Compelling valuation opportunities in the defensive areas of the UK market has led to Fidelity International’s Alex Wright to up his positioning to the highest levels in the history on the two portfolios he oversees.
Wright – who oversees the Fidelity Special Situations and closed-ended Fidelity Special Values fund – said that ongoing political chaos in the UK, US-China trade tensions and weaker fundamentals have created a challenging environment for UK equity investors. 
But while a cautious approach is needed, said the FE Alpha Manager, attractive valuations can be found.
“The sizeable risks and uncertain outlook mean that the UK remains very much out of favour with both global and domestic investors,” Wright (pictured) explained.
“For example, in July alone, investors withdrew £1.2bn from UK equity funds.
“The valuation of the UK market reflects this with a P/E [price-to-earnings] multiple that is low both relative to history and other equity markets globally.”
In addition, Wright said that there has been a significant divergence in valuations of value and growth stocks, which is throwing up some interesting opportunities.
“Despite value stocks having underperformed for a number of years, they have suffered further significant underperformance this year as, globally, interest rate expectations have fallen further from already low levels,” he explained.
As the below chart shows the MSCI United Kingdom Growth index has risen by 19.90 per cent so far this year, while the MSCI United Kingdom Value index is up by just 8.90 per cent.
Performance of indices in 2019
Source: FE Analytics
Wright added: “It’s not clear what will trigger a reversal in this growth-over-value trade, but it is clear that investors in growth equities are taking on much more risk that they have done in the past given the valuations they are paying.”
Rather than seek comfort in growth stocks, therefore, the manager has found some compelling opportunities in the value space and one area in paticular: defensives.
“Although I see a broad spread of value across the market, worsening fundamentals mean I am increasingly finding value in defensive stocks which I have increased to their highest overweight in history in the portfolios,” said Fidelity’s Wright.
“The UK market is a good source of defensive companies, both classically defensive and others with more hidden defensive qualities.”
Among the ‘classic’ defensives he has added to both the Fidelity Special Situations and Fidelity Special Values funds is Imperial Tobacco.
“Tobacco companies have de-rated significantly with Imperial now trading at an attractive 7.2x P/E multiple and offering a well-supported 9.1 per cent dividend yield,” he said.
“I hold it in preference to BAT [British American Tobacco] due to its stronger balance sheet and its promising new vapour innovations which are underappreciated by the market.”
Another classic defensive position the manager has opened up in the portfolios is ContourGlobal, a utilities stock specialising in power generation.
Source: Fidelity International
Among the ‘hidden’ defensives, he has added to the portfolios is educational publisher Pearson which continues its transformation from print to digital and has countercyclical characteristics.
“It performs well in a US economic downturn as education enrolment picks up,” he said.
As well as adding more defensive exposure to the portfolio, the Fidelity Special Situations manager has been trimming exposure to cyclical stocks and banks, in particular, amid deteriorating fundamentals of the sector.
Indeed, the manager noted that the significant move down in global bond yields will likely put major pressure on the net interest margin for banks.
“For most banks there are few avenues left to offset this margin pressure,” he added. “Most have little room left to cut costs and provisions are already at record lows.
“Unlike in 2009, all banks are well capitalised, encouraging competition. It’s therefore not an option to simply raise borrowing rates to compensate.”
As such, Wright – a long-term backer of Lloyds Bank – has recently sold out of the holding given the changing investment case.
“In line with our original thesis, the company was successful in cutting costs and driving efficiencies, but I saw limited upside,” he said.
“The bank has now become a bellwether for the UK economy with its future performance tightly linked to the performance of the UK mortgage market and interest rates.”
Wright said he prefers to own companies in control of their own fate, something that is no longer possible for the bank.
In addition, Wright said he also sold out of overseas banks Bank of Ireland and Discover and trimmed his position in Citigroup.
He hasn’t sold out of all banks though and continues to hold Royal Bank of Scotland, which he said is at an earlier stage of its recovery and still has room to evolve into a high-return back with excess capital.
Another exception to his reduction in cyclicals is UK-focused retail landlord Hammerson. Despite the challenges facing the retail sector, Hammerson’s 70 per cent discount to net asset value “more than compensates”.
“This extremely low starting point offers limited downside and we expect management to pursue further asset sales and bring down leverage,” he added.
Wright manages the £816m closed-ended Fidelity Special Values and £3bn open-ended Fidelity Special Situations funds.
The Fidelity Special Situations fund targets long-term capital growth through investment up and down the market capitalisation scale.
The contrarian manager favours companies that are likely to have gone through a sustained period of underperformance already but where the downside is limited. He focuses on unloved and undervalued companies which he believes the market has overlooked.
Performance of fund vs sector & benchmark under Wright
Source: FE Analytics.
The £3bn four-FE Crown rated fund has returned 46.47 per cent since Wright took over in January 2014, compared with a 34.75 per cent gain for the average IA UK All Companies peer and a 38.49 per cent rise in the FTSE All Share benchmark. It has an ongoing charges figure (OCF) of 0.91 per cent.