Investors should avoid cyclical and value stocks now Brexit is a reality, says Old Mutual’s Kevin Lilley, who has changed his portfolio accordingly following the UK’s decision to leave the EU.
Value stocks have been out of favour for some time as a sense of nervousness among investors, loose monetary policies by a number of European governments, and a low growth environment have weighed on returns relative to high-quality growth companies.
Relative performance of indices over 5yrs
Source: FE Analytics
However, many thought that this trend could be about to reverse, including Lilley, who had been positioning his fund - Old Mutual European Equity (ex UK) - with this in mind.
“I had been running the fund with a pro-cyclical bias to it because recovery was coming through India and we anticipated bond yields to go up,” he said.
“It had zero cash, it was maximum underweight defensives because they looked expensive particularly in food and beverages, it was overweight financials and it was overweight cyclicals.”
Lilley certainly wasn’t alone in his views, with the likes of City Financial’s Peter Toogood telling FE Trustnet earlier in the year that value stocks were almost “guaranteed” to outperform growth companies from here.
His views centred on the idea that given value had underperformed for so long and was so cheap, if economic growth picked up they would outperform as investors would be more confident and value indices are littered with more economically-sensitive companies.
On the other hand, if the economy slowed aggressively, he argued they would still outperform other stocks expensive growth stocks from a relative basis as they were already bombed-out.
Pre-referendum, Lilley’s £79.4m fund was heavily invested in financials and industrials – cyclical areas that tend to perform better when the market is on the upturn. 
Lilley said: “[Before Brexit] things were relatively clear in Europe. We had a firm game plan, we had a portfolio which was very cyclically orientated with very little cash.”
“Europe was in a recovery mode – it was a slow growth mode but it was gradually improving year upon year as the acts of austerity from the few years before were wearing off.”
From 18 July 2013 until 23 June 2016, the fund outperformed its benchmark slightly, returning 12.05 per cent compared to the MSCI Europe ex UK index average of 11.83 per cent, though it lagged behind the peer average of 15.45 per cent.
Since the referendum, however, the fund’s underperformance is more notable, ranking in the bottom decile of its peer group.
“We thought that bond yields were about to bottom out because inflation was about to return, led by the US, and that would be supportive of financials and some of the more cyclical parts of the market,” Lilley said.
But bond yields have continued to fall, with UK bond yields hitting a new five-year low in the aftermath of the vote.
UK bond yields over the last 5yrs
Source: FE Analytics
Additionally, Lilley thought the areas that had done well over the previous couple of years, such as the more defensive areas and the quality growth areas, would underperform.
“So it was basically in all the wrong positions to be in for the opening of the market after the referendum,” he said.
While still offering a positive return since the referendum, it has made just 2.87 per cent, almost 5 percentage points behind its benchmark and 3.5 behind the IA Europe ex UK sector.
Funds near the top of the sector, including the Baillie Gifford European fund, hold more defensive stocks, with larger weighting towards consumer products.
The £177m fund, run by Thomas Coutts, Stephen Paice, Moritz Sitte and Tom Walsh, has the likes of Nestle in its top 10, for example.
Performance of funds since Brexit vote
Source: FE Analytics
As a result, Lilley has made a lot of changes to the Old Mutual European Equities fund, selling off some of its more cyclical stocks, including Peugeot, as well as its holdings in Italian banks Banco Popular and Mediobanca.
“Financials have been reduced, the banking overweight has been reduced to slightly underweight because of the direction of bond yields and the direction of the economy,” he said.
He says the fund is now neutral on defensive stocks, from being underweight, adding that the only reason he is not yet overweight on the sector is because he cannot find food and beverage companies that look attractive on valuation.
“Where I have been putting the money to play within the defensive sector is in pharmaceutical companies and some utilities,” he said.
The fund has bought back into the likes of pharma group Novartis, as well as German utilities firm E-ON.
He has run the Old Mutual European Equity (ex UK) fund for five years, using a bottom-up strategy to find value in Europe.
Performance of fund versus sector and index over 5yrs
Source: FE Analytics
Since struggling initially in 2011, the fund has returned 31 per cent over a five-year period, but the outlook remain uncertain in Europe for a while he warns, with a number of further referendums coming up in the next few years.
“There are a lot of events in the next year to 18 months which mean that we almost have to take a more cautious stance than we would have done.”
It’s not all doom and gloom, however, as Lilley points out that European stocks are currently reasonably valued on a P/E ratio of around 14 times.
The Old Mutual European Equity (ex UK) fund is on a P/E ratio of 11.4, meaning it is essentially in cheaper stocks, but currently has a similar yield to the market (3.71 per cent against 3.8 per cent).
In a follow-up article, FE Trustnet will highlight the other that were caught out by the Brexit vote, and what they have done since to make amends.
