Maintaining an overweight in growth defensives and commodity cyclicals is a prudent way to minimise the impact of a business cycle tilt, according to Julie Dean (pictured). 
The star manager, who has been at the helm of the TM Sanditon UK fund since its launch in June last year, adopts a business cycle approach to selecting stocks, which is a process she has used since she started managing money at Cazenove (now part of Schroders) in 2002.
This process, as the name suggests, involves conducting economic research to accurately predict where we are in the market cycle and how much to allocate to cyclical and defensive sectors as a result.
The cycle we are currently in has been unusually long as a result of ultra-loose monetary policy from central banks such as ultra-low interest rates and the use of quantitative easing.
Dean – who has doubled the returns of her peer group composite since the turn of the century – warns that many investors have become complacent that this economic backdrop will remain as it is over the medium to long term, when actually they should be preparing their portfolios for the end of the cycle.
Performance of Dean versus peer group composite since Jan 2000
Source: FE Analytics
“Right now there’s still quite an entrenched view that the world is deflationary when in fact core inflation in the US is going up quite strongly – it’s up about 3 per cent on an annualised basis this year,” she explained.
“Unemployment is below 5 per cent in the US and if that carries on improving you will get labour market tightness a year or 18 months from now and that’s going to push inflation further.”
“The Fed essentially said in the middle of March that interest rates can stay very low for an extended period of time when they announced two rate hikes and not four this year – they need to be thinking about this core CPI because it’s getting sticky and if we carry on seeing commodity price recovery, even if it’s modest, that’s going to feed through into these numbers as well.”
Dean’s view in terms of the fund’s positioning at the moment is based around central banks’ response to the financial crisis of 2008, which led to quantitative easing and therefore the increase in asset prices.
The manager says that this simply isn’t sustainable and points out that it has led to higher asset prices because of excess capacity in the market as a result of the previous economic cycle.
“I think what you found was that companies didn’t invest, especially in the US, but what they did do was use ultra-low rates to retire their own equity by releveraging,” she pointed out.
“That’s why profits have been strong this cycle because every component of their margin has gone down – taxes have gone down, interest rates are low… for a long time you had a big arbitrage between labour costs in the West and the East which was helpful.”
“But now corporate profits in the US are beginning to come under pressure. It’s starting to roll and we’ve only just had one rate cycle - the Fed is increasing late at a time when inflation is already picking up and some asset prices are very high.”
Growth stocks have significantly outperformed value stocks on a global basis over the last five years, with the FTSE World Growth index outperforming the FTSE World Value index by 16.46 percentage points with a total return of 60.69 per cent.
Performance of indices over 5yrs
Source: FE Analytics
Dean says that this growth bull market has occurred because low interest rates have allowed long duration ‘safe haven’ assets to become very expensive. This therefore means that growth assets have become a riskier as they have continued to outperform, according to the manager.
“We think in this cycle, as with most other cycles, there’s going to be an under-appreciation of the inflation risks that are presently in the system if policy doesn’t respond,” she continued.
“The way we’ve structured our portfolio is to say, first of all, where is the value?”
The manager is finding a number of opportunities within the commodities sector due to low valuations caused by plummeting prices of oil and raw materials – while the FTSE All Share benchmark has a 14.6 per cent weighting to commodity cyclicals, TM Sanditon UK has a 17.7 per cent weighting in the sector.
“If you didn’t own mining in 2012, 13 and 14 when it fell in absolute return terms in each of those years, you’ve been gifted 5 or 6 per cent relative outperformance – you didn’t need to own it,” Dean said.
“When you get extremes like that it’s always interesting to think, ‘will it persist and crucially, what releases the value?’ With the business cycle we’re quite often a little early when looking for value and then you have to work out if it’s a trap or if it’s a genuine value opportunity.”
“We decided this was real value and the characteristic that will cause this to be realised would be a moderation in dollar strength – dollar bull markets usually last about two years and we’re two years into that now. There has already been some recovery in the oil price.”
Performance of index in 2016
Source: FE Analytics
The manager adds that many of these stocks are doing enough in terms of their balance sheets to improve cash flow, despite the broader headwinds facing the sector that many investors remain focused on.
She also warns that, if nobody owns commodities stocks and companies begin to dispose of some assets, produce better cash flows and reduce their cost base, the swing in equity performance can be violent.
Key stocks that the manager holds in this area of the market include Anglo American and Tullow Oil.
Another area of the market the manager is particularly keen on is defensive growth stocks although, as mentioned earlier, she points out that investors have to tread carefully given that the valuation of many of these assets is currently so high.
“You have to be very selective about what you own. Firstly at the end of cycles you tend to find that betas converge. What’s happened with betas within the growth defensive part of the market is they’ve converged at quite high levels – they’re not as good protectors of capital as perhaps they were in previous cycles,” Dean said.
“If you look at free cash flow yield on some of these stocks they’re very low and they’re still equities. It’s not like they’re the US government bonds.”
“There is a perception of very little risk of these. But actually there could be quite a lot of risk in these if inflation picks up as price-earnings multiples usually contract.”
She says that a lot of companies within this space have increased their prices aggressively as a result of falling currencies in emerging markets, which is yet to have an impact on volumes.
Because the manager believes this is unsustainable and there is therefore some earnings risk on the horizon for these businesses, she says that defensive growth stocks such as Babcock, Shire and Reed Elsevier are attractive holdings at the moment.
“We think [these stocks] are less prone to these risks and their starting multiples are lower. I don’t think either of these shares are particularly controversial but there’s more scope for real capital appreciation rather than just hiding in something that’s safe,” she explained.
Since she has been at the helm of the £89m TM Sanditon UK fund, Dean has provided a loss of 7.39 per cent compared to its sector average’s loss of 6.16 per cent and its benchmark’s loss of 6.95 per cent.
Performance of fund vs sector and benchmark
Source: FE Analytics
However, the manager points out that the business cycle approach involves buying into stocks before the longer term theme being explored plays out. Year-to-date, the fund is in the top decile for its total return of 2.25 per cent while its sector average and benchmark have lost 2.09 and 0.99 per cent respectively.
Though her former Schroder UK Opportunities struggled during her final year as manager in 2014, with her at the helm, it beat the sector and index in six consecutive years between 2008 and 2013.
Her new fund has a clean ongoing charges figure of 0.87 per cent.
