High valuations and a return to fundamental analysis have caused wide sector dispersions in the market – creating an interesting and challenging environment for investors, according to BMO Global Asset Management’s Rob Burdett.
As such the co-head of the multi-manager team believes funds with a valuation discipline and those focusing further down the market capitalisation spectrum have the best chance of outperforming in this uncertain backdrop.
Starting with the positives, Burdett said economic data seems to be improving while investors can also point to a revival in corporate earnings as positives to get excited about.
“To all intents and purposes, the year-to-date the economy is in a better place today than it was four or five months ago and it was a pretty decent backdrop for equities back then,” the manager said.
“[Meanwhile] the Citigroup Surprise index was rolling over back then and it is now surprising on the upside again.”
Performance of Citigroup Economic Surprise index
Source: Citigroup
The index tracks how economic data matches up to expectations with a positive reading indicating that data has been stronger than expected, while a negative reading suggests it has disappointed.
Burdett added: “Corporate earnings are more synchronised in their growth than they have been in about five or six years now that we have European companies firing on all cylinders again and emerging markets and China sort of okay.”
Overall, Burdett said he does not expect to see much more strength in economic data and earnings are likely to remain slow but steadily improving meaning that at a market level stocks are unlikely to move much higher either.
“I think that is a minority view as it is certainly fashionable to be bearish right now and we could list any number of high profile newsworthy issues that we are all aware of,” he noted.
Valuations on the other hand are a mixed bag. While certain sectors such as the ‘bond proxies’ have outperformed for the last decade as money flowed into companies with strong and consistent earnings streams, investors are now beginning to re-focus more on fundamental analysis.
As such, investors have the best chance of making high returns by exploiting the dispersion between valuations in certain sectors, which should help good stockpicking active managers to outperform.
Indeed, Burdett said he has observed more discerning reactions to stocks in the market meaning that underperforming expensive stocks in recent months have been “hammered” by the market in some cases losing 20 per cent in a single day.
While the fund of funds manager does not invest in stocks, he said these instances act as a good barometer of whether he has chosen the correct fund managers.
“We look on our systems and see if we have any exposures. You obviously can’t do anything about it but it helps you understand how good your stockpickers are and we have had hardly any of our fund managers have any of these blow ups,” he said.
In contrast, those companies that have been oversold in recent years are being re-rated, leading to his conviction in special situations and value funds.
“You are seeing active strategies do a bit better against passive in general but particularly high tracking error, special situations, stockpicking managers,” he noted.
In this space he is using the £792m Man GLG Undervalued Assets fund run by Jack Barrat and FE Alpha Manager Henry Dixon.
“You have a multi-cap, very disciplined approach to valuing companies that are very happy to be absent of large swathes of the market that they don’t like,” he said.
“They are happy to be patient and do have a real focus on this risk-rewards piste so are looking for very little downside in their stocks.”
The fund has been a top quartile performer since its launch in 2013, returning 55.1 per cent to investors compared to the IA UK All Companies’ 33.35 per cent and the FTSE All Share’s 32.14 per cent.
Performance of fund vs sector since launch
Source: FE Analytics
However, last year it underperformed despite a resurgence in the value style and was among the worst performers in the sector.
“Last year you had to be a bit patient with them for some of it but this year you have had your payback and a lot more as well and I really like their approach,” Burdett said.
As well as special situations, Burdett is also looking further down the market cap spectrum as another area that has been oversold over the last few years.
“Smaller companies are cheap in general terms relative to the broader market in more international markets at the moment and in some cases they are cheap relative to their own history,” he said.
Small caps have been ignored by more fearful institutional investors, the manager noted, and have moved away from the sector for many years in favour of safer more defensive larger companies.
“Who is likely to sell small caps? The institutions have to have pretty much finished selling: they are just not there, they are not present anymore,” Burdett said.
“It has to be either private investors – managers like us – or the management themselves who don’t generally don’t sell shares in their companies in the same way that large companies do and all of those areas look okay to us at the moment.
“So, you’ve got a valuation opportunity, a liquidity opportunity and a supportive economy at the moment.”
However, he cautioned that the one area investors need to pay attention to in the smaller companies space is the initial public offering (IPO) market.
“One area to watch with small caps is the IPO market because we are hearing that a lot of companies are doing their growth in the private markets either by private equity or just straight finance and then coming to the market to exit,” the manager said.
“So that is an area you have to be careful about because you could be coming in late in the game at a high price when most of the fun has been had. You need managers that don’t just rely on the IPO market for their outperformance.”
In this space, he is backing the £113m River & Mercantile UK Micro Cap investment trust run by FE Alpha Manager Philip Rodrigs.
Since its launch in December 2014, the trust has returned 87.19 per cent, 27.77 percentage points ahead of the IT UK Smaller Companies sector average, as the below chart shows.
Performance of fund vs sector since launch
Source: FE Analytics
“In an area that illiquid I do think it is useful to have a closed-ended structure and that fund is quite unusual in that it will actually give capital back if the board sees fit and the assets get over £120m. They have just done that earlier this year so it keeps it small and nimble,” Burdett said.