The basic materials, tobacco and technology/biotechnology sectors are likely to go through a period of underperformance, according to City Financial’s David Crawford, who is shorting all three industries within his top-performing absolute return fund.
Crawford is a firm believer that short-selling, or the practice of selling a borrowed asset in the hope of buying it back at a lower price, is one of the best ways to outperform and therefore uses his ‘short book’ as a tool for alpha generation rather than just a hedge against wider market falls.
This approach has worked well for him over the years as, according to FE Analytics, his £93m City Financial Absolute Equity fund has considerably outperformed the FTSE All Share since its launch in March 2008 with returns of 190.36 per cent – which are more than double the gains of the index.
Performance of fund versus sector since launch
Source: FE Analytics
Our data shows the long/short equity fund is also outperforming the index over one, three and five years. While it is by no means a traditional absolute return fund given its historical volatility, its maximum drawdown has been half that of the index since inception.
The manager has had a number of successful shorts over recent years, such as ASOS and Quindell last year, and now, given the UK market has got off to a flying start in 2015, he says he is finding even more opportunities to add to his short book.
“We would say, because the market is pretty bullish, there is more opportunity on the short side as some companies aren’t as good as the market thinks they are,” Crawford said.
With that in mind, he highlights three areas of the UK market he thinks are in for a rough ride.
Basic materials
First on the list is the basic materials sector and more specifically mining companies.
The sector has been out of favour for some time now due to the slowdown in Chinese economic growth, falling commodity prices and irresponsible spending on the part of company management teams in the past.
Performance of indices over 5yrs
Source: FE Analytics
Nevertheless, with a number of high profile CEO departures and a push for more shareholder-friendly activities, several leading experts have turned more bullish on mining stocks. But Crawford says there are still a number of reasons why the sector will continue to struggle.
“We've been short the mining sector and you might think we are doing that because of China, but actually we are short because we don't think the companies are not as good quality as the market thinks they are,” he said.
“In simple terms, you think about a mining company like Randgold Resources: the life of its mine is 10 years so there is 10 years' worth of gold in the ground. What that means is that after 10 years, there is nothing left.”
“They have short duration assets and that’s not a great business, in a way. It depends how you value it, but you shouldn't be paying an awful lot if you think the assets of the company are depleting.”
“Whereas, on the other hand, you have the likes of Unilever selling washing powder and as long as it keeps advertising and promoting itself it is probably going to be selling washing powder in 50 years’ time.”
Tobacco
Next on the list is the tobacco sector, which faces structural headwinds such as an increasing awareness about the health implications of smoking, the rise of e-cigarettes and the move to plain-packaging.
It has undoubtedly been one of the best areas to hold over the longer term, as FE Analytics shows that the FTSE 350 Tobacco index has returned a staggering 1,487.62 per cent over 15 years. Those gains have been 13 times greater than those of the FTSE 350 index.
Performance of sectors over 15yrs
Source: FE Analytics
The performance of tobacco companies such as British American Tobacco and Imperial Tobacco has helped star managers such as Neil Woodford and Mark Barnett to garner such strong track records during their careers.
However, Crawford thinks the sector’s golden age is now over.
“We are currently short some tobacco companies and the reason why isn't rocket science – cigarettes kill you,” Crawford said
“Also, there is obviously a declining market in the western world particularly with e-cigarettes coming in. There is still growth in other areas of the world but we would say that is an industry with lots of issues because it is a widely known fact that they can kill you and there is a substitute in e-cigs.”
“If you walk around London now you see people vaping and while that may not be the case around the rest of the world, in 50 years’ time do I think people will be smoking or using e-cigs? Probably an e-cigarette as it gives you the same effect but without the carcinogenic issues.”
Technology and biotechnology
The final area that Crawford is currently short is the tech and biotech sectors, two areas of the market which have delivered very strong returns over recent years.
“We have some shorts in technology companies and biotech companies – both areas where we think the market is expecting a lot and may actually be disappointed,” Crawford explained.
While tech companies have become increasingly en vogue following the dot-com bubble and its subsequent burst, biotechnology has come onto more and more investors’ radars following its stellar gains over recent years.
According to FE data, for example, Candriam Biotechnology has been the best performing fund in the whole Investment Association universe over 10 years, while AXA Framlington Biotech has beaten every other open-ended fund over three and five years.
Performance of funds versus index over 10yrs
Source: FE Analytics
Some have said the rally can continue, such as Polar Capital’s David Pinniger, who told FE Trustnet that biotech companies were deserving of their high ratings.
“I’m not being flippant here, but we are not in a bubble,” Pinniger said.
“You’ve had this woosh, so people look at the returns and think, ‘yikes this is crazy and clearly a bubble’. The difference this time is that it is being driven by real products which are generating phenomenal amounts of cash.”
However, the likes of Royce Associates’ Lauren Romeo has a similar argument to Crawford.
“It has hurt being out of that sector but we still feel like it is good to stick to our discipline [as] valuations are getting into bubble territory. It feels like that time in terms of the euphoria in terms of what has been going on in that space. We are wary of this sector,” she said.
While most biotech funds are predominately focused on the US, the UK’s biotech sector includes companies like Shire, Circassia, GW Pharmaceuticals and Precious Cells Group.