While technology stocks led performance in the US last year, Hermes Investment Management’s Mark Sherlock said he is focusing on more domestically-exposed sectors such as financials and industrials.
The US market enjoyed another strong year of growth in 2017 as the S&P 500 rose by 21.1 per cent, as the below chart shows.
The small-cap Russell 2500 index was also up, rising by 16.3 per cent last year. However, the big winner was the technology-focused Nasdaq index, which climbed 30.51 per cent higher.
Performance of indices in 2017
Source: FE Analytics
“It was a strong market year in dollar terms but really that was led by a couple of sectors – technology and biotechnology,” explained the small and mid cap specialist.
“It was the same in our market too. Anything that was growth/tech was very in-demand and consequently performed well.”
Yet Sherlock (pictured) – lead manager of the $1bn Hermes US SMID Equity fund – is slightly underweight technology as he believes the sector will struggle to replicate last year’s outperformance.
“This strategy does have technology in it but it was our inclination over the course of last year to take profit from some of those tech names rather than add to them,” he said.
While the fund factsheet shows a 4 per cent underweight to technology, Sherlock said there were classification issues surrounding one stock, meaning this is slightly narrower.
“We are not as underweight as we appear but the point is valid that we are not overweight and that really is because of valuation,” he said. “A lot of investors are not really that bothered by boring old DCFs [discounted cashflows] or so on.”
But this could be changing, he said, with a stronger US economy likely to benefit other sectors resulting in investors looking more closely at fundamentals than momentum.
“The good news on that is [momentum] was probably a 2017 story and it is our view that in 2018 the benefits of a stronger economy will broaden out to a larger group of sectors and really that the market leadership will change,” the manager said.
“Technology was the market leader last year. Does it go up another 40 per cent? It is possible but it appears likely to us that other areas will take up that leadership.”
The main theme he is playing this year is a stronger US economy. With unemployment levels around 4 per cent, wage growth beginning to come through and house prices rising, consumer confidence is growing.
Meanwhile, earnings growth and business confidence metrics are also expected to be high this year.
“I think the backdrop is strong but of course it has been turbocharged by [Donald] Trump’s tax reforms,” Sherlock added.
Indeed, the US president has cut corporation tax to 21 per cent from 35 per cent, increasing the amount of cash in the system.
“You also have the repatriation of overseas dollars coming back to the US. There is up to $3trn overseas not repatriated because of the tax rates,” he said.
“Obviously with the lower tax rates the expectation is that much of that will return onshore.”
This should lead to higher investment on capital expenditure (capex), which has currently been quite light so far in this cycle, as well as more mergers and acquisitions (M&A).
There are two sectors that are in a strong position to benefit from this change the fund manager noted: industrials and financials.
Industrials have underperformed for some time in the US, with the S&P 500 Industrials sector lagging the top-performing technology sector by 63.23 percentage points over the last five years.
Performance of sectors over 5yrs
Source: FE Analytics
But Sherlock said this could be about to change as boosts to the real economy should filter through to the industrial economy, allowing companies to improve their low-growth earnings figures.
“A lot of these businesses have had costs stripped out of them so they are very operationally geared and so we are pretty positive on some of the earnings growth that can be expected,” he said.
As well as this, they should benefit more from the tax reforms as they are typically domestic businesses, making and selling their products within the US.
“The importance of that is they tend to pay higher tax rates so Trump’s reduction will have more of an effect on them,” he said.
Large-cap financials have had a much better time over the last few years, but Sherlock’s focus on small- and medium-sized firms means there are a number that remain undervalued.
“Banks are generally valued on a price-to-book basis and that has varied in the past from companies being priced on 2-3x price-to-book down to sub 1x,” he said, noting that some remain at the lower end of the spectrum.
Rising interest rates will also help the sector as banks make a margin on the interest rate between which they lend out and the money they are paying to depositors for their savings.
“When interest rates are low that spread called the ‘net interest margin’ is tight but as rates push out they get a broader spread,” he explained.
“We know rates are going to rise and there are arguably upside pressures to that in terms of the pace of the rate rises and the eventual final level,” he added.
Unlike in the UK where the sector is dominated by a smaller number of larger players there are far more regional banks in the US and trading at lower valuations.
“The whole sector is ripe for consolidation and we might be about to see some more of that happening,” Sherlock noted.
The manager has run the three FE Crown-rated Hermes US SMID Equity fund since launch in 2012, latterly with deputy manager Michael Russell, during which time the portfolio has returned 102.13 per cent.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
This is 5.57 and 7.98 percentage points higher than the Russell 2500 benchmark and IA North American Smaller Companies sector average respectively, as the above chart shows.
It is slightly overweight financial services, healthcare materials while underweight consumer discretionary and energy companies, according to the latest factsheet.
The fund has a clean ongoing charges figure of 0.87 per cent.