As rising inflation and global growth expectations have benefited more cyclical areas of the UK equity market, contrarian Alex Wright has recently been drawn to more defensive stocks. He reveals how he is finding these opportunities in some surprising areas and how this is impacting positioning in the Fidelity Special Situations Fund and Fidelity Special Values PLC.
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.
There are opportunities in ‘hidden defensives’ in sectors which are regarded as cyclical, but where the companies themselves have limited exposure to the economic cycle.
Payments, coffee cups, petrol stations and engineering are key areas of interest and where Alex is finding the most valuable opportunities.
Special Situations portfolio evolution
During 2014 and 15, falling bond yields caused stocks with defensive and predictable earnings to become extremely widely owned relative to cyclical stocks. As such, I found 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. My portfolio positioning has evolved and adapted to the changing market conditions, and over the past six months, I have been finding more bottom-up opportunities in defensive businesses, and relatively fewer cyclicals. We produce the analysis in the chart below as part of our monitoring of macroeconomic risks affecting the fund and it shows how my positioning has evolved over tenure. These weightings are primarily an outcome, rather than something I target.
Value emerging in more defensive categories
Source: Fidelity International, as at April 2018. Macro weightings chart for illustration purposes only. Sector/stock categorisation is at Fidelity’s discretion.
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, I have found 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 the second highest dividend yield in the portfolio 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.
I have re-bought into DCC. This 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 structurally, 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 5 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.
The value of investments and the income from them can go down as well as up, so you may not get back what you invest. Past performance is not a reliable indicator of future returns. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The Fidelity Special Situations Fund and Fidelity Special Values PLC use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. They also invest more than other funds in smaller companies, which can carry a higher risk because the share prices may be more volatile than those of larger companies. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.
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