Last year was a “difficult” one for the Merian UK Mid Cap fund but manager Richard Watts has gone into 2019 feeling much more confident in his outlook. 
The £3.1bn Merian UK Mid Cap fund posted a 21.54 per cent loss in 2018, making it one of the worst-performing members of the IA UK All Companies sector and representing its worst year relative to the FTSE 250 since 2009.
In an update to investors, FE Alpha Manager Watts noted that fund was around 2 per cent ahead of its benchmark at the end of 2018’s third quarter but ended up 6.4 per cent behind it after an “extremely poor” final quarter.
“It’s very rare for the fund to have a drawdown versus the benchmark of this magnitude, but previous instances include the second quarter of 2014, when growth stocks sold off aggressively, and in the weeks after the EU referendum result,” the manager added.
Performance of fund vs sector and index over 2018
Source: FE Analytics
On both of these occasions, he used the significant share price weakness to increase exposure to names that had been sold off too aggressively.
Explaining Merian UK Mid Cap’s weak 2018 fourth quarter, Watts argued that the portfolio suffered from a combination of the sell-off in technology/growth stocks and elevated fears around Brexit and the UK’s political situation.
“From a UK perspective, this proved to be a toxic combination,” he said.
“UK domestic cyclicals performed poorly. Whilst modestly underweight this part of the market, the outflows from UK equity funds seen across 2018 has meant that the UK market has been weighted towards selling, and this likely accelerated given the Brexit and political turmoil in Q4.
“As such, lots of UK stocks sold off aggressively, particularly highly rated and cyclical names. AIM stocks were particularly badly hit.”
Merian UK Mid Cap owns several stocks that fell by 30, 40 or even 50 per cent at the end of 2018, including boohoo, Fever-Tree, Blue Prism, Burford Capital and Ashtead. It also owns domestic cyclicals such as Barratt Developments, Taylor Wimpey, Purplebricks, OneSavings Bank and Charter Court Financial Services, in addition to some AIM stocks.
“I enter this year feeling more optimistic,” Watts said.
“There’s only so far our highly rated stocks can fall before their valuations look very compelling, particularly in comparison with slower growing, highly rated bond proxies. With some of our growth names having declined by 30-50 per cent it’s highly unlikely that they’ll decline by that amount again.”
In 2018’s fourth quarter, it was “quite clear” to the FE Alpha Manager that global stock markets were trying to price in the increased risk of US and global recessions, a policy mistake by the Fed and the trade war between the US and China.
Performance of indices in 2018
Source: FE Analytics
But Watts added that he believes “the markets want to move higher” now. Merian Global Investors considers the near-term risk of a US recession to be low while the Fed has said it is prepared to be flexible with policy in response to the economic data.
“An outcome to the Brexit negotiations that is seen to be market friendly – even if ultimately not optimal from a long-term economic perspective – will be received very well, in my view,” he said.
“UK equities, and obviously domestic cyclicals in particular, could rally aggressively in that event.”
Merian UK Mid Cap is currently trading a slight premium to its FTSE 250 ex Investment Trusts benchmark but Watts expects to this to unwind because of its exposure of to fast-growing companies such as boohoo, Burford Capital and Fever-Tree.
“I would argue, however, that the fund’s premium is justified given that it’s expected to deliver much stronger earnings growth than its benchmark,” the manager said.
“In terms of activity, we’ve been adding to names that have been heavily sold off and increasing exposure towards the UK domestic cyclicals given how weak they’ve been and our expectation that we won’t end up with a ‘No Deal’ Brexit.”
Watts has managed the Merian UK Mid Cap fund since December 2008, over which time it has made a top-decile 392.34 per cent total return. This is ahead of its benchmark’s gain and ranks it seventh out of the 200 funds in the IA UK All Companies sector with a track record this long.
Performance of fund vs sector and index under Watts
Source: FE Analytics
The FE Invest team, which has the fund on its Approved List, said: “The fund has consistently beaten its benchmark, with stock selection the main driver of relative performance.
“Gains from stock selection have been strong across both time and industry, demonstrating the strength of the flexible investment process.”
Merian UK Mid Cap has an ongoing charges figure (OCF) of 0.85 per cent and is yielding 1.73 per cent.