Valuations suggest the UK market is set for a decade of annual returns of up to 10 per cent, according to FE Alpha Manager Mark Martin
Negative news about the UK economy has made investors seek refuge in bonds or defensive equity income funds in recent years, or alternatively look abroad to emerging markets.
However, Martin (pictured)
, who heads up the five crown-rated Neptune UK Mid Cap
fund, says that an analysis of the historical link between valuations and stock market returns shows that this is one of the best times to invest since the 1970s – the last period to seem so gloomy economically.
"Over the last 20 to 30 years, when the market has been trading on 12-times P/E [price to earnings], it has been followed by 8 to 9 per cent real total returns for the next 10 years," he said.
"For example from 1974 to 1979 the market was on six- to seven-times P/E and although it didn’t feel like a good time to invest, real returns were over 15 per cent."
"The market was at similar levels to that period in 2009, and now isn’t as good a time to invest as then, but it is infinitely better than in 1997 or 1999 when the market was much more expensive and you ended up with negative annual returns."
"In the short-term you can have markets driven by sentimental indicators and short-term events, but over the long-term, valuations act as a sort of gravity field."
Neptune UK Mid Cap currently has the best three-year returns of any fund in the IMA UK All Companies sector.
It has returned 94.42 per cent over this time, while its FTSE 250 (ex IT) index benchmark has made 59.25 per cent, according to data from FE Analytics
The fund underperformed its benchmark in the first two and a half years of its life, but has managed to beat it overall.
Performance of fund vs index since launch
Source: FE Analytics
Martin says past underperformance came as a result of his rigorous valuations-based approach, which meant he did not fully participate in the QE-fuelled rally in cyclicals.
"For a few years from 2008 and 2009 to the end of 2010, people really thought that QE was going to be the answer to our problems," he said.
"Mid caps performed very strongly and it was cyclical companies and those with the riskiest balance sheets that performed the best, and in general we do not tend to invest in companies which are financially leveraged."
"That type of company over the short-term outperformed because everybody wanted to buy risky companies."
"From 2011 onwards, people started to think that QE wasn’t the solution to all our problems and there were structural issues within the economy, and that started to change."
"We take the longer-term view. I prefer to invest in companies that are pretty high quality for the most part, with strong fundamentals. As the economic cycle has turned, so our relative performance has improved."
The manager says that a valuations-based approach also reduces the volatility in his fund.
"I target valuations and I think that doing this gives me a way to take advantage of volatility."
"Because we focus on valuations and we aren’t going to be caught up by fear and panic, we can turn it to our advantage when everybody is caught up in concerns about the eurozone crisis, for example."
"The mid cap index is pretty cyclical and a lot of the other funds are pretty volatile, but we think this strategy provides balance and offers something different from what other mid cap funds out there do."
Data from FE Analytics
shows that Neptune Mid Cap has recorded an annualised volatility of 13.94 per cent over the past three years, significantly less than the 18.43 per cent of the FTSE 250 (ex IT) index.
It made 40.85 per cent in 2012, more than all but two funds in the IMA UK All Companies sector. The FTSE 250 rose 28.71 per cent in this time.
Mid caps have not always outperformed larger companies, as data from FE Analytics
Between January 1990 and December 1999, the FTSE 100 grew 283.5 per cent while the FTSE 250 grew 205.06 per cent.
Performance of indices from 1990 to 1999
Source: FE Analytics
Martin says that valuations suggest mid caps' good run can continue.
"If you look at the 'FTSE 80', as I like to call it (the smallest 80 companies on the FTSE 100), it is trading on a forward P/E ratio of 13-times."
"However, the FTSE 250 (ex IT) is on just 12.2-times, so it is cheaper. On the other hand, it is true that the 'FTSE 20' does look cheap, on valuations of 10.4-times forward P/E."
Martin adds that another reason for optimism is the sort of companies in the FTSE 250.
"They tend to be companies focused on niche areas of growth."
"The 250 is overweight industrial engineering and things the UK is good at. There are a lot of firms using cutting-edge scientific knowledge."
Neptune UK Mid Cap is available with a minimum initial investment of £1,000 and has a total expense ratio of 1.67 per cent.