The past two years have presented a difficult environment for value investors. The stocks that have powered the market over that period are steady, defensive names, such as British American Tobacco, Imperial Brands and Reckitt Benckiser. They are well run companies but they are also well owned. The prices you are asked to pay for them today leave little margin for error.
Many investors seem to be positioned for this trend to continue indefinitely. But while it is easy to take comfort from a successful period of outperformance, complacency can leave you dangerously exposed if patterns of market leadership evolve.
Although some defensives are continuing to do well, there is unmistakably more of a value flavour now filtering through to the market and we are seeing a renaissance of certain sectors.
Oil majors and banks
Two out of favour sectors I like at the moment are oil and banking. Oil has fallen a long way and this has hit company profitability, but the huge cuts being made to capex spending are already having an effect on supply. We are heading into an era where oil prices will recover, perhaps not to previous highs but we see a lot of upside from here, and oil stocks look very attractive on that basis.
Meanwhile, the banking sector continues to underperform, which I think is unjustified. Post-financial crisis, there has been a lot of consolidation and balance sheets have shrunk so less capital is chasing the returns in the market. Balance sheets have been repaired significantly so downside protection is better than it has been historically, especially for two names we hold: Lloyds and Citigroup. These banks are trading on seven to nine times earnings and returning substantial amounts to shareholders through buybacks and large dividends.
We think Lloyds can yield in excess of 8 per cent this year, which is a very attractive prospect and a more secure yield than people think. The market is not yet willing to pay for those strong fundamentals, so we have not seen the re-rating that should follow this uplift in performance.
“Looking at relative valuations of defensives versus cyclicals today, they are almost at crisis levels, even though the global economy is in recovery mode”
Supermarkets and miners
Two sectors have performed reasonably well so far this year after a dire 2015 but my view is that their fundamentals do not reflect the improvement in their share prices.
One is the mining sector, where sentiment has been poor for some time. There is a global surplus of most metals but, because of the long lead times in mining, production is continuing despite the existing supply glut. This means spot prices cannot remain at current levels.
Then there are the supermarkets. The problem they are facing is also one of supply. A lot of new convenience and discount space is being added, as well as the virtual space being created online. In an industry where demand is fairly steady, this constant increase in selling space could impact returns. While there might be relative winners that might be able to take short-term market share, it will be a difficult trade to play in an industry where the backdrop is very poor, margins are low and balance sheets are highly leveraged.
Looking at relative valuations of defensives versus cyclicals today, they are almost at crisis levels, even though the global economy is in recovery mode. Investors have crowded into defensives because they are worried about the future but we are taking the view that the chances of a “muddle-through” scenario are much better than the market expects. If a more benign macroeconomic picture endures, the market will reappraise the prospects of the stocks currently in the reject bin and the gulf of valuations will have to narrow. Contrarians could be well rewarded for being willing to consider the more unloved names in the UK market.
Alex Wright is manager of the Fidelity Special Situations fund and Special Values plc.