Coordinated global growth, strong earnings momentum and lower valuations make cyclical stocks a potentially lucrative investment over the long term, according to Saracen Fund Managers’ Graham Campbell and David Keir.
The co-managers of the £114m TB Saracen Global Income & Growth fund said they had moved away from expensive so-called ‘bond proxies’ in the consumer staples sector in recent years in favour of more attractively-priced cyclical stocks.
Demand for consumer staples doesn’t slow in down times, which traditionally makes these stocks a good option for investors seeking steady growth, dividends and low volatility.
Conversely, cyclical stocks are heavily dependent on the economic cycle and the economic conditions and are, as a result, exposed to fluctuations in consumer spending.
So, when the economy deteriorates, consumers tend to spend less money on non-essential cyclical products but will continue spending money on food, beverages, tobacco or household items.
Performance of indices since index inception
Source: FE Analytics
Markets have performed strongly since the global financial crisis due to the introduction of stimulative policies enacted by central banks, with consumer staples enjoying a tailwind and driving the market.
As the above chart shows, however, cyclical stocks have begun to outperform consumer staples more recently as the global growth story became more entrenched.
“When we first launched the fund, we had 27 per cent of the portfolio invested in consumer [staples] shares. Today, this stands at 5 per cent and we have more cyclicals than other funds,” the pair noted.
“It’s the consumer staples that have driven the market but these businesses are expensive, they are growing slower than what we anticipated and they are not growing earnings,” said co-manager Keir.
“The combination of increased leverage, still- elevated valuations and a subdued growth outlook in shares means it is too early to re-invest in consumer staples.”
While cyclical stocks have performed more strongly recently, the pair noted that on a price-to-earnings (P/E) basis, valuations were only at long-term median levels.
The recent backdrop of global equities grinding higher with volatility at all-time lows came to an end with the market correction at the beginning of February, as investors began questioning the sustainability of continued global growth as the stimulative central bank policies began to be withdrawn.
Downward movement in markets during the first quarter of the year has led many cyclical shares to underperform during that time, with a number of stocks falling despite reporting solid 2017 numbers and positive outlooks for 2018.
The managers noted that the market correction has increased their conviction that equities look “incredibly good value relative to bonds”.
However, not all equities are rated the same with the managers preferring undervalued European cyclical names in favour of US stocks.
“Global businesses in the US are more expensive than those in Europe, they have higher ratings,” said Keir. “The US is at the end of the cycle whilst Europe hasn’t recovered yet.
Performance of indices since 2008
Source: FE Analytics
“The way these businesses tend to operate is that volumes pick up and when volumes pick up eventually you get pricing coming through.”
The managers noted: “In the States you’ve had volume and price recovery but in Europe we haven’t had that. This year is the first year where we are seeing price rises and volume growth since 2011 across cyclical businesses, which can lead to very significant profit growth and margin growth.”
As such, the TB Saracen Global Income & Growth currently includes cyclical stocks such as Evonik Industries, HeidelbergCement, Schneider Electric and oilfield services company Schlumberger.
Highlighting the importance of choosing the right businesses and the dangerous combination of cyclicality with leverage, the managers said their investment approach focuses on potential losses rather than gains, something that differentiates them from their peers.
“We have developed what we call the worst-case scenario modelling, that we consider important when looking at cyclical and indebted businesses,” the managers said.
“A stock can be very cheap but we need to look at what’s the realistic worst case for the business, this is: how wrong can we reasonably be?
“For example, when we look at banks we look back at 2007 and ask: How did that go? Has it been a change of management? How is the balance sheet?” they asked.
“Do they have more than sufficient capital? If the business has just enough capital everything can go really wrong. Thus, we don’t buy the riskier banks.
“You have to understand the risk of our business because it could be really cheap with huge dividends but, if the worst case says its bankrupt in two years’ time, we won’t invest in that business at all,” they noted.
Other attractive areas of the market include financials where the pair believe some are trading at extremely depressed valuations. The managers also like the technology sector – which they believe go through 10-year computer cycles, 10x the size of the previous cycle – and healthcare, which is trading in line with market for only the third time in the past 20 years.
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
Since launch in 2011, TB Saracen Global Income & Growth has delivered a total return of 103.02 per cent compared with a gain of 80.04 per cent for the average fund in the IA Global Equity Income sector and a 69.84 per cent gain for the FTSE All Share benchmark.
The fund has an ongoing charges figure (OCF) of 0.99 per cent and yields 3.9 per cent.