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David Coombs: Why I’m buying into UK mid-cap funds

19 July 2016

The FE Alpha Manager, who heads up the multi-asset portfolios at Rathbones, tells FE Trustnet why he hasn’t sold out of his UK blue-chips and is also adding further down the cap spectrum.

By Lauren Mason,

Reporter, FE Trustnet

 Attractive valuations mean that oversold domestic-facing UK stocks and mid-caps present the most attractive buying opportunities today, according to David Coombs (pictured).

The FE Alpha Manager, who runs a series of multi-asset portfolios for Rathbones, admits that, while he had positioned his funds in case of a Brexit, he wasn’t expecting the shock EU referendum result.

As such, his original plan was to invest most of the high levels of cash he was holding in UK stocks (explained in a previous article), although now he still feels comfortable leaving a reasonable weighting of his portfolios un-invested.

What he has bought though is domestic-facing and mid-cap stocks including the likes of ITV, BT, Lloyds, Legal & General and clothing retailer Next.

Performance of stocks in 2016

 

Source: FE Analytics

“Plan A was, if we stayed in, we would buy some domestic stocks. Plan B was in case of an exit and what we expected was that the whole market would fall by 10 or 15 per cent including the overseas earners and we’d go in and buy all the overseas earners on the Friday [after Brexit],” he explained.

“Actually, because we held the overseas earners, we thought we’d add to our positions. Unfortunately, we couldn’t because they all stayed up so we didn’t have those bargains.”

“What we ended up buying was the Brexit stocks that got hit even harder. We thought we’d be buying the overseas earners and we ended up buying the domestic earners as they were so sold off. We weren’t massively aggressive with this though because clearly there is a lack of visibility.”

In addition to adding to these stocks, the manager also bought Schroder UK Mid Cap and JP Morgan’s Mercantile investment trusts to bolster his holdings within the market area.

Schroder UK Mid Cap, which is headed up by FE Alpha Manager Andrew Brough, is £147m in size and holds the likes of Rightmove, Redrow, Homeserve and Kennedy Wilson Europe Real Estate in its list of top 10 largest positions.

Given the fact that property stocks have been left particularly bruised since the Brexit results, the trust is currently trading on a 17.3 per cent discount and yields 2.3 per cent.

Similarly, the Mercantile investment trust holds Bellway as its largest holding and also has Howden’s Joinery in its top 10 holdings, which is a stock that can often be dependent on the housing market.


The £1.8bn trust, which is benchmarked against the FTSE All­ Share (ex FTSE 100, ex Inv Companies) index, is trading on a 10.2 per cent discount and yields 2.8 per cent.

Performance of trusts vs benchmarks in 2016

 

Source: FE Analytics

“If you’re dollar investor, you can buy the Mercantile investment trust on a double digit discount, it’s benchmarked against an index which has fallen a long way and you’re buying in dollars,” Coombs said.

“UK mid-caps look really cheap to many investors. I think you can afford to invest today, lose a bit off of them today and add some more later. You can try and be too clever with these things”.

“Of course when markets are down shares will drop, but does that mean the company is just going to disappear in a month’s time? Absolutely not. You have to just put a bit in and if you lose 10 per cent, you lose 10 per cent. Don’t worry.”

While the FE Alpha Manager has been buying-mid-caps, he has also opted not to sell out of any of global-facing UK large-caps despite the current strength of the blue-chip index.

Performance of indices in 2016

 

Source: FE Analytics

This has meant that he has witnessed “incredible dispersion” between the equity holdings in his portfolio since the EU referendum, with notable winners over recent weeks including Rio Tinto and Shell.

While this sentiment isn’t shared by everyone (Fidelity’s Kevin O’ Nolan explained in an article last week that he has aggressively reduced his UK equity exposure), JP Morgan’s Talib Sheikh says that he expects UK investors to reduce their appetite for risk over the medium term which will benefit the large, defensive dividend-paying UK stocks.

The last few weeks have already seen meaningful repricing of credit and rates, as they’ve rallied to historically pricey levels, but we’ve yet to see a fully commensurate repricing in defensive dividend payers.  We suspect this trend is in its infancy and we continue to like sources of high quality income that can add diversification, in sectors including healthcare, consumer staples, utilities and telecommunications,” he said.

“In the post-Brexit landscape, where the yield grab will continue as we venture further into negative rate territory, a preference for quality assets with strong liquidity and a strong focus on broad diversification seems prudent.”


Coombs says that it is wise to maintain some exposure to these sorts of stocks, so long as they aren’t venturing into extremely expensive and defensive bond proxy territory as he warns there is a significant chance these could mean revert.

Instead, the manager describes himself as holding large UK stocks that pay dividends and are of high quality but sit “one tier below” so-called bond proxies.

“If interest rates don’t rise for four or five years, if we do see a recession in the UK and Europe, if we do see global growth continue below-trend over the long term, I think those more expensive stocks will do so much better,” he reasoned.

“I think you should trim them but don’t sell them, that would be my advice, I think otherwise you might regret it.”

“If we have negative interest rates, a P/E ratio of 18 times won’t be that expensive so we have to re-think what is cheap and actually, you might be quite happy to pay 25 times earnings if you’re confident we’ll have negative interest rates or negative real yield over the next three years.”

“They may not be as expensive as we think.”

 

Over five years, Coombs has outperformed his peer group composite by 7.81 percentage points with a total return of 32.13 per cent.

He has achieved this outperformance with a better-than-average maximum drawdown (which measures the most potential money lost if bought and sold at the worst times) and downside risk (which predicts the potential to lose money during a falling market).

Performance of manager vs peer group composite over 5yrs

 

Source: FE Analytics

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