Despite being in an out of favour region, in a neglected asset class and using an out of favour investment style, the Fidelity UK Smaller Companies fund managed to beat both the FTSE All Share and the MSCI World index last year.
Over the course of 2021, this UK small-cap value fund returned 34.5%, compared to a 22.9% return from the MSCI World index and 18.3% from the FTSE All Share index.
It was also the top performing fund in the Investment Association’s UK Smaller Companies sector, comfortably beating the Numis Smaller Companies index return of 21.9% and the IA UK Smaller Companies average return of 22.9%.
But manager Jonathan Winton said that despite his success, it is “lonely” being a value investor in UK small-caps. This is because most investors associate small-cap stocks with growth or those with potential to evolve into the next big growth business.
“That's great because it makes this part of the market really inefficient,” he said. “It means that there's very few people looking for companies with attractive valuations, which gives us a large universe of ignored stocks to choose from.
“And importantly it gives us time to do due diligence and get comfortable with companies that are going through a period of uncertainty and build conviction in those companies.”
Winton’s investment philosophy is based around value investing, but places emphasis on finding companies that are going through a period of positive change.
The idea is that companies that have gone through a period of temporary difficulty have a chance to get revalued upwards as they also deliver earnings growth.
“I think a key difference to other value investors is that we don't just look for cheap stock, we want ones where the valuation is low, but where there's also that positive change,” he said.
“Hopefully that focus on positive change helps us perform during periods where value is out of favour because we try to be invested in companies where we think the earnings can improve over the medium term.”
Although Winton’s approach paid off last year, it has also worked over the long-run. For the vast majority of his tenure, value investing has been out of favour, but the fund has still managed to keep ahead of its peers and the index.
Performance of the fund under Winton’s management
Source: FE Analytics
In 2021 this was a particular boon to the fund’s performance however, as companies started to recover from the Covid crisis and dislocation.
Last year was one of recovery, he said, with earnings rebounding in a number of positions taken out in 2020 and their multiples consequently expanding.
The fund also benefitted from the boom in takeover activity in the UK amidst record levels of merger & acquisition activity (M&A), which removed UK-listed companies from the market at significant premiums to their depressed share prices last year.
“As a value investor, buying businesses where we think the valuations are attractive but where they’re good franchises and they can get better over the medium-to-long term, those are often susceptible to M&A,” Winton said.
There have been at least 10 previously UK-listed companies that the fund has owned over the past few years that have received bids from private buyers.
The most recent examples include the takeover of wealth manager Charles Stanley by rival Raymond James, and the acquisition of aerospace manufacturer Meggitt by its US rival Parker-Hannifin.
“Given how lowly valued the UK market is relative to a lot of international markets, plus a lot of the dry powder that private equity have in corporate balance sheets, I wouldn't be surprised if that didn't continue,” Winton added.
“The UK is home to a lot of good-quality companies with growth potential but trading on very low valuations, so that makes them susceptible to M&A and that's something that we've benefitted from last year.”
Looking ahead, the fund’s highest conviction investment at the moment is in the government contractor Serco Group – which makes up its biggest position at 3.4%.
Winton said: “It is in a fairly unfashionable part of the market, but that's a business where we think we've seen an incredible amount of positive change over the last few years.”
Performance of Serco Group over 1yr
Source: FE Analytics
Winton continued: “We think the management has not only improved the culture significantly there, it's improved the margins and profitability of the company, it's diversified the business geographically, so we think it's more resilient than it used to be.
“We think it’s a business that's delivering attractive growth potential and should be able to do that over the medium-to-long term, but when you look at the valuation, it looks very low.”
Serco’s shares currently trade at a price-to-earnings (P/E) ratio of 5.6 times. Although Winton has held the business for “quite some time” he still believes his thesis for the company still holds.