Cyclical parts of the market outperformed last year as investors chased the recovery story, but the market has increasingly come to focus on earnings growth and to discriminate between companies that have it and those that don’t. Fosh says that this dynamic will benefit quality companies and the funds like his that invest in them.
“In the recovery last year it was difficult time because quality stocks tended to do badly and what has been interesting is this year despite the recovery becoming entrenched there has been a swing back to this type of stocks,” he said.
“The underperformance of quality was unprecedented by historic standards. Quality companies underperformed for eight consecutive quarters.”
“If you go back 25 years that’s not been seen before, which points to the selloff being overdone.”
“In the first flush of optimism a rising tide lifts all boats and people go for stocks with the most gearing to the recovery. Now people are being more picky.”
“The value rally went too far. We are starting to see one year out earnings growth [forecasts]. Few companies are reporting above average earnings growth.”
“In year two or three of the recovery we would expect earnings growth in quality companies to come through.”
Fosh and co-manager Anthony Cross, also an FE Alpha Manager, saw their funds underperform last year as more cyclical companies were back in vogue.
Performance of fund vs sector and index in 2013
Source: FE Analytics
However, Liontrust Special Situations is top quartile in 2014 so far as the market has struggled to rise and companies that fail to meet earnings expectations have been hammered.
Performance of fund vs sector and index in 2014
Source: FE Analytics
Fosh says that the earnings outlook for “dull” quality companies is rosy this year, which should support their share prices as investors focus more on the hard numbers.
“This time last year quite a lot of our companies’ earnings grew at 2 or 3 per cent which looked pedestrian, but when you look one year out they are at 9 or 10 per cent, at least as much as market was expecting if not more,” he said.
Source: FE Analytics
FE data doesn’t suggest there has been a huge rotation in the UK market at this point in time. Most of the funds that outperformed last year remain largely the best-performing this year.
In fact, even following the market downturn that started in February, which was focused heavily in the tech and biotech sectors, the leading portfolios have remained very similar.
Funds such as MFM Slater Recovery, R&M UK Equity Unconstrained and Standard Life UK Equity Unconstrained feature highly over all three time periods.
However, the MSCI indices do suggest there has been a slight tick back to quality over the latter period.
Momentum stocks outperformed in the first past of the year but quality has outperformed since the market pull-back began, a possible first sign of the dynamic Fosh warns of.
Performance of fund vs indices since 7 Jan
Source: FE Analytics
Some commentators such as FE Alpha Manager Steve Russell of Ruffer, have warned that the tapering of quantitative easing by US authorities could cause sell-offs in riskier, cyclical assets, and have blamed the recent falls in the tech sector on this cause.
This would seem to be a potential tailwind for quality at the expense of cyclicality. However, Fosh warns on building a portfolio around expectations of changes in the macro-economic environment.
“We deliberately don’t try to build a portfolio on macro considerations,” he said. “There are as many false signals as there are true ones.”
“[However,] I can remember the first warning of early QE last year caused a sharp change to the benefit of quality.”
The manager prefers to focus on the valuation argument, and says that the market is likely to focus in the value in quality companies this year.
“Valuations have become extreme by historic standards,” he said.
