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The market that long-term investors should avoid at all costs

06 January 2015

Kennox’s Geoff Legg highlights the equity market he expects to materially underperform over the longer term.

By Alex Paget,

Senior Reporter, FE Trustnet

Investors with a long-term horizon should avoid the “overheated” US equity market within their portfolios, according to Kennox’s Geoff Legg, who predicts it is going to struggle over the coming years due to its very high valuation.

While the US equity market was viewed as being expensive at the start of 2014, the S&P 500 went on to have another thunderous year with returns of 20 per cent in sterling terms, building on its 29 per cent gain in 2013 and 10 per cent rise in 2012.

Performance of indices since Jan 2012

Source: FE Analytics 

However Legg, who heads up the £320m Kennox Strategic Value fund, warns that the rally has been driven by factors which aren’t sustainable and given that it has surged over recent years, he fully expects the US equity market to materially underperform from here.

“The performance of the US can perhaps be explained by several factors,” Legg (pictured) said.

“The first is that as prospects of higher interest rates recede (and government bond yields remain unpalatably low as a result), investors are forced to find income from equity dividends. In this environment, 2 to 3 per cent yields become artificially enticing.” 

“The second is the enormous injection of capital into the market from corporate buyback. The $130bn being bought by companies each quarter dwarfs other sources of investment. Add into this mix the depreciation of gold and ongoing uncertainty in other regions – notably Europe and Japan –the perfect environment for an overheated US equities market has developed.” 

He added: “This is an area to avoid for investors with long-term horizons.”

Legg and his co-manager, Charles L Heenan, are value investors. This approach meant that they had very little exposure to North America last year and also held a large proportion of their portfolio in cash – at times close to 20 per cent.

Given that the US accounts for more than half of the various global indices’ compositions, it doesn’t come as much of a surprise that their fund underperformed the IA Global sector last year. Large positions in the UK, Europe and Japan meant the fund actually lost money in 2014.

Performance of fund vs sector in 2014

Source: FE Analytics

However, Legg is a firm believer that the greatest driver of an investor’s return is the price they pay for an asset.

This process has worked for him over the long term. According to FE Analytics, Kennox Strategic Value has been a top quartile performer since its launch in July 2007 with returns of 70.03 per cent, nearly doubling the sector average in the process.

Performance of fund vs sector since July 2007

Source: FE Analytics

There are a number of experts who agree with Legg’s assessment of the US market. While the likes of Neptune’s Robin Geffen say the S&P 500’s valuation is justified due to the US’s robust economic growth, Premier’s Simon Evan-Cook and FE Alpha Manager Marcus Brookes of Schroders have warned the future looks bleak for North American equities.

As Legg is a value investor, he says the volatility of 2014 has thrown up a number of interesting opportunities. One of which is the energy sector, given the fact the price of oil fell a staggering 40 per cent last year.

“The underperformance of the energy sector, however, may provide an opportunity,” Legg said.

“Oil prices are likely to remain under pressure, so it is sensible to focus on larger, integrated oil majors that are less exposed to short-term swings in the oil price, and are able to benefit from the extreme price movement in smaller exploration companies – providing M&A opportunities to replenish reserves at appealing prices – and increased pressure on the oil services sector; resulting in costs declining for their clients.”

Legg is also relatively bullish on gold miners heading into 2015.

In an article this morning, FE Trustnet highlighted that gold funds within the IA universe are down an eye-watering 75 per cent since January 2011 as a result of a falling gold price, a lack of inflation and concerns about company management teams.

While a lot of investors will, understandably, want to avoid gold equities, Legg says there is an abundance of valuation support for those who can stomach the volatility.

“With suppressed gold prices, the market has focused on dwindling earnings of gold miners, and is ignoring the longer-term value of the reserves of gold they own. Valuations are exceptional, with many miners trading at significant discounts to book value and at all-time lows versus reserves.”

He added: “Only a partial recovery in the gold price is needed to realise significant returns.”

Legg is also optimistic about Japanese equities, which account for 13.56 per cent of his portfolio and are an overweight position relative to the IA Global sector.

Though the Nikkei surged in 2013 on the back of prime minister Shinzo Abe’s pro-growth reformist policies and huge amounts of stimulus provided by the Bank of Japan, it ended 2014 in negative territory as a result of a VAT hike, the economy falling into recession and as concerns were raised about the longevity of ‘Abenomics’.

Performance of indices in 2014

Source: FE Analytics

However, the manager says there a number of reasons why Japan could well have a good year in 2015.

“Japan may offer opportunities as macro tailwinds appear set to continue: the national pension fund is set to double its allocation to domestic equities – an injection of $150bn into the market – the introduction of a stewardship code to encourage efficiency of corporate Japan – creating an incentive for surplus cash to be returned to investors – and the continuation of QE,” Legg said.

“These factors, combined with companies still trading at attractive valuations, will make Japan a region to watch in 2015.”

Kennox Strategic Value is a highly concentrated portfolio of just 28 holdings and currently holds 16.71 per cent in cash. Its ongoing charges figure is 1.14 per cent.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.