A number of stock-specific disappointments and an indiscriminate sell-offs in high quality growth companies have caused the five crown-rated Neptune UK Mid Cap fund to post uncharacteristically large losses over recent months, according to FE Alpha Manager Mark Martin. 
Martin, who has run the £650m fund since its launch in December 2008, is one of the highest rated managers in the UK equity space thanks largely to his track record of protecting investors against the worst the market has to offer.
Despite his primary focus on FTSE 250 stocks, which are seen as inherently more volatile than mega-caps, his top decile returns since he started running the fund have been generated during periods of weakness such as in 2011 when the European sovereign debt crisis intensified.
As a result, he has consistently been among the best for his risk-adjusted returns over the past seven or so years.
Therefore, investors in the fund may have been surprised to see how Neptune UK Mid Cap has performed over the last six months.
Although it is a very short time frame, FE data shows it has underperformed both the IA UK All Companies sector average and the FTSE 250 ex IT index with losses of 13.78 per cent – a return profile which is certainly at odds with Martin’s longer term track record.
Performance of fund versus sector and index over six months
Source: FE Analytics
Speaking to FE Trustnet, Martin says that while he has been left very frustrated by his fund’s performance during the latest market rout, there are a number of reasons behind those losses.
“It has been really interesting times, but I have been a bit disappointed with the fund’s short-term performance,” Martin (pictured) said.
“There are two things I would say, though. One is six months is a pretty short time frame and there has been, to some extent, people taking money indiscriminately out of shares that have performed well. The likes of profit centres that the fund now has less exposure to as we have been actively trying to move things around a little bit.”
“Undoubtedly, there has been a move in the market to take money out of profit centres and momentum as a style factor has begun to wear off. Clearly, the fund does have a few momentum names – reasonably high quality companies – which have performed well.”
Martin points out, though, that this in an interesting and potentially worrying dynamic.
While value stocks have tended to be hit hardest during previous market falls and value as a style underperformed the likes of quality, growth and momentum stocks over the last few years, over the past two months all four major investment styles have been hit equally hard as sentiment towards equities has fallen off a cliff.
Performance of indices since December 2015
Source: FE Analytics
He says this is because markets have been turned on their head over recent years, with high quality growth companies having pushed indices higher while poorer quality cyclical stocks have been left by the wayside.
“For me, the fascinating thing in the market is – where is the risk in the market? One of the strange features of the last three or four years is that it has largely been the higher quality, more defensive companies, which have led the market higher in what has generally been a rising market,” Martin said.
“It has therefore created a bit of a quandary. If you think (and this isn’t my view) that we are heading for recession, you would instinctively think to yourself, I need to own healthcare or consumer staples and I definitely shouldn’t be owning banks etc.”
“However, the profit centres basically are healthcare which is, potentially, quite scary for the market as people don’t know where the fire exits are.”
Martin says the reasons for this could be because managers have been covering short positions, or are now looking at bombed-out oil and mining companies having been overweight mid-caps for most of the last 12 months.
He says while this has certainly hurt the fund, given he benefitted from the reverse of that trend (i.e. managers taking big bets in FTSE 250 stocks to outperform the wider UK equity market), his underperformance would have inevitably happened at some stage.
However, this indiscriminate selling hasn’t been the only driver of Neptune UK Mid Cap’s losses over recent months as Martin admits there have been certain stock calls that have blown up on him.
“TalkTalk is an example,” Martin said. “Over the last six months or so that has certainly been disappointing and, obviously, a cyber-attack is pretty hard to predict. There was also PZ Cussons, which has been impacted by fears over the Nigerian economy. PZ Cussons derives a significant proportion of its earnings from Nigeria.”
He also says defence company Chemring has been another disappointment, given there was an order slippage and its management announced a rights issues that he wasn’t expecting.
According to FE Analytics, all three stocks have fallen significantly over recent months (as the graph below shows) but Martin has felt comfortable buying more of all three of the companies following their weakness.
Performance of stocks versus index over 1yr
Source: FE Analytics
Of course, any criticism of Martin’s short-term performance should be caveated by his strong longer term numbers.
The manager runs a ‘three silo’ portfolio, whereby he always holds at least 20 per cent in either ‘structural growth’ companies, ‘economic recovery’ companies and ‘corporate turnarounds’, so that his fund has the ability to perform in most market conditions.
This has meant that while he has tended to lag his benchmark and sector in strongly rising markets, he has historically come into his own during flat or falling ones.
Since launch, for example, the fund has been the sector’s fifth best performer and beaten its benchmark by 56 percentage points with its returns of 274.89 per cent.
Performance of fund versus sector and index since launch
Source: FE Analytics
Thanks to the fund’s performances in difficult years such as 2014 and 2011, Neptune UK Mid Cap has also had the fourth best risk-adjusted returns (as measured by its Sharpe ratio) and the lowest maximum drawdown in the sector since launch, despite its area of focus.
As such, Charles Younes – research manager at FE Research – still rates the fund highly. However, he says Martin’s recent performance is something investors need to be aware of.
“This is a very good and interesting fund and I like Martin’s consistent approach, which I think is well thought out and diligently put into practice. His valuation-based strategy and his use of the ‘three silos’ has helped to reduce the fund’s the volatility relative to the FTSE 250, which in turn has helped to limit drawdowns,” Younes said.
“Clearly, though, this hasn’t been the case more recently and there seems to have been no change to his investment style or process. Therefore, question marks surround his stock-picking and we will have to see whether Martin can bounce back from this tough period.”
During these recent falls, though, Martin has been changing the portfolio slightly.
For example, he has – at the margin – reduced his weighting to healthcare by exiting his long-standing position in Dechra Pharmaceuticals following its strong gains. On other hand, he has bought Victrex, which manufactures polymer solutions for various industries and is therefore a more cyclical stock.
As a result and again, at the margin, Martin says he has increased his exposure to his ‘economic growth’ silo at the expense of his ‘structural growth’ silo as bond yields have fallen.