Fidelity’s Alex Wright: making money out of turnaround stories

2021 has offered some reprieve for UK value investors, who have been operating in the unloved areas of an unloved market for much of the past decade. This has led to Fidelity Special Values (FSV) having the best net asset value (NAV) performance in Winterflood’s UK All Companies sector for the 12 months to 8 December, with its shares trading at a 2 per cent premium to NAV. 

Despite a recent strong run, Wright, who also manages the £3bn Fidelity Special Situations Fund (GB00B88V3X40), believes the absolute valuations across both funds, which have a similar ‘contrarian’ investment style, continue to be “really low”. Speaking on a recent Investors’ Chronicle podcast, he says the price/earnings ratio of Fidelity Special Values' and Fidelity Special Situations' portfolios is “about 11.5 times, compared to the market’s long-term average of 13 or 14 times”, adding that the price/earnings ratio is not that different to what it was towards the end of 2019. This reflects the fact that the earnings of the holdings in the portfolio (and the market more broadly) have bounced back strongly during the pandemic.

Investment process

Wright thinks that the best way to make money is to go against the consensus. “If people think a company is great, even if its prospects are great, you're already paying for that,” he says. “You're not going to make money in normal times by just following what everyone else is already doing.” While momentum traders have seen strong returns over the past decade as growth stocks have performed well, Wright believes that contrarian investors should perform better over multiple market cycles.

To spot mispriced assets, he uses different metrics for different types of companies. He particularly likes looking at companies with negative broker ratings that have been underperforming the market. When it comes to financial ratios, for capital intensive businesses he looks closely at a company's price-to-book ratio, whereas for an asset-light company or a company that invests mainly in intangible assets, he looks at its enterprise value compared with its sales base.

In terms of trying to avoid value traps (investments that appear undervalued but turn out to be cheap for a reason), Wright tries to avoid areas where he thinks there have been structural changes, as technological developments have left some companies and sectors permanently disrupted. “We don't just buy those companies and hope that things will get better, we do an awful lot of due diligence around the company and the industry the company is in to really see what we think a catalyst for change will be,” he says. “It's a very time-intensive process.”   

Wright adds that his funds have a mid- and small-cap bias, with around half of the portfolios invested in companies with a market capitalisation of under $5bn (£3.79bn). This is because it is easier to find turnaround stories further down the market cap scale, where there are more agile and less well researched companies. 

Recent fund activity

Despite recent concerns over the Omicron variant, Wright says fundamentals "look really strong, and particularly in the consumer area”. He thinks consumer activity has been “particularly moribund” over the past five years since the EU referendum brought a lot of nervousness around political and regulatory change. Wright believes this left people holding off on bigger ticket items, from home redecorations to car and house purchases. Add to this the pandemic, which has restricted people's spending, and “there’s bigger pent up demand in the UK than in many other markets”, he says.

“What’s good now is that the fundamentals actually look good, as well as the valuations, and that's actually very different from what we've been seeing before,” he says. Relating to that theme, Wright has increased his exposure to retailers, adding B&Q-owner Kingfisher (KGF) as a stock-specific turnaround play following the introduction of new management in 2019. He also added some more housebuilders, Redrow (RDW) and Vistry (VTY), because as well as spending on home improvements there has also been a surge in home purchases. Wright has also added holdings involved in the housing supply chain, including brick manufacturer Forterra (FORT) and brick distributor Brickability (BRCK). 

The biggest pandemic era sale has been CLS (CLI), which has delivered a return of about 70 per cent over the past five years. Wright thinks its business model of being an office landlord faces structural challenges, given that more people are likely to work from home. “We've made a point of talking to all the companies we invest in, probably over 250 to 300 meetings over the last 18 months,” Wright says. “And every company, without exception, says they're going to need less office space - they're just not sure how much less.”

Market outlook 

Wright thinks the market has taken a “schizophrenic view” of inflation, because if inflation is going to become more embedded, particularly labour inflation which is currently “quite high” in the UK and US, “that clearly does need to lead to higher interest rates and higher discount rates”, Wright says.

But we haven’t yet seen a structural increase in long-term bond yields. “Nor are you seeing very highly rated stocks see their share prices compress, because people are thinking about higher discount rates,” Wright explains. He thinks this is strange because when he talks to companies he says it’s “very clear there are lots of cost pressures”, which are punishing some companies. He says a really good example of this is Unilever (ULVR), which is finding it hard to pass on price increases because people aren't spending more on household products and food, but the company's cost of labour is going up. However, the stock hasn’t derated in the way he might expect.  

Life insurance, a sector that makes up about 12 per cent of Fidelity Special Values' portfolio, is an area that Wright thinks contains materially underpriced companies. While stocks including Aviva (AV.) and Legal & General (LGEN) – both large portfolio holdings – have performed well, Wright is surprised that their share prices haven't performed better, given they produced largely the same profits in 2020 as they did in 2019. “They are very steady Eddie businesses much more akin to a consumer staple stock [than a bank], but on a massively lower valuation,” he says. “They still trade like banks on eight to nine times earnings, yielding dividends of 6 to 8 per cent.”

If interest rates rise, banks – which make up 8 per cent of Fidelity Special Values – are an obvious beneficiary, particularly of initial rate rises. Wright says there are very few marginal borrowers for whom an increase in rates of 1 per cent would cause any problem with paying their loans, but it can be “quite transformational” for a bank’s profitability. He adds that Natwest (NWG), the trust’s second-largest bank position, would see a boost of profits to the tune of around 25 per cent if interest rates moved from 0.1 per cent to 1 per cent. This is because it has a very large current account base, so rate increases of up to 1 per cent are unlikely to be passed on to customers. “That initial move is really positive for the banks’ profits,” he says, adding that a move from 1 to 2 per cent would be less transformational. 

Fund composition

Fidelity Special Values is a widely diversified fund with more than 100 holdings. Wright believes it’s important to have a large portfolio to cover different eventualities. He also says only around 60 per cent of holdings turn themselves around and enjoy share price re-ratings. “Having a broad portfolio of 100 ideas allows you to be patient on each individual name,” he says. “Effectively, not trying to time the market to see when things are going to turn around quickly, just being in a stock, as long as we see that the balance sheet is solid and we've got good downside protection from the valuation, we'll stick with a name as long as the potential for change is still there.”

The fund's turnover is relatively high at 40 to 50 per cent, but Wright says this is partly because they gradually buy into positions and then gradually sell. The holding period for a stock is generally two and a half to three years. “When we're looking to invest, we're thinking about what a stock's fundamentals can do over a three- to five-year period. So looking a bit further out than the average analyst or the market looks to see what the medium-term prospects are. And what we generally find is if those prospects come through as hoped, the market starts to pay up ahead of time."

A challenge is that Wright needs to have a long pipeline of companies to replace stocks as their potential is met and share prices catch up. “When you think about that average two, two and a half year holding period, and a fund of 100 stocks, you're needing sort of 30 to 50 new ideas per annum,” he says. To run a value strategy effectively, Wright adds: “ I think you really need a big organisation to successfully be able to run this process” because a lot of new ideas need to be generated.

Source: FE Analytics, returns in GBP, 09.12.21

Alex Wright CV

2001: joins Fidelity

2008-2014: manager of Fidelity UK Smaller Companies fund

2012-present: manager of Fidleity Special Values

2014-present: manager of Fidelity Special Situations fund