Arnold says that the rising markets of last year were led by lesser-quality, cheaper stocks rebounding as investors chased the highest returns.
However, Arnold, who runs the fund with FE Alpha Manager Richard Plackett, says this underperformance will reverse in the near-term as investors focus on companies able to produce earnings growth, which will favour his style.
“The mid cap story growth can continue but it will come through from quality companies’ earnings growth rather than valuations,” he said.
“Last year was all about share price recovery and multiple expansion rather than earnings growth.”
“Across the market the strong performance came from the lower quality end of the market, which is understandable because the money coming into the equity market flowed into the stocks that looked like the best value, rather than those more highly rated.”
“While they’re not small or mid cap companies, just look at Rolls-Royce, BAE and Tate and Lyle recently – disappointments are getting punished because people are looking for that earnings growth to come through.”
Rolls-Royce issued its first profit warning in a decade earlier this month due to defence spending cuts, pushing shares down 17.81 per cent.
Performance of stock vs index over 1month
Source: FE Analytics
BAE shares fell more than 10 per cent after its profits warning, while Tate and Lyle was down 17 per cent after cutting profit expectations.
The £2.1bn BlackRock Special Situations fund has performed well in the longer term and is the 14th best performer in its sector over 10 years, but has struggled more recently.
Performance of fund vs sector and index over 3yrs
Source: FE Analytics
FE Analytics data shows BlackRock Special Situations has returned 31.3 per cent over three years compared with 34.49 per cent from the sector average.
Arnold attributes BlackRock Special Situations' underperformance to the fund’s strategy of picking quality over value over this period.
“We are a fund that concentrates on the small and mid cap sector but very much with a growth and quality angle rather than value, which worked against us last year,” he said.
The manager says that his three-year numbers were dragged down by a poor 2011, when small and mid cap funds suffered.
Data from FE Analytics shows that the small and mid cap indices lost much more than the FTSE 100 during that year.
“More importantly, last year we underperformed [the sector] despite doing better than the All Share,” Arnold said.
“It was a really bad year for the index and active managers because the growth was in the value end of the market.”
Many managers have warned that earnings growth will determine which companies do well this year, with the overall market likely to be less exuberant than in 2013.
Arnold says this will boost his fund. He expects earnings growth will come through in the near-term but only in certain areas and this is where the fund will generate alpha.
“This year is going to be a harder year for the market in absolute performance than last year. It’s all about picking your way through it,” he said.
“And if you’re in a world where earnings growth matters, you need to be in well positioned quality companies because they need to be able to exploit the growth when it comes and not be hit by big falls in the share price when earnings growth doesn’t come through.”
“It comes back to five things: the track record of a company, management quality, whether they are the market leader, if they can generate cash and have a strong balance sheet.”
Arnold expects that the near-term will be characterised by lower growth in which small and mid cap companies grow, particularly those that invested during the downturn and are thus able to boost market share in the recovery.
“We’ll continue to see a low-moderate growth world where the stronger companies that have invested through the downturn, whether through research and development or capacity, will continue to exploit that investment and increase market share.”
“Companies that are well invested will benefit and companies that miss earnings will be punished.”
“We won’t see multiple expansions, that period has gone it’s now all about the growth environment.”
Despite several recent closures to funds in the small and mid cap space, Arnold dismisses the idea that BlackRock Special Situations could be too big to operate successfully in the lower end of the market.
“Soft closure is just not on the table. It’s not something we’ve even discussed,” he said.
