In order to reflate their dwindling economies, the world’s central banks have pursued a policy of ultra-low interest rates and increasing the monetary supply via QE to incentivise consumers and investors to spend more.
However Leahy, who manages the five crown-rated Hermes UK Small and Mid Cap Companies fund with David Stormont, says that investors must realise that the value of companies is likely to change dramatically if interest rates change, which could catch a lot of people out. The manager says that valuations are everything to his strategy and because of the ultra-low interest rate environment it is becoming increasingly difficult to evaluate a stock’s long-term worth.
"We use the DCF [discounted cash flow] model when it comes to picking stocks," Leahy said.
"The problem is, you need to be able to discount rates, but when the likes of Bernanke, Carney and other central bankers are doing their best to keep a lid on long-term rates, it can lead to distorted valuations."
"You have to be very, very careful, as if interest rates were to change at some point in the future, it could mean what you feel is fair value for a company changes as well. We want to try and own companies that are resilient and ones that are not affected by exogenous events like tapering."
The DCF model works by estimating the money someone would receive from an investment, adjusting for the time value of money, which includes expectations of interest rates.
Therefore, if rates were to change suddenly and sharply– which seems possible in the future – then it could create a real problem.
Leahy says that another aspect of the problem in the current environment is that due to the huge wall of money being injected into the financial system by the likes of the Fed and the Bank of England, there is more capital sloshing around in equity markets.
Because of that, the manager says there is a diminishing amount of genuine value plays.
"To be honest, it is more difficult, but that isn’t to say there aren’t value opportunities out there," he said.
"But there are a lot of fund raisings happening, which are attracting very hot money. Foxtons was around seven times oversubscribed, which I see as a bit of an early warning sign. There are a lot of inflows into equities in general, but a lot of investors are looking for liquidity events to deploy capital quickly," he added.
He says that one of the potential headwinds facing the market is a lack of earnings growth, because company fundamentals have not risen in line with share prices.
"We will scan every sector with David and I both in the roles of analyst and fund manager. We screen for and meet companies and though a lot of people say it, it is still true that you only get to know the company if you actually meet them."
"By knowing the company inside out, you can take advantage of short-term noise, as it can provide buying opportunities."
"But it has been getting harder to do that. We have seen a significant re-rating in the equity market but not much in the way of earnings upgrades. As the economy strengthens, we are going to need to see earnings upgrades to match the re-ratings that have happened," he added.
Leahy and Stormont have managed their Irish-domiciled Hermes UK Small and Mid Cap Companies fund since its launch in December 2008.
According to FE Analytics, the £242.6m fund is the seventh-best performer in the IMA UK Smaller Companies sector over that time with returns of 236.7 per cent, beating its composite benchmark – 90/10 split FTSE 250 ex IT and FTSE Small Cap ex IT – which has returned 221.87 per cent.
Performance of fund vs sector and index since Dec 2008
Source: FE Analytics
The fund is also a top-quartile performer over three years and has tended to be less volatile than its composite benchmark.
Leahy says that one of the main parts to his approach is "risk management". He looks for companies with attractive valuations and that should be able to perform in all market conditions.
One stock he is backing at the moment is the FTSE 250-listed Senior Group, which is a holding company for the manufacturing and engineering industries.
He says the company looks cheap compared with its long-term earnings growth. He particularly likes its visibility and transparency, meaning he can work out its long-term value with more confidence.
"We are still very happy with Senior Group," he said.
"It is an aerospace company which has very good visibility of orders, as it designs components for companies like Boeing and Airbus."
"Given those companies have very large order books, they need suppliers that are reliable and provide a quick service, and because of that, Senior has been winning more orders recently."
"Senior Group’s share did have a bit of a wobble in the summer. Because the company management team is open and honest, they admitted that they had seen pricing pressure from the aircraft companies, but it was a bit of a storm in a teacup really."
"I first went to see Senior a decade ago and I visited their operations out in the States. What I found was that every layer in the management was very open about its operations being a possible threat to the company."
"The chief exec was very happy with me seeing all of the business without having to chaperone me,” he added.
Investors in Senior Group would have seen returns of 37.15 per cent if they had bought at the start of the year, which is higher than the returns available from the wider FTSE 250 index. However, as the graph shows, the share price did fall considerably in June.
Performance of stock vs index year to date
Source: FE Analytics
Senior Group is Leahy’s ninth-largest holding, making up 2.5 per cent of his portfolio.
The Hermes UK Small and Mid Cap Companies fund has an ongoing charges figure (OCF) of 1.36 per cent and requires a minimum investment of £1,000. It currently has limited availability on platforms but the group plans to change that in the near future.
