With the recovery trade potentially on its last legs, and the low interest rate tailwind for growth stocks probably coming to an end, now could be the time for quality.
Tom Wildgoose, manager of the $115m Nomura Global High Conviction fund, argued that given the current market environment, by focusing on quality companies at a discount, investors may avoid the risk of buying at the top of a trend.
He said: “Growth outperformance has clearly been boosted by low - but more importantly - falling bond yields.
“As bond yields go lower, discount rates go lower so the value of cash flows further away in the future become relatively more valuable.”
Over the last decade as bond yields have fallen lower, growth stocks have benefited from this additional tailwind.
However, Wildgoose argued that this trend is unlikely to continue because as the economy is starting to recover from the Covid crisis and inflation worries start to manifest, the probability of future interest rate hikes down the line starts to rise.
“It's difficult to see bond yields going dramatically lower, which means that that tailwind for growth stocks is probably ending,” he said.
“I'm not saying growth won't do better or worse at some point in the future, it's not really a prediction.
“It's more that the tailwind which has really supported growth stocks, is not so much a wind anymore but more like a flat calm.”
In recent months, value stocks have made a long-awaited comeback and the recovery trade has become a popular success story as global economies re-open after the coronavirus lockdowns.
However, Wildgoose believes much of this trade could already be over.
“The recovery period of the economy has more or less passed,” he said. “The economy is still not recovered, but it has done a really sharp rebound period.
“Of course, it's somewhat dependent on whether there is a third wave or fourth wave of Covid and that's what makes this situation different to previous ones, but the third stage of the economic upcycle has happened.
“So the extent to which recovery is priced into the more cyclical stocks is quite well done.”
Performance of MSCI World since March 2020
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Source: FE Analytics
Wildgoose continued: “People have realised the economy is not going to hell in a handbasket and that it is recovering.
“It might be different in the future to what it was in the past, but the cycle has turned and the cyclical stocks tend to get that priced in very quickly.
“There is probably still more economic recovery to happen, but people already know that, so it's already priced into the stocks. From an investment perspective that ‘trade’ is nearly done.”
This has been seen repeatedly in previous economic cycles, with the last global financial crisis being the most obvious and recent example.
“The market hit a bottom after the crash of the financial crisis in early 2009 and then started to bounce back,” the manager recalled.
“The very cyclical stocks - in particular mining companies and things like that - rebounded very sharply in the first part of it.
“That great trade where you can buy things super cheap and make huge returns very quickly, passed in quite a short period.
“You could pick out retailers that that doubled, tripled or quadrupled in a very short space of time - because they're the ones that benefit most from the recovery and you saw exactly the same thing as the market bounced back from the low in 2009.”
But timing when to go overweight growth stocks or overweight cyclical stocks is often problematic, which is why Wildgoose and co-manager Ilan Chaitowitz prefer to take a neutral weighting to both growth and value stocks and focus instead on quality.
In 2020 growth stocks outperformed as interest rates were slashed to boost economies amidst the coronavirus pandemic, but in 2021 as markets grapple with inflation and the fear of rising rates, cyclical and value stocks have outperformed.
Nomura Global High Conviction’s exposure to growth stocks such as Alphabet and Microsoft did well in 2020, but it is the performance of certain cyclical holdings that have contributed to returns in more recent months.
One such holding is Inditex, the Spanish multinational clothing company that owns well-known global fashion brands such as Zara and Massimo Dutti.
“We saw that was a great quality company with a very strong balance sheet but was still being punished for by the market because of the impact of Covid and lockdowns and so on,” Wildgoose explained.
The managers bought the company when it was trading at roughly €23 a share but started trimming it when it reached €32. Today the stock trades at just over €30.
Another cyclical holding is Lear Corporation, an American auto parts manufacturer focused on seating and electrical systems.
Wildgoose asserted that the auto parts manufacturer is not as heavily exposed to the declining internal combustion engine as most would expect, and instead more geared to electrification.
“It's obviously cyclical and most quality growth fund managers wouldn't even look at it, but actually it's a nice business with a strong balance sheet that sailed through the Covid period pretty well despite obvious headwinds,” he said.
Performance of fund versus sector & benchmark over 5yrs
Source: FE Analytics
Over the last five years, Nomura Global High Conviction has delivered a total return of 123.60 per cent compared to 104.69 per cent from the MSCI All Countries World Index and 100.08 per cent from the average IA Global peer.
It has an ongoing charges figure (OCF) of 0.8 per cent.