Martin, head of UK equities and manager of the five crown-rated £588m Neptune UK Mid Cap fund, said with the Bank of England starting to talk about raising interest rates, there could be downside risks to current consumer sentiment.
With the economy yet to show any significant impact following the EU referendum, borrowing and spending have increased as interest rates remain low.
Indeed, it is a trend that has been picked up by consultancy Capital Economics, which noted that the recent rise in unsecured borrowing had started to ring alarm bells.
UK household savings ratio
Source: Office for National Statistics
“Consumers still appear confident enough to borrow in order to sustain spending growth in the face of higher inflation,” said Ruth Gregory, UK economist at Capital Economics.
“But how worried should we be that higher household borrowing and debt will ultimately prompt a steep drop in spending or riskier lending leads to an abrupt fall in credit supply?”
FE Alpha Manager Martin said low savings levels and low wage growth put the UK’s low, consumption-driven economic growth at risk.
He said: “The household savings ratio is lower than it has been for 60 years. A 4 per cent savings ratio is arguably unsurprising given how low rates are.”
Martin and deputy manager Cassell believe that risks have not yet been priced into the domestic cyclical space and have instead focused on companies with lower correlation.
While many investors retreated from mid- and small-cap stocks over concerns they were too exposed to the domestic economy unlike more globally-focused FTSE 100 stocks, Cassell said the FTSE 250 had more overseas revenues than many might expect.
Martin prefers exporters categorised as ‘strategic winners’ – those substantial exporters from the UK – and ‘financial winners’, which benefit from foreign exchange translation. Indeed, the fund is underweight exposure to UK revenues compared with the FTSE 250 benchmark, with greater exposure to North America and Asia.
Martin said more recent industry trends have highlighted some of the dangers of flocking to larger companies and the investment case for investing in mid-cap space.
“In the current market, there is a big move from active to passive. I think that is creating all sorts of fragility in the market,” he said.
The manager said passive investment encourages herding among investors and active managers in the market towards larger companies, with active managers acting to minimise career risk.
“Contrary to what people think there are a lot of opportunities in the FTSE 250 and FTSE Small Cap,” Martin said. “A lot of people have been indiscriminately selling the FTSE 250 and indiscriminately buying the FTSE 100.”
Performance of FTSE 250 (ex ITs) over 1yr
Source: FE Analytics
Mid-cap stocks suffered in the immediate aftermath of the EU referendum last year. The FTSE 250 fell 14.92 per cent between 23 and 27 June before recovering those losses later in the month, although it underperformed the blue-chip FTSE 100 index by some margin.
Despite some of the challenges and the underperformance of large caps, the managers remain convinced that their investment approach can yield results.
Cassell said: “We’re trying to do something different from most of our peers in the mid-cap space.”
She highlighted the fund’s high active share – 93.7 per cent – reflecting the concentrated portfolio of 31 stocks and its high conviction approach.
The average market capitalisation of stocks in the fund is just over £1bn and has the flexibility to invest in smaller companies. Cassell said investing in the mid- and small-cap space increases its prospects of owning an M&A target, highlighting high long-term averages compared with blue-chip companies.
While M&A activity last year was inhibited by the challenging political climate, the lack of deals was a historical anomaly rather than a trend.
“If you want to maximise the chances of M&A, then you want to be in the mid- and small-cap space rather than the FTSE 100,” she said.
Cassell said that weaker sterling following the referendum made UK companies a more attractive prospect for overseas buyers, although an M&A bubble in 2017 was unlikely.
Its portfolio of 31 stocks fall within silo approach to investment split fairly evenly between three themes: economic recovery, structural growth, and operate turnarounds, which have helped minimise cross correlation and moderate downside risk in the fund. Both managers highlighted the fund’s low volatility and high alpha generation, as represented by the Sharpe ratio (which measures risk-adjusted returns) of 1.05.
Although the fund has underperformed the FTSE 250 (ex IT) benchmark’s 18.03 per cent over the past year, the fund has returned a respectable double-digit return of 16.63 per cent. The fund is in the all-cap IA UK All Companies sector, which is up by 23.33 per cent over the same period.
“We have outperformed quite significantly over the long term,” said Cassell. “When the market is rising fairly rapidly we just about caught up with the benchmark. Where we see significant outperformance when the market is flat or falling.”
Performance of fund vs sector & benchmark over 1yr
Source: FE Analytics
Over three years the fund is up by 34.62 per cent compare with the benchmark’s gain on 34.05 per cent, while over five years the fund has returned 116.37 per cent against a 107.44 per cent rise in the benchmark.
The fund has an ongoing charge figure (OCF) of 0.82 per cent.