Fidelity Special Values Plc - Half-year Report

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Smita Amin

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FIL Investments International

Portfolio Manager’s Half-Yearly Review

Performance
In the six month reporting period to 29 February 2024, the Company recorded a net asset value (“NAV”) per ordinary share return of +4.0% and a share price return of +4.8%, compared to a +3.9% return for the Benchmark FTSE All-Share Index (all on a total return basis). This report seeks to summarise the period, highlight the key drivers of performance and set out the Portfolio Manager’s forward-looking views.

Stock Market and Portfolio Review
UK equities advanced during the period despite persistent global challenges including geopolitical tensions, economic uncertainty, high borrowing costs and China’s sluggish post pandemic economy. Nevertheless, the market narrative was supported by decelerating inflationary pressures that allowed the Bank of England (“BoE”) to keep interest rates unchanged during the review period after fourteen successive rate hikes. This has led to expectations that we may have reached the peak of rate increases, while improving economic data increased conviction in the soft-landing narrative, providing a tailwind for equities.

From a sector perspective, market gains were led by technology, industrials and consumer discretionary, while basic materials and consumer staples were the biggest detractors. While both the value and growth segments showed gains, the technology-led rally from November meant that growth outperformed over the period. Similarly, small cap stocks rebounded strongly following two years of significant underperformance.

The period started with UK equities posting gains in September as easing inflation prompted the BoE to keep its policy interest rate unchanged at 5.25%. The decision to leave rates unchanged surprised the market, as previous expectations factored in a high likelihood of an imminent rate hike. Encouragingly, positive inflationary developments extended beyond the UK, with the eurozone and the US also reporting decelerating price pressures, which heightened investor optimism over a soft landing. By the end of November, markets had priced in a peak in current interest rates, with expectations of cuts in 2024, both at home and abroad.

However, equities started off 2024 on a weak note. This shift was underpinned by investors recalibrating their expectations for imminent and substantial interest rate cuts by major central banks. A desire for firmer evidence that inflation was under control and the lack of commitment on the timing of rate adjustments by central banks contributed to an atmosphere of uncertainty among market participants. Meanwhile, geopolitical concerns remained centre stage as a result of disruption of commercial shipping in the Red Sea, leading to some supply chain bottlenecks.

Economic indicators in the UK painted a mixed picture. Preliminary estimates revealed a 0.3% contraction in UK GDP (quarter-on-quarter) in the fourth quarter of 2023, driven by declines in both consumer and government spending. While this marked the second consecutive quarter of contraction (defined as a technical recession), nevertheless, GDP is estimated to have increased overall in 2023 but only by 0.1%. On a positive note, the preliminary data for January was more encouraging showing a 0.2% month-on-month GDP expansion. UK inflation has also fallen rapidly from its peak of more than 11% in late 2022 to just 3.4% in February, but it is still above the Bank of England’s 2% target and wage inflation remains stubbornly higher than the headline rate.

Over the period, the Company’s NAV marginally outperformed its Benchmark. Irish support services group DCC was the leading contributor as its shares benefited from an improving outlook, delivering on ambitious new targets for its energy division. Its aim to evolve its strategy towards lower carbon energy solutions was underlined by its acquisition of Progas GmbH, a leading distributor of LPG in Germany, considerably expanding its customer base in the country. Ryanair Holdings continued to benefit from the post-pandemic recovery in demand for international travel, as a strong Easter, record summer traffic and the growth in air fares offset higher fuel costs. The company also announced it would pay its first ever dividend, as it continued to benefit from the constrained supply environment and higher cost of new planes. Similarly, defence contractor Babcock International Group paid its first dividend in four years, as it reaped the benefits of a turnaround plan, becoming a more predictable business, that is well placed for higher military spending amid rising geopolitical tensions.

Mergers and acquisitions (“M&A”) activity continued to be a significant performance driver during the period with five of the top ten contributors attracting bids, or becoming subject to takeover speculation. Smart Metering Systems agreed to a £1.3 billion deal from US private equity firm KKR (Kohlberg Kravis Roberts) while ten-pin bowling operator Ten Entertainment Group was taken over by another US private equity firm Trive Capital. Shares in Direct Line Insurance Group rose on news that Belgian insurer Ageas was considering making a takeover offer. Meanwhile, shares in Aviva, the UK’s biggest insurer, rose after reports that it could be the target of a takeover by a foreign buyer. Media and events company Ascential also added value after the company agreed to sell its digital commerce business to Omnicom Group and its product design business to funds advised by Apax Partners. Once the transactions are complete, Ascential intends to distribute £850 million to its shareholders.

Conversely, the holding in Swiss pharmaceuticals group Roche Holdings detracted from performance, as investors weighed the company’s more modest than expected 2024 outlook. Group sales, which include diagnostics, were expected to grow by a mid-single digit percentage, when adjusted for currency swings, but the projections were lower than consensus estimates. Nevertheless, results showed the company was overcoming a slump in demand for its COVID-19 products and a decline in sales of a trio of established cancer drugs.

Shares in merchant banking group Close Brothers declined sharply after the Financial Conduct Authority announced that it would review historic claims of unfair costs on discretionary car finance commissions and ensure that consumers received compensation if it uncovers evidence of widespread misconduct. Although we had significantly reduced our holding having identified this risk, the estimated fines are likely to be higher than previously thought and the residual position proved a drag on returns given the significant sell-off.

Industrial threads maker Coats Group was another detractor. The company has seen a decline in trading revenues, but there are signs of a gradual recovery, while its balance sheet and cash generation remain strong. Elsewhere, Victrex was weighed down by weakness across the chemical sector.

Meanwhile, shares in health and beauty products company PZ Cussons fell following the devaluation of Nigeria’s currency, the naira, before the company’s results announcement in February and this led to a reduction in its dividend and a paring back of profit forecasts. The company counts Nigeria as one of its four major markets, although it now only represents 15% of profits. PZ Cussons is undergoing a turnaround having reinvested in its core brands, professionalised the organisation and has started to simplify its operations.

Use of gearing
During the review period, we continued to use contracts for difference to gear the portfolio’s long exposure and eliminate some of the currency exposure for those holdings listed outside the UK. Overall, there was a small reduction in the Company’s gearing level over the period. Gearing remains low at 5.9% at the end of February (compared to 6.5% at the end of August 2023). While valuations are attractive and we are finding new ideas, we are conscious of the increased cost of borrowing and want to retain some dry powder to take advantage of opportunities and any short-term volatility.

Outlook
While there continues to be a degree of economic and geopolitical uncertainty, the attractiveness of UK valuations versus history and compared to other markets, as well as the large divergence in performance between different parts of the market, continue to create good opportunities for attractive returns from UK stocks on a three-to-five-year view. Their unloved status means we continue to find overlooked companies with good upside potential across industries and the market cap spectrum. What is more, the lack of interest from other investors means that, despite our focus on attractive valuations, we do not have to compromise on quality.

While the value in the UK market is not being recognised by investors, it is being acknowledged by other market participants. Overseas corporates and private equity firms are seeing the value and are taking advantage of those attractive valuations. As noted previously, we have had a lot of success with M&A across the portfolio in the last six months. After a lull in the middle of last year, activity has picked up. The low valuations are also reflected in the substantial buyback activity among UK corporates.

From a portfolio perspective, we remain disciplined, taking profits in stocks that have performed well and where the risk/reward is no longer as attractive. We are particularly wary of stocks where fundamentals and margins have been strong, and a deterioration is not priced in. A stock we sold after strong returns was Marks & Spencer, where we felt the investment thesis had played out. The stock had doubled having taken market share in the clothing, home and food segments which had benefited from the exit of the likes of New Look, Arcadia and Debenhams, favourable weather conditions as well as a switch from shopping online back to shops after the pandemic. Market sentiment was becoming overwhelmingly positive and after such a strong run, we felt the risk/return was more skewed to the downside given a wide range of scenarios in a relatively weak economic environment. Elsewhere, higher interest rates have benefited sectors such as banks and life insurers, which had been shunned since the global financial crisis. While they continue to be well represented in our portfolios, we have taken some profits following strong returns, and changed some of our positions, for instance reducing our NatWest Group position in favour of Standard Chartered, given better revenue growth prospects, and switching some of our Phoenix Group Holdings exposure into Just Group, a move that paid off handsomely in light of the very strong set of results they recently announced.

Conversely, we have been on the lookout for companies that have seen their earnings rebased and which trade on low valuations with limited downside and the potential for significant upside once the environment normalises. We have been finding new ideas in cyclical areas such as industrials, media, and staffing and adding back into some UK housing related names of late, where demand appears to be stabilising and valuations remain low.

Overall, we continue to see potential for attractive returns given the upside/downside profile of our portfolio. We are encouraged by the performance of our holdings in the recent reporting season. We have seen a strong full year 2023 reporting season, and in particular excellent results from some of our financials positions. With the exception of high-end and big-ticket consumer goods, where spend is under pressure, generally the results season has painted a fairly robust economic picture, with things actually starting to look more positive in most areas into the fourth quarter of 2023 and first quarter of 2024, compared to 2023 as a whole. The one exception is China where poor economic conditions on the ground appear to be deteriorating further. Our holdings have low revenue exposure to China (much lower than the UK market) given our low exposure to big staples, financials and mining companies that are driven primarily by Chinese demand. Overall, we have been encouraged by the robustness of earnings in the portfolio and indeed the market as a whole.

Alex Wright
Portfolio Manager
25 April 2024

Twenty Largest Investments as at 29 February 2024

The Asset Exposures shown below measure exposure to market price movements as a result of owning shares, bonds and derivative instruments. The Fair Value is the actual value of the portfolio as reported in the Balance Sheet. Where a contract for difference (“CFD”) is held, the Fair Value reflects the profit or loss on the contract since it was opened and is based on how much the share price of the underlying share has moved.

	Asset Exposure		Fair Value
	£’000	%1	£’000
Long Exposures – shares unless otherwise stated
AIB Group (corporate bond and long CFD)
Banks	46,005	4.8	16,597
	---------------	---------------	---------------
DCC
Industrial Support Services	44,061	4.5	44,061
	---------------	---------------	---------------
Imperial Brands
Tobacco	36,957	3.8	36,957
	---------------	---------------	---------------
Ryanair Holdings (shares and long CFD)
Travel & Leisure	33,616	3.5	4,371
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