Fidelity’s Alex Wright: Finding value in UK equities in 2022

by Rebecca Tomes

UK equities have delivered positive returns in 2021, with the FTSE All Share index returning +13%. Yet relative to other markets, the UK still stands out as cheap and unloved; retail investors have pulled -£1.33bn from the sector so far this year. 

Alex Wright, portfolio manager of the £3bn Fidelity Special Situations and the £935m Fidelity Special Values PLC, outlines his outlook for UK equities in 2022:

“UK equities remain significantly undervalued compared to global markets and reasonably valued in absolute terms. This has been reflected in a meaningful uptick in M&A activity, which has been a key contributor to performance for our funds. We are likely to see more bids if valuation discounts compared to overseas companies do not close.

“While the UK market has looked cheap over the past five years, the key differentiator compared to prior years has been that fundamentals on the ground have been strong. The removal of the Brexit uncertainty and the country’s swift vaccination rollout have contributed to the improved outlook.

“Meanwhile, consumers who have been unable to spend during the lockdowns have extra savings. Companies are also finally committing to making new investments in the country. We have seen strong trading updates across the portfolio reflecting the faster than anticipated recovery.

What could surprise markets in 2022? 

“The final shudders of the Covid-19 pandemic should work their way through the global economy in 2022, but as we have seen in just the last few weeks, the arrival of a yet more dangerous variant would certainly be a downside risk to global markets.

“Talking to companies, it is clear that rising input costs are increasingly becoming an issue given supply chain shortages and soaring raw materials, energy and labour costs. These factors are going to lead to rising margin pressure on some industries and individual businesses.

“This is a key topic in our conversations with companies, as we try to assess how they are affected and their ability to pass the extra costs onto their customers. We favour companies with strong supply chains and those well positioned to capitalise on the shortages in areas such as building materials and car distribution and hire.

“On a more positive – and often overlooked – note, the pandemic has accelerated the pace of change both at individual companies but also within industries where some competitors have exited. The lockdowns have allowed faster restructuring as companies have used the downtime to accelerate changes (e.g. refurbishing of premises, or digitalisation of their business) and realised cost savings. A reduction in the number of competitors in areas such as specialist retailers, travel and leisure, banking in Ireland and drink distribution should be reflected in improved profitability in future. Our holdings in M&S, Ryanair, AIB and C&C should benefit directly from these capacity exits.

Positioning for what lies ahead in 2022 

“Supply constraints and cost inflation create both risks and opportunities, and this is an area we are monitoring particularly closely. We have reduced our exposure to areas faced with meaningful rises in input costs, such as UK housebuilders. A recent update by builders’ merchant Travis Perkins highlighted an 11% rise in the cost of building materials in Q3 alone. Similarly, we have sold our small position in Restaurant Group as consumers have not been eating out as much as expected. The company is likely to struggle to pass on rising cost pressures in a lower demand environment.

“On the flip side, we believe the likes of Inchcape and Halfords are well positioned to take advantage of supply constraints in cars and bikes (given superior supply chains), as is vehicle rental business Redde Northgate. We also have exposure to building materials in short supply such as bricks through brick distributor Brickability and also own Norcros, which makes showers and tiles.

“Another area well placed to benefit from inflation and higher interest rates is financials, where we have maintained meaningful exposure to life insurers and banks. Indeed, our largest sector exposure is to life insurers, which remain cheaply valued, despite strong balance sheets, positive earnings outlooks (thanks to a healthy demand for protection products, bulk annuities and pension de-risking) and attractive dividends.

“While we have selectively reduced our exposure to consumer-facing businesses given the recent pick up in the cost of living, they remain a core part of our portfolios in part reflecting very healthy household finances. Our preference is for specialist distributors operating in areas where supply has shrunk, as they can capitalise on rising prices but are less affected by rising input costs.

“Conversely, we remain meaningfully underweight consumer staples, which remain expensively valued, and global mining stocks, many of which trade on peak earnings amid deteriorating supply/demand dynamics.”

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