Fund managers need to be more upfront about the risks of investing in growth stocks and keep a close eye on their portfolios, according to EdenTree Investment Management’s Phil Harris.
Harris, co-manager of the £183m EdenTree UK Equity Growth fund, said while the growth style has driven markets in recent years, investors need to be aware of the risk of such strategies.
Over the past five years the MSCI United Kingdom Growth index has outperformed its value-focused counterpart, delivering a total return of 50.48 per cent, as the below chart shows.
Performance of indices over 5yrs
Source: FE Analytics
However, EdenTree manager Harris said his strategy begins with identifying and managing risks within the portfolio.
“Our strapline is ‘not getting it wrong is as important as getting it right’. The reason behind that is that growth is an interesting and fascinating area of the market but it is intuitively high risk,” he explained.
“When fund managers talk about all the growth stocks they’ve got, what they very rarely do is talk about what the risks are. Higher growth is higher return but also higher risk.”
As such, the EdenTree manager aims to reduce the underlying risk as far as possible through intensive periods of meetings with companies – not only those he invests in – to understand the risks his holdings face.
“It’s not about eliminating risk – you’ll never do that – it’s about trying to avoid the problems that you might have in the companies and trying to minimise those risks,” he explained.
Another way that Harris aims to control risk in the fund is by – counterintuitively – running a concentrated portfolio of around 60 stocks, allowing him to have greater oversight than a more diversified portfolio.
“My experience has always been that those tiny holdings at the tail-end for those who have them are usually the ones that go horribly wrong because they’re not watching them,” he said.
Harris typically classifies stocks in one of three buckets: ‘dependables’, ‘super growth’ and ‘incubators’.
‘Dependable’ stocks, said the EdenTree UK Equity Growth fund manager, typically have high margins and cash flows, and grow at a rate of around 15 per cent.
“History has told us that businesses that grow up to 15 per cent per annum can grow sustainably,” he said. “But if you go over 15 per cent, the quantum change in the growth and the compounding effect means that the difficulties of growing at that level rise exponentially.”
As such, the next bucket – ‘super growth’ – Harris said anything growing at more than 15 per cent requires a higher level of due diligence and higher risk processes and are therefore demand more intensive oversight.
Lastly, ‘incubators’ are much smaller companies with the potential to grow over the long term, according to Harris.
Whilst acknowledging the strong returns of the growth style in recent years, fuelled by more risk-on investors looking for better returns on offer than in other parts of the market, it has pushed valuations higher.
Performance of index over 10yrs
Source: FE Analytics
“Things are still quite expensive in the growth part of the market and I like to think of it as an elastic band: things are being stretched,” he said. “The growth multiples at this end are squeezing ever more and the value, domestic plays and cyclicals are being squeezed down in terms of valuations.”
More recently, however, the manager has sold out of or materially reduced holdings in the EdenTree UK Equity Growth fund where valuations have seemed too stretched.
Putting that money back to work, however, has been quite challenging, said Harris. He said while the fund usually holds around 1-5 per cent in cash more recently that has swelled to 8.36 per cent, according to the latest fund factsheet.
“There are a lot of interesting companies out there but nothing particularly that we have bitten on,” he said. “We’ve been very selective of what we’ve bought back.”
Indeed, Harris said that recent volatility has prompted further caution but ultimately companies seem fully valued, making him wary of buying back into markets.
The EdenTree manager also been mindful of the fact that the end of the cycle may be approaching given how long the bull run in equities has lasted and the prospect of central banks beginning to normalise policy following a decade of quantitative easing and low interest rates.
“We are getting towards the end of the cycle and we have to be careful about the type of things we are investing in,” he added.
Harris was appointed manager of the EdenTree UK Equity Growth fund in September 2015 and was joined by Ketan Patel in 2016.
As a growth-focused manager, the manager has a significant exposure to smaller companies with greater potential to grow.
Indeed, small-caps make up 49.27 per cent of the portfolio while mid-cap stocks represent a further 22.25 per cent of the fund, with the remainder made up of large-cap companies.
The largest holding in the portfolio is housebuilder Bellway, accounting for 4.1 per cent of the portfolio, followed by automation-focused software company Blue Prism Group and oil giant BP.
Performance of fund vs sector & benchmark under Harris
Source: FE Analytics
Since Harris joined, the fund has returned 34.99 per cent, slightly behind the FTSE All Share benchmark gain of 39.09 per cent but ahead of its average IA UK All Companies peer’s 32.76 per cent return.
EdenTree UK Equity Growth has an ongoing charges figure (OCF) of 0.79 per cent. It has a yield of 1.71 per cent.