UK equity income manager Hugh Yarrow has started to tilt his Wise Investments’ Evenlode Income fund back towards small and mid-caps, making more changes to the portfolio than usual in a bid to go against the crowd. 
Investor sentiment towards small and mid-caps soured last year, after both parts of the market were hit by profit-taking following their stellar runs in 2012 and 2013. Meanwhile, many investors started to pay more attention to the FTSE 100, arguing that this was now a source of obvious value in the UK market.
The below graph shows how the FTSE 250 and FTSE Small Cap’s rallies tailed off over 2015, in what was generally a difficult year for most equity markets to make progress.
Performance of indices over 2013 and 2014
Source: FE Analytics
However, investors now appear to be looking at small and mid-caps once more. A recent FE Trustnet survey of high-profile fund selectors found that 56 per cent say small-caps are the part of the UK market they are the most optimistic about; large and mid-caps won 22 per cent of the vote each.
While Evenlode Income was biased towards large-caps last year, Yarrow is one of the managers who has been looking for opportunities further down the cap spectrum as these appear to be more attractive on a valuation bias.
Recent changes have seen the large-cap exposure fall to about 70 per cent, down from the peak of 85 per cent it reached in 2014. When the fund launched in October 2009, just half of the portfolio was allocated to this part of the market.
Yarrow said: “We are by temperament long-term investors, but this valuation discipline tends to result in us moving, incrementally, in the opposite direction to the crowd.”
“In 2012-13, we moved towards larger and more stable UK businesses that were underperforming a risk-taking market hungry for smaller stocks. This benefited our performance in 2014, as the market became more risk adverse.”
“Recently, we have been more active than normal in terms of making changes to the portfolio, driven mainly by volatility in individual shares. Several larger and more stable businesses have performed extremely well over the last year.”
This outperformance has led the manager to sell out of holdings in Novartis and Smith & Nephew while “significantly” reducing positions in Reckitt Benckiser, SABMiller, Reed Elsevier and Compass.
FE Analytics shows that all of the London-listed companies above have significantly outperformed both the FTSE All Share and the FTSE 100 over the past 12 months. Food service business Compass Group leads the group with a 33.70 per cent gain over one year.
Performance of stocks vs indices over 1yr
Source: FE Analytics
As well as selling down large-caps, Yarrow – who runs the portfolio with deputy manager Ben Peters – has been buying in the “contrarian” small and mid-cap part of the market.
Ten new positions have been implemented since the summer of 2014 – including non-FTSE 100 names like Spectris, IMI, Informa, Paypoint, PZ Cussons, WS Atkins and MITIE – and existing positions were added to on share price weakness. International stocks Wolters Kluwer and Sanofi have also been bought, as has FTSE 100 member Weir Group.
“These companies fulfil our quality criteria (they are asset-light, cash generative businesses) and offer good potential for long-term dividend growth. But they have been out of fashion recently for various reasons, which has improved valuations,” the manager explained.
None of the small-cap additions have made it to the fund’s top 10, which is currently led by Unilever, Diageo, GlaxoSmithKline, AstraZeneca and Pearson. The fund’s exposure to mid-caps stands at 25 per cent of the portfolio, while it has cash accounting for just over 3 per cent.
Other investment professionals have been vocal recently about the opportunities being seen outside of the FTSE 100. Last month, Hargreaves Lansdown head of research Mark Dampier said UK small-caps have become “unloved, unwanted and unfashionable”.
“When they’ll bounce back I don’t know, but historically they’ve come back 30 or 40 per cent very quickly. It’s proven a good accumulation opportunity in the past,” he added.
Yarrow maintains that equities remain “the best house in a bad neighbourhood”, but concedes that valuations in some parts of the market are starting to look unattractive and have encouraged him to explore areas overlooked by other investors.
“Starting dividend yields of 3 per cent to 4 per cent for sensible companies are still available across European markets, including the UK. These yields do not stand out on the slide rule of long-term history, but they do stand out as an oasis in the desert of yields available on cash and bonds. They also have the potential to protect investors from inflation if and when it picks up again – neither of which is something cash and bonds can deliver,” he said.
“However, it is an unavoidable fact that valuations are rising, and a strong bull market is like a bucket of cold water on the prospect of generating future returns. While we are big advocates of owning cash generative businesses with pricing power over the long run, even the best business is not a good investment if the starting valuation is too high.”
Since launch in October 2009, the five FE Crown-rated Evenlode Income fund has made a first-decile total return of 108.50 per cent, ranking it seventh in the IA UK Equity Income sector where the average gain was 83.57 per cent.
Performance of fund vs sector since launch
Source: FE Analytics
It’s achieved these gains with less annualised volatility and a lower maximum drawdown than its average peer. The fund’s risk-adjusted returns, as measured by the Sharpe ratio, is the sector’s third best at 1.15.
Evenlode Income has a clean ongoing charges figure of 0.99 per cent and currently yields 3.60 per cent.
