8,000 – but valuations have not recovered to the same extent, with the underlying P/E for the FTSE All-Share standing at 12x below the long-term average of 14x****. Part of this is down to mid and small-caps struggling to a degree, but sentiment plays a major role.

Uncertainty in the UK has created a very interesting dynamic. The London Stock Exchange is struggling to attract new listings, while M&A has been rife. It leads to the big question UK fund managers often get asked: What can be done to close the UK discount?

“I really don’t care if people are starting to take notice of UK equities performing better. What I care about is producing strong performance for investors in my portfolio. This is what matters; there are opportunities and the portion of the market I am focused on is working well.”

That’s the view of Alex Wright, manager of Fidelity Special Values Trust (FSV). FSV aims to achieve capital growth by investing primarily in unloved UK companies and waiting for them to come back into favour. The portfolio is multi-cap, investing in 80-120 stocks, although it does have a bias toward small and mid-cap holdings. Performance has been very strong, with a share price total return of 26.7% over the past five years^ – not only the highest in the Association of Investment Companies UK All Companies sector, but more than double its nearest competitor. FSV also pays a dividend yield, which currently stands at 3.07%^.

Having managed FSV since 2012, Alex also runs the open-ended Fidelity Special Situations fund. He initially joined Fidelity in 2001 as a research analyst. He runs the portfolio with Jonathan Winton, who joined as co-manager in 2020. Jonathan joined Fidelity in 2005 as an analyst, covering various sectors including pan-European support services, small-cap technology, and beverages & tobacco. He also manages the Fidelity UK Smaller Companies fund.

A contrarian approach with downside risk at its heart

Alex and Jonathan’s investment style is best described as contrarian. This means they look for stocks that are out-of-favour, but that must meet two strict criteria. The first is the preservation of investors’ capital: the managers aim to do this by choosing companies with exceptionally cheap valuations or an asset, such as intellectual property or inventory, which has the potential to limit share price falls. Secondly, they look for companies where there is a catalyst for significant earnings growth. Although this approach often puts the managers on the opposite side of consensus, they are patient investors and are prepared to wait for stocks to deliver.

“It’s not about finding a nice story and trying to reverse engineer some downside protection. We look and say how volatile are the earnings of a company over the long-term? It gives us a greater idea of the range of outcomes over 3-5 years,” says Alex.

They try to steer clear of heavily indebted companies, as well as look closely at whether there is negative working capital or off-balance sheet liabilities.

Alex says: “We also think about the stability of the earning streams backing up that financial risk. There are companies with high levels of debt to EBITDA (National Grid, SSC, Imperial Tobacco) but have steady earnings streams in parts of their business to service that. It is not just about absolute debt to EBITDA, but the business model it is attached to. It is not about matching earnings and financial risk together.”

The team steer clear of any valuation risk. Businesses can have good balance sheets and steady earnings, but you can easily pay too much and lose money on those shares – hence the strong preference for a contrarian process.

There is a three-stage cycle for companies held by FSV. The first is the initial position, which is subsequently increased when the team’s conviction increases. Once this operational change in a company start, to take effect and there are signs of growth, companies move to the second stage, where the perception of change by the wider market leads to the stock re-rating. The third stage is when the story of the company is well known (other investors buying growth) and the stock has reached its upside target and there is less downside protection. At this point the managers will look to reduce the position.

FSV aims to produce in excess of 3% net outperformance across a market cycle. As mentioned, the fund maintains a bias towards small and mid-caps where these contrarian stories can garner stronger returns.

Why now for this portfolio?

• Performance has been extremely strong over the long term, leading the AIC UK All Companies sector over both five (26.7% share price return) and 10 years (132.9%)
• Although expected given its contrarian nature, FSV is still on an attractive underlying P/E of 9.8x (compared with 11.6x for the FTSE All-Share)
• It has consistently reaped the benefits of strong M&A activity
• SMID focus increases the chances of greater long-term returns (also increases the risk)
• Strong focus on downside protection
• Strong domestic play with 15% overweight to companies purely focused on the UK economy
• Still on an attractive discount (7.6%) despite excellent long-term performance

Manager’s View

“The trust and the market have been very strong over the past 12 months. The market at 12x is attractive – but not bargain basement. The trust is at 10x, which we believe is still good value and that is across companies of all sizes.”

Having seen the FTSE All Share return 10.9% in the past 12 months – and the underlying P/E reach 12x (versus a long-term average of 14x), Alex believes the UK is still attractive, but no longer at extreme levels. But the dislocation in markets is present, and this creates opportunities in the areas of the market he focuses on.

“There are plenty of things we don’t own like Diageo and Unilever – big players which are expensive. The same is true in mid-caps, with names like Rightmove and Sage. By contrast, we have big positions in banks and companies, like Imperial Brands, these are still cheap on 7-8x. There are opportunities across the entire market-cap.”

Interestingly, Alex does not buy into the argument about there being a stigma around UK equities. By contrast, he feels it is more a case of US equity performance dominating the rest of the world. He says the 10-year figures for US equities have captured the imagination of investors, with the rest of the world being overlooked to some degree as a result.

One of the reasons equity performance has been so good for the UK, and particularly for FSV, has been the growing M&A activity seen in the market over the past three years. Alex says this is one of the reasons why earnings per share (EPS) in the UK has been stronger than the global market.

Over the past couple of years, companies held by FSV have been subject to a number of bids, with the likes Hurricane, Medica, Finsbury Food, Ascential, Ten Entertainment and Base Resources among those to complete. Recent deals have been completed on a 30-50% premium range, boosting the performance of the trust.

Portfolio activity

FSV is bottom-up in nature, with the goal of identifying companies which have been undervalued by the market, with a potential catalyst for change. A bi-product of this investment approach is a focus on four specific “supersectors” (financials, defensives, resources, and other GDP-sensitive companies).

Financials

Financials is an area Alex believes investors have shied away from since the Global Financial Crisis, due to the risks and complexities associated with it. However, he is steadfast in his belief that the sector has been cheap and also has a number of varying models – meaning there is a lot of choice. He cites banks as an example of this; while the likes of NatWest and Lloyds will have similar performance, others like Standard Chartered might be based in the UK, but have Singapore and Hong Kong as their biggest markets.

He has been a supporter of insurers, but has reduced the position recently due to strong performance, citing the likes of Aviva, L&G and Phoenix. He also holds non-life insurance positions in Conduit and Direct Line, as well as asset and wealth managers like Brewin Dolphin, Brooks Macdonald and Man Group.

Rate cuts clearly have a big impact on the sector, which is why Alex likes to have a diversified bucket of financial holdings. Retail banks are affected by interest rates because the current account business model relies on free banking and that money is funding zero-cost deposits. So while this may impact banks where current accounts are a big driver of performance (NatWest/AIB), this is not the case for the likes of Barclays and Standard Chartered.

He says: “Rates moving from 5% to 3% does not make a big difference – as banks can cut the cost of their interest bearing deposits. But obviously, going down below 2% or 1%, you can’t cut below zero. In that scenario the earnings of banks will be harmed.

Defensive holdings

The defensives bucket has not changed much in the past 12 months – although some stocks have become less attractive due to strong performance (stage 3 of the investment cycle). Examples include Smart Metering Systems (which was bid for and acquired in the first half of 2024), as well as support services companies like Serco, Babcock and Mities, all of which have seen positions reduced****.

Names added to include consumer health and hygiene brand owner Reckitt Benckiser and retailer Tesco – although interestingly Alex has already sold some of the latter. He says: “Tesco was unusual as I owned it through what was the very big turnaround under the previous management team, when margins were very low and the stock was priced as if it was not going to recover its prior margin levels. It played out quickly and we made a lot of money.

“I regularly visit the firm as we own a number of Tesco suppliers (tobacco etc). We were not thinking of it as a new position but we were surprised Tesco was doing well at a time when the industry was seeing capacity shedding. Morrisons and Asda were shutting stores, meaning capacity was coming out of the industry – by contrast Tesco was doing well, but was still trading on 10x earnings. We actually bought it at phase two of our investment cycle.”

Resources

This is an area where FSV has the least exposure. Not only does falling inflation often lead to reduced demand for commodities, but Alex also believes commodity prices are too high. He believes the oil price has had a strong run since 2020 and has reduced exposure. Recent sales here include the likes of OMV, Shell and Schlumberger.

The team has added a position in Total Energies, a company Alex says has been trading off because of political instability in France.

He says: “Although French listed, Total gets about 6% of its revenues from France. The stock trading off because of local instability is anomalous and Total has also done a good job of investing counter-cyclically – with much less of the flip flop in and out renewables.

“Total kept investing in the base business, so while its valuation today looks cheaper than Shell, if you go out three or four years the valuation really looks different, as a number of new oil & gas projects come online. Contrast that with Shell, which does not really have any new projects that come on in the next five years.”

Any other portfolio changes?

The other GDP-sensitive segment has arguably seen the most changes, with holdings in the likes of commercial property and housebuilders. FSV has had no exposure to commercial property since 2021, but Alex added a few small positions (Empric Student Property, Warehouse REIT and NewRiver REIT). He says yields now look attractive in areas where rents have substantially increased. Despite some positive fundamentals, many of these companies are still trading at a 25-35% discount. Each position is around 75 basis points in the portfolio.

Other additions in this space include construction and materials businesses Genuit and Howdens, both of which have grown market share at a time when their respective industries have struggled.

“Both are higher quality companies compared to the portfolio on current earnings for 2025 (15-17x). They could be higher because the market is improving and people are missing the market share gains, which are going to be bigger than expected,” adds Alex.

Alex says the team are also finding opportunities in advertising (WPP) and staffing (Hayes).

One of the largest overweights Alex has in the portfolio is exposure to the pound. While the FTSE All Share’s domestic exposure has fallen below 25% in the pound****, FSV is between 35-45%, something Alex believes is the biggest risk position in the trust. This means if the pound falls, FSV will struggle.

“Since 2016, UK domestics have looked more attractive versus international earners. That is why we have been overweight and have added through the GDP-sensitive bucket,” he adds.

Market-leading performance

FSV has been incredibly successful under Alex’s tenure, leading the AIC UK All Companies sector over both five (26.7% share price return) and 10 years (132.9%)^. It is also ahead in terms of NAV total returns over five (42.1% vs. 13.6) and 10 years (135.9% vs. 96.7%)^. The contrarian style will have supported performance in recent years, with growth stocks out of favour in a rising rate environment.

What else do investors need to know?

The board allows for a maximum gearing level of 40% of net assets, however it is typically much lower. It currently stands at 9%^, which is close to the long-term average. Alex says this is due to both the increase in the cost of borrowing and the fact that although valuations of UK equities are attractive compared with the US, they are less so when compared to their own history.

The board of FSV will look to keep the discount of the trust in single digits, and will consider buybacks if it breaches this level. Alex says he is surprised the trust is still at a discount of 7.6% (the five-year average is 4.8%)^^, considering the strong performance in that period. This is more surprising given he has seen more interest in the open-ended fund, which does not have the discount applied.

While the focus is on long-term capital growth, dividends have formed a big part of FSV’s returns. The board pays dividends twice a year. Total interim and final dividends came in at 9.54p for the last financial year, representing the 15th consecutive year of dividend growth.

Outlook

Strong outperformance can continue given contrarian focus

Alex is confident FSV can continue to deliver low double-digit returns over a three to five-year view, considering where fundamentals and valuations are in the UK at this point. It is hard to disagree, given the strong performance already seen, coupled with the contrarian nature of the portfolio. The UK is still unloved and there will be significant dispersion in performance from here – that creates opportunities across companies and sectors – and this is what Alex and the team have shown they can take advantage of. Add in the current discount level and this could still be a very attractive entry point for this portfolio.

*Source: FE Analytics, total returns in pounds sterling, 14 January 2022 to 15 January 2025
**Source: FE Analytics, total returns in pounds sterling, 12 January 2024 to 14 January 2025
***Source: Calastone
****Source: Fidelity Special Values presentation, January 2025
^Source: Association of Investment Companies, 14 January 2025
^^Source: FE Analytics, figures at 14 January 2025
^^^Source: Fidelity Special Value annual report, 31 August 2024