Resources, financials and technology companies are the three main areas investors should avoid if focusing on capital preservation, according to BMO Global Asset Management’s Thomas Wilson. 
The manager of the four FE Crown-rated F&C UK Mid Cap fund said there are two ways he aims to protect client capital through investment in the mid-cap space.
The first method is by buying good quality businesses while the second is ensuring that he does not pay too much for these companies.
“Tech falls into the bucket of not paying too much for them because of where valuations are at the moment while the others fall into the good quality businesses as within banks and resources it is a lot harder to protect capital,” Wilson said.
Since Wilson took over the fund in 2015, it has been among the most volatile funds in the IA UK All Companies sector, which includes many funds that invest on an all-cap basis.
Yet, it has a low monthly maximum drawdown figure – the most an investor could lose if buying and selling at the worst possible moment – of 8.39 per cent over that period.
Indeed, this is one of the lowest in the sector and below the 8.76 per cent figure for the FTSE Mid 250 ex Investment Trust benchmark.
Performance of fund vs sector and benchmark since manager start
Source: FE Analytics
Despite a focus on downside protection, the fund has returned 26.47 per cent since Wilson took charge, 4.38 percentage points ahead of its benchmark.
Below Wilson, who manages the £32m fund alongside deputy manager David Moss, outlines the areas he has avoided to protect investors on the downside.
Resources
While resources companies make the list of avoided sectors, the manager emphasised that this was very much from a mid-cap perspective.
“In the large-cap space I do actually own Rio Tinto which I feel is a good business,” he explained. “It has a competitive advantage in terms of being very low down on the cost curve, a strong balance sheet and generates a significant amount of cash etc.”
However, in the mid-cap space, resources companies tend to be at a much earlier stage in their development and unable to finance themselves.
As such, many of these businesses are exploration-based with very little in the way of production.
“In many of these instances these businesses do not have producing assets so clearly that is a very finite game in terms of how long you can accept negative cashflow for,” Wilson noted.
“Also, those with production tend to be a lot less diversified, so there could be two or three fields that make up a significant amount of production if the business has it all.”
This opens a company up to significant operational issues such as delays in production coming on-stream as they are overly reliant on one asset.
The other issue resource companies in the mid-cap sector face is the amount of leverage they have to take on the balance sheet to find new assets.
“Take a company like Tullow Oil for example,” Wilson said. “It has a very stretched balance sheet so any operational issue or cashflow mismatch is substantially accentuated by the leverage.
“You could very quickly become beholden to the debt holders in that scenario,” he added.
Financials
“Leverage is something we think is key to preserving capital,” the manager said, with financials such as banks and specialist lenders another area he does not invest in. “The problem I have with those is you have leverage on leverage.
“The businesses themselves tend to have leverage within them and obviously the customer they are lending to is leveraged by definition: if your product is a mortgage it is a leveraged product.
“If you go through an economic downturn or a consumer downturn where real incomes get squeezed or a housing crisis or anything like that, the leverage on leverage effectively becomes very painful because it works its way through to the returns that a bank or a lender can make.
“The leverage that the end consumer is taking on becomes difficult for them to manage but that gets further accentuated by the fact that the vehicle that is lending to them is potentially leveraged as well.”
This phenomenon has meant that while financials have made a positive gain for investors over the last five years, they have also been highly volatile during periods of market concern.
During the period, the FTSE 350 Banks index has returned 32.27 per cent but last year recorded a monthly maximum drawdown figure of 33.03 per cent – significantly higher than that of the wider market.
Performance of indices over 5yrs
Source: FE Analytics
On a macroeconomic level, the sheer amount of debt in the system has increased exponentially over the last decade, with consumer debt such as credit cards and auto loans, now growing at five times the rate of income growth.
“Clearly that is not sustainable and the issue you have is with interest rates at record lows consumers can take on a significant amount of debt and feel they can service it very cheaply,” he said.
“If interest rates ever do go up obviously the cost of servicing that debt goes up and it becomes very unaffordable and these types of businesses are very geared into that market.”
Technology
Sometimes valuations can be enough for Wilson to avoid a sector and such is the case with technology stocks, which he said are bordering on bubble territory.
Indeed, since the start of 2016, the FTSE 350 Technology sector has returned 74.34 per cent, more than double the wider FTSE 350 index, with valuations soaring to record highs.
Performance of indices over 10yrs
Source: FE Analytics
“Valuation in itself can be enough to not protect investors on the downside because you don’t have that margin of safety.
“On high valuations any slight disappointment is going to be taken very badly by the market. The share price reaction to the downside can be very extreme.
“You have two potential issues. Firstly that the market just says that valuations for some of these businesses have got to extreme and fundamentally don’t reflect the prospects of this business.
“The second point is maybe the market changes and someone else comes in which means that this stream of cashflows needed to justify the valuation doesn’t come through.”
As such, the manager said he has no exposure to companies including online takeaway expert Just Eat, financial services information company Fidessa or security technology maker Sophos, some of the largest technology names in the FTSE 350.
“If I were to look through the UK mid-cap software and services sector I think there are two stocks that are below 20 times earnings and there are a plethora of stocks on 30 or 40 times,” Wilson noted.
In an upcoming article, FE Trustnet will look in more detail at why the manager believes the technology sector has taken on bubble characteristics, and why he has no exposure to the sector.