The theory is that double dip or no double dip, the developed world is in a slow-growth environment for the foreseeable future. Markets are extrapolating growth rates from cyclical stocks such as mining equivalent to their levels in 2009. These stocks are therefore expensive and to be avoided.
This is bread and butter for IMA UK Equity Income managers such as Neil Woodford (pictured right), or Tony Nutt. But this is spreading to the UK All Companies sector.
Among the high profile backers of defensive stocks is Stephen Anness, manager of the Invesco Perpetual UK Aggressive fund, who said: “We are still very cautious about the outlook. Also, there has been a large valuation compression, with lots of stocks trading on broadly similar multiples. Investors have gone for all defensive or all cyclical without differentiating between good and bad companies. This is the opportunity – at the moment, there is no premium for high quality companies.”
He believes that large caps have been the victim of the selling of UK equities over the last 20 years. He points to a recent survey suggesting that UK institutional holdings have gone from 62 per cent in 1992 to 17 per cent today.
Derek Stuart, Trustnet Alpha Manager of the Artemis UK Special Situations fund, has been consistently underweight mining stocks in his fund. He says that the market is now extrapolating too high a margin for these and other cyclical companies, basing earnings on a strong rebound year in 2009 that is unlikely to be repeated.
But despite this high profile backing, the outlook for value stocks may not be as clear-cut as it seems. The resurgence of value after 18 months of underperformance was also a common theme at the start of this year. Since then it has, surprisingly, been small caps that have outperformed. In the UK All Companies sector the top funds year-to-date have all tended to have a small cap focus: Unicorn Outstanding British Companies, Manek Growth, F&C UK Mid Cap, Allianz RCM UK Mid Cap and Liontrust First Opportunities.
Top sector performers, year-to-date
Jane Coffey (pictured right), head of UK Equities at Royal London Asset Management, makes the case for cyclical companies. She said: “The global recovery will
be led by emerging markets, which will have a significant effect on commodities prices. Therefore we are more positive on resources and industrial companies.” However, she adds that she is generally underweight financial cyclicals, where she does not see significant upside.
There have been some signs over the past few months that the value argument may be winning out. The gap between the performance of the value-heavy IMA Equity Income sector compared to the more cyclical UK All Companies sector on a year-to-date basis has narrowed.
The average equity income fund is now up 7.1 per cent, compared to 7.6 per cent for the UK All Companies sector. These year-to-date figures take into account the deleterious effect of the BP disaster on many UK Equity funds. The two sectors are equal over three months, in spite of a stronger September for the UK All Companies sector.
The ultimate winner is likely to depend on the relative strength of global economic recovery. Cyclical companies may still move up faster if recovery surprises on the upside, particularly in emerging markets. China has bounced back from earlier weakness, so this remains a possibility. On the other hand, defensives look historically cheap, are subject to diminishing sell pressure and have attractive dividends. However, the high profile backers should not blind investors to the other side of the story.