Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

Typically, recessions are caused by rising interest rates and lending or liquidity in general drying up, resulting in a meaningful squeeze in monetary conditions. However, the current situation is very different. We have seen a huge amount of global monetary and fiscal stimulus in response to Covid-19 and, as a result, interest rates are at all-time lows and credit facilities for firms and consumers plentiful.

Unusually, consumers have not been able to spend as much as they would normally due to lockdowns and other containment measures still in place. Through our frequent conversations with individual companies, we have a good insight into new spending patterns.

Consumers are spending considerably less on transport and travel, leisure activities and eating out - normally a substantial share of their spending - leaving them with more disposable income to spend on housing, DIY, electronics and sports equipment and clothing. This trend has benefited some specialist retailers such as Halfords, Dixons Carphone, Studio Retail Group and Frasers Group, which have been reporting stronger-than-generally-anticipated trading.

Within the portfolios, we also own some attractively-valued housing-related stocks that are well positioned to benefit from changing accommodation needs, lower rate mortgages and help-to-buy/stamp duty support initiatives.

Narrow market focus

However, the current market focus has been extraordinarily narrow, leaving large swathes of the UK equity market overlooked and unloved. Investors seem to have lost sight of valuations and are focusing on those stocks they think might become long-term winners. The companies currently favoured are typically capital-light and expected to generate high returns - notably, this extends beyond virus beneficiaries.

This has proved a challenging backdrop for contrarian value investors, where even steady companies with visible and relatively safe earnings such as Sanofi (with strong diabetes, cardiovascular and oncology franchises and a credible Covid-19 vaccine under development) or Imperial Brands (with a core cash-generative business and a loyal customer base) are getting very little attention.

On the positive side, the current market is resulting in very cheap valuations and the most opportunities I can remember since 2008. We are not having to compromise on quality and are even able to buy companies that are seeing earnings upgrades but remain very cheap compared to the broader market. The result is a portfolio of companies with more resilient earnings, better returns on capital and less debt but on considerably more attractive valuations than the broader market.

The opportunities

We continue to favour life insurers with strong positions in pensions and retirement income. The life insurance sector offers an attractive combination of cheap valuations, strong demand/supply fundamentals and growing earnings. The cyclicality of these businesses is lower than it was and their solvency significantly better than during the financial crisis. The improved disclosure by these companies during the Covid-19 crisis further strengthened our conviction and recent results demonstrated their improved resilience. We believe that the durability of the cash generation, ongoing potential for management actions and the likelihood of future deals are not currently reflected in valuations.

Aviva is a good example of the value currently on offer and is one of our largest holdings. It trades on five times 2021 earnings, despite reporting strong first half results that underlined its resilience during the Covid-19 crisis. The insurer has recently appointed an impressive new CEO and is implementing far-reaching strategic changes aimed at refocusing on its core businesses.

This exemplifies the type of opportunities that can be found where valuations are extremely attractive, and change is afoot, but the market is unwilling to give these stocks any credit in the current environment. This is particularly the case among smaller companies and those with more of a domestic focus.

Conversely, two areas where we are significantly underweight are oil companies and banks. While both sectors are very cheap, their medium-term outlooks are uninspiring. Mainstream banks are likely to continue to suffer from low - or event negative - interest rates and potentially deteriorating credit demand would add to those woes. Meanwhile, UK oil majors Royal Dutch Shell and BP have decided to embark on a long, complex and high-risk transitions towards a more diverse energy mix, which will likely put pressure on future cash flows and ability to distribute cash to shareholders.

Outlook

Looking ahead, there is undoubtedly a lot of near-term uncertainty and, on the virus front, the availability of an effective vaccine will be a key part of the solution to allow households and businesses to fully resume normal activity.

The lack of progress on the Brexit negotiations has also cast a shadow on the UK market. A successful outcome would help lift investors’ optimism towards UK equities. While a no-deal scenario would be negative, the robustness of UK supply chains through Covid-19 does give us some comfort that there is a lower risk for businesses than originally perceived and companies are better prepared.

Improved clarity on these matters may well be the catalyst for investors to broaden their investment horizons beyond the narrow range of secular growth stocks currently in favour.

The recent period has been painful for value investors, but we believe it sets up a very attractive opportunity set and very good upside potential from here. We believe the portfolio offers great value and are continuing to find a lot of new investment opportunities.

More on Fidelity Special Situations

More on Fidelity Special Values

Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. 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. Fidelity Special Values and Fidelity Special Situations funds 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. Currency hedging is used to substantially reduce the effect of currency exchange rate fluctuations on undesired currency exposures. There can be no assurance that the currency hedging employed will be successful. Hedging also has the effect of limiting the potential for currency gains to be made. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

Topics Covered:

UK; Investment trusts; Active Investing; Volatility

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