Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Alex Wright, Manager of the Fidelity Special Situations Fund and the close-end fund Fidelity Special Values.
Hi, Alex.
Alex Wright: Thanks for having me.
Wall: Happy anniversary on the Fidelity Special Situations Fund, three years. It has been an interesting three years if you look at the backdrop for the U.K. and as an all-cap fund you can go up and down the cap scale. One of the notable absences from the portfolio has been commodities where people have lost a lot of money and then more recently, made a lot of money. Why have you chosen not to include commodities in the funds?
Wright: You're right. My exposure to the mining side of commodities is very low. It's about 1% in Special Situations today and that has been the case for pretty much all of the three years that I've been running the fund. And I think the big difference between mining and oil, an area that I do like where we've got about 10% of the fund, is the returns that the companies are currently making.
So, actually, even though, sort of, share prices are still well down on previous years, when you look at the returns and the profitability of the miners at current spot prices are actually quite high and certainly, a lot higher than the long-term 20-year history. And I think that reflects the fact that actually the reason mining has come back in the last year, which is very different again from oil, is because demand has surprised positively.
So, China has not slowed as much as people expected and infrastructure spending has been very strong there. But when you look at sort of how high is that demand versus history and how sustainable is that demand at current levels, I think there's a big question mark around that because the fixed asset investment in China is very high, infrastructure is really, really good, spend has been going on for 10 years plus. And so, that demand outlook to me looks potentially risky when the supply side of mining continues to increase supply. And so, the demand-supply gap is ever narrowing.
Wall: Having a look at those oil stocks then, oil of course, has been incredibly controversial space in that this time last year we were looking at bottom lows, around $25 a barrel. Now, we're at sort of $55, $60. Is that your base case for investing, because of course certain companies can only survive if the oil price sustains those levels?
Wright: Yeah. So, oil is an area that I've had a lot more confidence in. I've got about 10% of Special Situations invested there. And our overall team have had a very strong view since late 2014 when we saw the big oil price falls that in order for sort of CapEx to be re-incentivized, investment to be re-incentivized in the space we needed to see at least $55, $60 per barrel. A lot of work around, particularly the shale producers in the U.S., which I think are the global swing producers. So, it's very clear that costs have fallen and that these companies can invest at much lower oil prices.
But when you look at the global picture, what I'd like to see is the big falls we've seen in supply because of those cuts in CapEx really writing the demand and supply balance. And then when you do that specific work, that really says to us that the oil prices didn't need to be a lot higher than they were 12 months ago. And so, I've had confidence they would rise to these levels. And the equities still look very attractive. Even though the oil prices increased and share prices have done well, you are still seeing sort of big dividend yields coming out of the majors, very good valuations from some of the smaller cap stocks.
Wall: The nature of a Special Situations or Special Values fund is that you quite often have controversial sector exposure, controversial name exposure. And from commodities, which everyone loves to talk about, to financials, you are more positive on financials, aren't you, where some people are still keeping them at arm's length?
Wright: Yeah. So, in fact, the entire time I've been running money since 2008 actually, I've had a big weight in all my funds to financials and that very much continues today in Special Situations, so about 35% in that area, because I think it is an area that's complicated and therefore, needs a lot of analysis and the deep analysis and teams we've got at Fidelity helping me really allow me to get under the hood of these models.
And then obviously, with the financial crisis and the banks in particular being sort of blamed for that, people have just shied away from these companies. And so, yeah, I've got about 10% in banks and then about 25% across a wide variety of other financial business models.
Wall: And one of the U.K. banks you have exposure to, I suppose the only well-known high-street bank is Lloyds, but you did halve exposure to Lloyds on the Brexit vote, didn't you?
Wright: Yeah. So, banks at their heart are a play on the economy where they are based and Lloyds has about a 25% market share in the U.K., only really operates in this country. And therefore, sort of the lower level of interest rates we've seen post-Brexit, so halving of interest rates that has affected their margins. And also, the lower GDP growth that we're seeing, it's maybe not as bad as some people feared, but it is definitely lower than it was previously. So, again, that's crimped loan growth and other income.
So, there has been quite a downgrade to earnings of around sort of 15% to 20% for Lloyds post the Brexit vote. That said, the stock is very cheap still on those earnings about 10 times, yielding about 5%. So, I think the stock is still attractive, just not as good as it would have been if GDP growth and interest rates had been higher.
Wall: Alex, thank you very much.
Wright: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
