Industry Voice: Alex Wright, portfolio manager of the Fidelity Special Situations Fund and Fidelity Special Values PLC, analyses how as a contrarian investor, he has had to adapt to changing market conditions in order to stay ahead of the market. He also discusses why he has recently been drawn to more defensive areas.
Over the last few years there have been two fairly distinct market regimes which have impacted the types of shares that have been in and out of favour.
During 2014 and 2015, falling bond yields caused stocks with defensive and predictable earnings to become extremely widely owned relative to cyclical stocks. As such, there was very little value among defensive stocks.
However, since the first half of 2016, expectations for global growth and inflation have risen, and valuations in some cyclical stocks now reflect a fairly optimistic view of the future. As a result, portfolio positioning has evolved and adapted to the changing market conditions.
More recently, I have been finding an increasing number of bottom-up opportunities in defensive businesses, and relatively fewer cyclicals. We produce the analysis in fig 1 as part of our monitoring of macroeconomic risks impacting the fund and it shows how portfolio positioning has evolved over time. These weightings are primarily an outcome, rather than something I target.
While some previously popular stocks such as BAT or Reckitt Benckiser have underperformed significantly over the past year or so, and may look appealing on dividend yield and P/E metrics, significant debt piles at the companies mean they are not yet attractive to me on a more revealing EV/Sales basis. In addition, these are businesses which have been optimised over many years, meaning positive change to profit margins is more likely to be behind us rather than ahead of us.
Although I am yet to find much value in the most obvious defensive sectors, such as large-cap staples, there are a number of ‘hidden defensives' - companies in sectors which are generally regarded as cyclical, but where the companies themselves have limited exposure to the economic cycle. In some cases, in fact, a weakening economy would work in their favour.
Payments, petrol stations and coffee cups
When people think of the industrials sector, they tend to think of engineering and manufacturing businesses heavily linked to economic growth cycles and capital spending.
In reality, the industrials sector covers a hugely diverse range of businesses, including some which are have much more defensive business models than the general view of ‘industrials' would suggest.
Perhaps the most stark example is Paypoint, which is not only defensive but also actively counter-cyclical. The company operates terminals for pay-as-you-go utility customers. Utilities tend to put customers onto these tariffs if they miss payments, which is much more common during times of economic stress. The stock has a high dividend yield at c10%, which tells us that the market views this company as in rapid structural decline. This appears too negative based on the work we have done.
DCC is a company I have owned before and sold at a large profit in 2015. Since then, the market has become concerned about the impact of the growth of electric vehicles on DCC's European petrol station business, and the stock has de-rated to a more attractive level. Although I accept that structural demand for petrol will decline, this will be at a manageable rate which does not seriously threaten the profitability of the business.
Bunzl delivers disposable items such as coffee cups and paper towels to thousands of customers globally. Until recently, the stock had attracted a premium valuation as it successfully executed its acquisitive consolidation strategy, and was priced out of reach for a value investor. However, the stock has de-rated over the past 12 months, as the market has become concerned about increasing competitive pressure from Amazon, which has weakened sentiment and in my opinion, created an attractive buying opportunity.
While it is true that if you or I wanted to buy a stack of paper cups, we would probably buy them from Amazon, most of Bunzl's customers are commercial, and many of them, such as Walmart and Costa Coffee, are huge businesses. As such they need a customised, regular and reliable delivery service that is fits in with their own operating patterns. Waiting around for an Amazon courier to deliver coffee cups is just not an option for the likes of Costa Coffee. After peaking on a P/E of 24x in mid 2016, the stock has now de-rated by 25% and is close to a five year low valuation.
There are also engineering businesses which have very low correlation to the economic cycle - I have added to Ultra Electronics, Meggitt and Chemring. These businesses operate on different cycles to most engineers, with links to defence spending in the case of Ultra and Chemring, and the aerospace and defence aftermarket in the case of Meggitt. Meggitt has been increasing its market share in supplying critical components such as brakes for landing gear, which have long-term predictable revenue streams attached to them. The stock is one of the cheapest engineering stocks in the market despite significantly improving fundamentals.
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