High valuations have made many wary of the UK market but Alex Wright, manager of the Fidelity Special Situations fund, insists there are still plenty of unloved opportunities.
Being a contrarian, I have become a little more cautious following the strong market rally. The FTSE 250 and FTSE Small Cap indices are now trading at premiums to their 15-year price to earnings multiple averages.
The FTSE 100, on the other hand, still looks cheap compared to historical averages (see chart). This has proved a fertile space for idea generation recently.
One interesting investment idea we have come across in the FTSE 100 recently is SSE. Market sentiment towards this UK power company has deteriorated considerably over recent months and we have used the opportunity to add to positions in our portfolios.
The market has begun pricing in a possible political intervention in energy markets. The consensus view is that the company’s retail supply margins are under serious pressure, posing a threat to the profitability.
While there is certainly a chance SSE’s retail margins may come down, they contribute only 18% to the company’s overall earnings. The loud political noises are obscuring some good opportunities for a company trading on only 10.5x next year’s earnings, which is at the bottom end of its historical valuation range.
The opportunity for the company comes from the changing nature of the UK energy market. Years of low returns have led to underinvestment. However, over the coming years, many of the country’s coal-fired plants are to switch off, which will reduce supply considerably as there is currently little in the pipeline to replace it.
SSE, which has developed a strong position in renewable energy sources, should be able to benefit from this change in the UK energy mix and the potential for improved returns for its existing and planned investments as supply tightens.
Being a highly geared company under increasing scrutiny from politicians has caused investors to run in the opposite direction. Looking past the political bluster, I think we are owning shares in a very cheap company which has an important role to play in the future power generation of the UK.
Another example of a stock among the large-caps is Carnival, the giant cruise ship operator. Shares in the company had performed very poorly after the Costa Concordia disaster and a series of further high-profile operational failures.
The company recently traded down to a value only slightly higher than the asset value of its ships, which gave me comfort that any further share price falls would be limited.
Investor sentiment towards the company has been poor, which is a key attribute for the contrarian strategy I use.
Returns in the cruise industry have been under pressure in recent years as competitors have accelerated their investment in new capacity. This growth is now slowing substantially, which should leave Carnival well placed to improve its yields, as it has a very high market share.
There are also a number of other supportive medium term changes, such as its move away from using intermediaries for its sales. With more customers going direct through Carnival’s website, the company can make savings on commissions paid to travel agents.
As a cheap, unloved stock with many options to deliver surprising levels of earnings, Carnival fits my investment philosophy of looking for unloved companies that are entering a period of positive change that has not been recognised by the market.
Of course, with well over 1,000 companies in the mid- and small-cap investment universe, there are still out of favour stocks in that area of the market that fulfil my investment criteria. It is at times like this, when the next idea is a little harder to come by, that the importance of talented analyst resources come to the fore. The good ideas are still out there, we just need to turn over a few more stones to find them.
One example of stock I believe has yet to be appreciated by the market would be the small-cap Norcros. We took advantage of a liquidity event to buy shares in this company, which sells Triton showers and Johnson Tiles.
4 Secondary property
Another area where I am finding opportunities at the lower end of the market-cap spectrum is within secondary property. Secondary property offers investors great risk reward payoff at the moment, which I believe remains unappreciated.
These stocks, which own and develop property outside of the prime city centre locations, have been trading at deep discounts to their net asset value for some time, as investors have considered their portfolios too risky given resoundingly negative views on the UK economy and the consumer in particular.
If you can identify cheap stocks with good quality assets and upside potential from development, I think these could turn profitable in 2014 and beyond.
So, the strong performance over the last year or so has meant that many companies now look expensive and I have naturally become a little more cautious as consensus expectations have caught up with my own.
However, I still believe there are plenty of cheap and unloved opportunities across the market-cap spectrum that meet my criteria of limited downside and unrecognised growth potential. It is now a matter of finding the ones that have been unfairly left behind.
FTSE 100 looks cheap
Joined as head of strategy, multi asset, in June
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