Whether to have a defensive or cyclical tilt is one of the most important and effective ways of expressing a bearish or bullish call on the market.
Whereas defensive sectors such as healthcare, utilities, food retailers and tobacco tend to perform better when the economy and markets take a turn for the worst, cyclicals like housebuilders, airlines, industrials and technology thrive when the outlook improves.
Walker, who heads up the £1.1bn Invesco Perpetual UK Growth portfolio, says worries over the economic recovery and the consequent strong relative performance of defensives has made cyclicals far more attractive, as the below graph shows.
12-month forward price-to-earnings ratio defensives/cyclicals
Source: The Lazarus Partnership, as at 20 October 2014
For those who think like Walker and are looking to increase their cyclical exposure as a result of the changes in valuations, here are five funds you may wish to consider for your portfolio.
Old Mutual UK Equity
Ben Williams (pictured), investment manager at Saunderson House, has had a pro-cyclical bias for some time, which benefitted him significantly in 2012 and 2013.
He agrees that they look more attractive than high quality, defensive stocks, believing that the latest sell off was “a mid-cycle correction rather than anything more serious”.“It’s certainly not time to be going massively defensive as most of these typical stocks – AG Barr, Whitbread, AB Foods and so on – still look too expensive and are priced for perfection,” he said.
“Looking at cyclical funds we like, I would highlight Simon Murphy’s Old Mutual UK Equity fund. It currently has large overweights in financials such as Aviva, Prudential, HSBC, Barclays and Lloyds, as well as mining, oil & gas and UK commercial property.”
“The fund only holds 1 per cent in consumer goods stocks, compared to a 14 per cent weighting in the index. Murphy is cautious on ‘bond proxies’ such as Unilever, Reckitt Benckiser, Diageo and BAT given their expensive valuations and potential to underperform when government bond yields rise,” Williams added.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
The cyclical bias has held Murphy in good stead over the past three years; FE data shows that Old Mutual UK Equity has returned 60.08 per cent over the period, compared to 41.12 per cent from the IMA UK All Companies sector average and 34.98 per cent from the FTSE All Share.
Unsurprisingly, performance has suffered so far in 2014, though the fund is still ahead of its peers year-to-date with losses of 3.16 per cent.
Murphy took over Old Mutual UK Equity in March 2008 and has outperformed both its sector and benchmark with returns of almost 70 per cent.
It underperformed in the down years of both 2008 and 2011, but has outperformed every year the FTSE has made a positive return.
The fund has ongoing charges of 0.93 per cent.
JOHCM UK Dynamic
While not an out-and-out cyclical fund, FE Research’s Amandine Thierree thinks FE Alpha Manager Alex Savvides’ JOHCM UK Dynamic portfolio is a good choice for investors looking for exposure to the cheaper areas of the market.
The manager’s value bias has led him to significant cyclical exposure and, while he has some defensive holdings in the shape of AstraZeneca and GlaxoSmithKline, he has a hefty weighting to financials, oil & gas, basic materials, tech and industrials, which have a combined weighting of 64.66 per cent.
Top-10 holdings include the likes of Aviva, Qinetiq Group and Anglo American.
JOHCM UK Dynamic has been a standout performer in the IMA UK All Companies sector in recent years, achieving top quartile returns over one, three and five-year periods.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
Savvides has an excellent record in rising markets, but Theirree says his tendency to target companies with sustainable dividends has also helped him protect against the downside.
FE data shows the fund is a top-quartile performer in 2014 in spite of its cyclical tilt.
JOHCM UK Dynamic has ongoing charges of 0.75 per cent, but charges a performance fee on top of that.
Miton UK Value Opportunities
Gavin Haynes, managing director of Whitechurch Securities, also believes cyclicals are more attractive now as a result of the sell-off.
“Some of the worst performers in the recent sell-off been those stocks with a cyclical bias as investors have become concerned that the economic recovery is in danger of slowing,” he said.
“This has led to an increase in the valuation gap between quality defensive areas of the market and more cyclical stocks. This could provide an opportunity for investors taking a value approach and prepared to ride out the short-term volatility.”
Haynes highlights George Godber’s Miton UK Value Opportunities portfolio as a good option, pointing out it has a deep value style and a hefty weighting to cyclicals.
Alex Brandreth, a deputy fund manager at Brown Shipley, agrees.
“In a recent conversation with the managers of the fund they discussed where they are finding value: some of their more recent purchases have had a more cyclical bias,” he said.
FE data shows the fund has had a great start since its launch in March 2013, delivering top decile returns of 24.63 per cent.
Unlike many of its deep value rivals, it has delivered a positive return year-to-date.
Performance of fund and sector since launch
Source: FE Analytics
Godber and co-manager Georgina Hamilton, formerly of Matterley, have a heavy tilt to mid-caps, which tend to be more economically sensitive than their large-cap counterparts.
Housebuilders are among their biggest sector bets, while industrials are also an overweight.
Miton UK Value Opportunities has ongoing charges of 0.94 per cent.
FE Trustnet choice: Standard Life UK Equity Unconstrained
Ed Legget’s £1.1bn fund is one of the more obvious momentum plays in the sector.
The fund manager very openly admits that he will most probably underperform in down markets, thanks to a significant tilt to economically sensitive companies.
In 2008 he lost a whopping 41.05 per cent and in 2011 the fund was down 20.47 per cent, meaning that in both cases he underperformed his peers by more than 10 percentage points.
However, Legget’s ability to identify cheap companies capable of a re-rating means he more than makes up for these losses when markets rebound.
In 2009 Standard Life UK Equity Unconstrained made an incredible 99.17 per cent and in 2013 it made 43.33 per cent.
The fund has been a top quartile performer in his sector in every year the market has risen since it was launched in 2005.
Performance of fund, sector and index since launch
Source: FE Analytics
FE data shows that the fund is far and away the best performer in the IMA UK All Companies sector since inception, with returns of 283.4 per cent.
MFM Slater Growth comes a distant second with 228.4 per cent.
Legget targets companies with cash flows that are underestimated by the market. This means he tends to invest in cyclicals, as the strong cash flow of companies like AstraZeneca and BAT is well documented.
The fund has a big tilt towards industrials which have a 33.6 per cent weighting, while financials have a 22.3 per cent weighting. Top-10 positions include L&G, FTSE 250 chemicals business Synthomer and packaging company DS Smith.
Standard Life UK Equity Unconstrained has ongoing charges of 1.15 per cent.
R&M UK Equity High Alpha
Andrew Johnston, investment research analyst at Square Mile, says he prefers to get access to UK cyclicals via a more flexible fund that is able to find cheap stocks in any sector.
With this in mind, he highlights Hugh Sergent’s R&M UK Equity High Alpha portfolio.
“R&M’s more flexible approach encompasses both valuation and market timing as part of their process,” he said.
“This year Sergent has gradually been rotating the portfolio as we move through the market cycle by reducing early cycle stocks and small cap growth, and rotating into better values later cycle recovery names, especially in the mega caps space. These include Royal Dutch Shell and Vodafone.”
As well as these large caps Sergent includes banks Lloyds and Barclays in his top-10 and mining giant Rio Tinto.
Financials currently have a 24 per cent weighting, while oil & gas and industrials have a combined weighting of over 20 per cent. R&M UK Equity High Alpha has been a strong performer since its launch in 2006, outperforming its sector and FTSE All Share benchmark over one, three and five-year periods.
It has ongoing charges of 0.84 per cent.
