While growth companies have outperformed value stocks globally so far this year it may not mean what many investors think, warns FE Alpha Manager James Thomson.
The lead manager of the £1.1bn, five FE Crown-rated Rathbone Global Opportunities fund said outperformance of growth was more likely to signal a risk-off market.
Performance of FTSE World Growth vs FTSE World Value YTD
Source: FE Analytics
He said: “This year growth stocks have outperformed value by the most in 20 years. Large caps are outperforming small caps in every sector.
“Growth is outperforming value in every sector. It’s telling us something about the future, but it may not be what you’re thinking. This is what markets do when they’re risk-off.”
Thomson explained: “Value stocks aren’t just boring, plod-along consumer staples stocks of the past. Value stocks today are economically-sensitive banks, industrials and commodities stocks.
“These companies require an economic revival because their revenue growth is so closely linked to GDP. That’s why they rallied so hard after [Donald] Trump was elected.
“But now as Trump’s economic renaissance falters investors have returned to a proxy for stability in a risk-off world. That is growth.
“True, valuations don’t look cheap, but you have to distinguish between growth and value.”
Growth stocks, he said, were trading at price/earnings valuations close to historical averages, while value stocks were trading at a 40-year high. However, Thomson said the business cycle was a much better predictor of stock market performance.
“If you can predict the market cycle, you can predict whether stocks will outperform and, more importantly, what types of stocks,” he said.
Thomson said there was evidence that the business cycle was deteriorating as PMI (Purchasing Managers’ Index) data peaked during the first quarter and interest rate increases had started to filter through to the real economy.
Other indicators had also hinted at the deteriorating business cycle including new orders and consumer confidence.
However, markets had begun to start pricing in the business cycle deterioration, which was why value stocks had fallen, he said, “anticipating weak, below-trend economic growth”.
He said in such an environment, there were several areas to avoid, including, emerging markets, commodities, industrials and banks.
Emerging markets would suffer most as developed markets slowed because of their reliance on exports, said Thomson (pictured). 
Similarly, miners, oil & gas producers, and economically-sensitive industrials all thrived when aggregate demand was strong, the manager further explained. Banks were also likely to suffer due to their dependence on rising rates.
He said the areas that were likely to perform well in the current environment include: technology, healthcare, and “well-managed, albeit slightly more boring” food, beverage and tobacco companies.
“These are the areas that will do best in a risk-off, below-trend economic growth world,” he added.
As such, the manager has begun to recalibrate the fund to target areas that provide stability, reliability and repeatable growth.
“The first thing is essentials, companies that provide essential products and services where demand is more time-sensitive than price sensitive,” he said.
One such example is the pest control company Rollins, adding: “The best thing about the pest control business is that it requires repeat visits or the bugs will come back.”
Another area is AO Smith, the US boiler maker, where 90 per cent of demand is for replacement and customers are more time sensitive than price sensitive. The firm also sells water filtration systems in China, where contaminated mains water remains a problem.
Reliable growth companies include companies offering tobacco, nursing homes, beer and energy drinks. These companies he said have pricing power and a reliable demand for their products.
Lastly, ‘tidal wave growth’ companies are “powerful, perhaps unstoppable” and among the biggest growth trends today, he said. The sector includes companies involved in gaming, and e-sports in particular, Thomson said.
Another key example is Amazon, which he said, “is, or is rumoured to be, about to steamroller every industry in the world”.
“Their latest push into grocery is typical of their ‘shock and awe’ tactics when they commit to a new market,” he said.
During the first eight months of the year the fund was up by 16.5 per cent compared with a 10.2 per cent rise for the average IA Global sector fund.
A big contributor to performance in 2017 has been euro strength with around 27 per cent of the fund invested in European-listed stocks from Germany, France, Spain, the Netherlands, and Ireland.
However, Thomson said the biggest contributor to performance has been its focus on growth stocks and stockpicking.
“Its longstanding underweight position in banks and commodities stocks has also been a positive contributor as the value sectors reversed during the market rally in 2016 and the Trump reflation trade ‘fizzled’,” he said.
Despite strong performance this year, Thomson highlighted there had been several drags on performance, most notably its UK holdings.
He said: “Our UK holdings did nothing for us: no disasters but just treading water. We have reduced our UK holdings from 25 per cent of the fund to just six per cent today for some stock specific reasons but also [because] we just don’t know how Brexit will affect our UK holdings “
Additionally, the US dollar has been a headwind after rolling back from strong performance against sterling in 2016. Its 0 per cent weighting to emerging market stocks also impacted the fund.
“The biggest negative was our poor investment in US retail stocks. Of all the sectors I look at, this is undergoing the most upheaval,” he said. “Primarily in the shift in the way people shop, where they shop, heavy levels of promotion and price cuts.”
Thomson said he had sold out of several US retail names more recently, including Ulta Beauty, Foot Locker and O’Reilly.
“The worst performer over 2017 so far was O’Reilly a US auto parts company that sells mainly to the trade,” he said.
“The company has blamed weather, delayed tax refund cheques and a greater focus on DIY auto repairs, all symptoms of a business where all growth drivers just aren’t working any more. We sold the holding entirely.”
The fund has generated a top quartile performance over three years, with a 126.1 per cent return compared with the sector’s 88.6 per cent gain.
Performance of fund vs benchmark & sector over 3yrs
Source: FE Analytics
Thomson is joined on the fund by deputy manager Sammy Dow. It has an ongoing charges figure (OCF) of 0.75 per cent.