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Three rallying areas of the market value investors should really be selling

11 April 2016

As a successful long-term investor, FE Alpha Manager ‘hall of famer’ Robin Hepworth tells FE Trustnet which areas of the market he deems to be overvalued and ripe for profit taking.

By Alex Paget,

News Editor, FE Trustnet

US equities, government bonds and UK mid-caps are all areas of the market value investors should be selling, according to FE Alpha Manager ‘hall of famer’ Robin Hepworth, who believes valuations are now unsustainably high.

Hepworth, who manages the £275m EdenTree Higher Income fund, has retained his FE Alpha Manager status in every year since the ratings were introduced 2009 as he has forged a successful long-term career running retail money.

According to FE data, for example, his fund has been the best performing member of the IA Mixed Investment 40%-85% Shares sector since its launch in November 1994 with returns of 477.75 per cent and has beaten its FTSE All Share benchmark by some 130 percentage points.

The fund is also top decile over 10 years, having beaten the sector in eight out of the last 10 calendar years.

Performance of fund versus sector and index since launch

 

Source: FE Analytics

However, Hepworth (pictured) – who invests across bond and equity markets – has struggled more recently as his favoured value investing style has fallen out of favour due to various macroeconomic trends.

That being said, many now believe value, as style, will start outperforming again and in this article Hepworth explains how investors can prepare for such an event by selling areas which have delivered strong gains over recent years – but look pricy as a result.

 

US equities

First and foremost, Hepworth dislikes the US equity market.

In truth, many have deemed the S&P 500 as an expensive area of the market for some time now but it has continued to power ahead of most other regional indices thanks to its increasingly ‘safer’ status and the US’s economic recovery.

It means the US market has posted gains in every year since the financial crisis (during which it fell less than most other areas).

Performance of indices since 2008

 

Source: FE Analytics

“We have had a long-term underweight to the US, but that hasn’t done us any favours over recent times,” Hepworth said. “However, we think average corporate profit margins in the US are unsustainably high. They have never been as a high as they are now.”


 

He points out that though profit margins have begun to fall, they were initially pushed up thanks to low wage growth and ultra-low interest rates, but now both trends are starting to reverse.

Hepworth is also nervous on the US as corporates haven’t been investing for future growth, rather using their spare cash to buy back shares and therefore increase their earnings per share – a trend he says is very unsustainable.

He added: “On valuations, the US looks expensive to us. We just had the Q4 numbers out of the US and we have seen earnings decline and that has had an impact on valuations.”

“You could make an argument that it is cheap (or not too expensive) if you look at the reported earnings at 17 times. However, reported earnings exclude all the bad stuff and management have been excluding the bad stuff more recently, so what we do is track reported earnings against Gap earnings (which is a more conservatively calculated accounting principle) and the difference between the two is the highest it has ever been.”

Though the likes of Rathbone’s Julian Chillingworth have recently told FE Trustnet that the US rally can continue, with ‘real’ earnings showing the S&P 500 on a P/E of 22 times, Hepworth points out that it has never been that high in modern times except for the tech boom of the late 1990s.

 

Government bonds

This is another area of the market many industry experts have been avoiding on valuation grounds over recent years, only for prices to continue to rise.

Indeed, over the last two years, 10-year gilt yields have fallen some 46.5 per cent to their current level of 1.38 per cent thanks to dwindling inflation expectations, equity market volatility and general macro uncertainty.

Performance of index over 2yrs

 

Source: FE Analytics

However, Hepworth says investors need to remember that it is still a grossly overvalued area of the market – even if avoiding government bonds has so far proved to be a poor decision.

“We have no government bonds. With 10-year government bond yields now at 1.4 per cent, there is very little cushion there for a potential rise in inflation,” Hepworth said.

“Some of the core numbers in the US are suggesting some inflationary pressures are coming through. Real wages are starting to rise over recent months, having previously seen many years of negative wage growth.”

“There are certainly reasons to think that inflation may rise and, if we see interest rates rise quicker than the market is expecting, that should be good for value investing.”

“Yields have been forced down by QE and other forced buyers, like the MPC, pension funds and insurance companies. This has pushed rates down to unsustainably low levels. If you are taking a long-term view, why do you want to lock in a 30-year yield at under 3 per cent?”


 

UK mid-caps

The final area Hepworth says investors should sell is more contentious than US equities and government bonds.

Certainly, investors have been able to find very high returns from domestic facing UK mid-caps over recent years as they have been buoyed by an improving UK economy and surprise majority for the Conservatives during last year’s general election.

However, with the FTSE 250 having posted a gain of 34.8 per cent over three years compared to a 10 per cent rise in the FTSE 100, Hepworth has been selling down his exposure to mid-caps

“Smaller companies have had a particularly good run in the UK, they have outperformed in each of the last three years and the FTSE 250 index is now trading on around a 25 per cent premium to its long-term average,” Hepworth said.

Performance of indices over 3yrs

 

Source: FE Analytics

“One of our strategies at the beginning of this year was to look to reduce our weighting to small-caps. Of course, not all of our small-cap exposure is to the UK but it is our UK exposure that is more subject to change.”

“So, while we are overweight small-caps in the fund, but we expect to reduce our UK holdings over the course of the next 12 months.”

Though this is certainly not the consensual view, a number of industry experts have been taking money out of mid-caps (and funds that focus on them) due the stellar gains last year and the uncertainty surrounding the upcoming referendum on the UK’s future relationship with the EU.

However, Hepworth’s decision is purely due to valuations and not the possibility of Brexit.

“No, it’s all to do with valuations. They have had a very good three years as they have consistently outperformed large-caps, but our numbers show they are trading close to a 30 per cent premium to their long-term average.

“We are not usually sellers as we are long-term investors, but when something is trading at 30 per cent above what we think is fair or intrinsic value, that’s when we starting thinking about reducing our positions.” 

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