Now could be the time for large-caps to begin outperforming again, according to Lazard Asset Management’s Alan Custis, who is finding many ideas among financials, mining and even some consumer staples stocks.
Typically, mid-caps have been the place to be invested in the UK over the past decade, with the FTSE 250 besting the large-cap FTSE 100 index by 143.06 percentage points.
More recently, this has reversed, with the FTSE 100 ahead over the past three years – partly as a result of the EU referendum, which has impacted more domestically-focused names.
Performance of indices over 10yrs
Source: FE Analytics
However, despite this recent strong run, the manager of the £206m Lazard UK Omega portfolio said he remains overweight in FTSE 100 stocks and underweight mid- and small-caps.
Indeed, within his fund he has 87.7 per cent of the portfolio invested in FTSE 100 names and just 6.5 per cent in mid-caps.
He is not alone in this positioning. Speaking at a conference earlier this month, Vishal Bhatia, co-manager of the £424m JOHCM UK Growth fund, said mid-cap is the part of the market where he sees the most overcrowding.
“People are hugging for comfort because the momentum in the market has been good,” he explained, adding that he only owns four names from the FTSE 250, as despite being good companies, they are not currently good investments.
Lazard’s Custis is a bit less negative on the mid-cap space as a whole than Bhatia, although he still believes that following a decade of underperformance the large-cap region of the market might be due a rotation of fortunes.
“Mid-caps have serially outperformed for the last 10 years versus the FTSE 100 and I think there has been significant overvaluation, particularly in the growth mid-cap names,” said the Lazard UK Omega fund manager.
“Having said that, we hold a number of mid-cap names and there is lots of good value in mid-caps.”
As well as the relative underperformance over the past decade, another argument for holding large-caps is the ongoing Brexit negotiations, which continue to cloud the UK market outlook.
If there is a ‘hard Brexit’ domestic-focused stocks will be sold-off, sterling will fall and international earners will outperform – or at least that’s the theory.
However, while the reverse may be true for a softer Brexit, foreign investors could be encouraged to return to the UK, giving a boost to the larger names of the FTSE 100.
Below, Custis explains how he is positioning his fund for both scenarios.
One area he is keen on is financials – particularly banks – which at the start of the year appeared poised for a comeback as bond yields were expected to rise.
“Obviously we hit the Italian bond crisis in May and financials sold off aggressively on the back of that, even though a lot of the UK financials have no direct exposure to the Italian economy and bond yields,” he said.
Performance of index over YTD
Source: FE Analytics
Indeed, the banks sector – down 15.67 per cent – has fallen much further than the wider FTSE All Share index, which has lost 5.37 per cent year-to-date.
“Financials, as we sit here today, have been a very poor investment so far this year,” he explained. “But we do think that you can paint a scenario where if we are not tipping into recession [as the market currently believes], where you get bad debts going up from what is an historically low level, then I think financials should continue to be a very good place for money.
“Valuations are rock bottom for a number of financials. It is the one sector that hasn’t performed at all well. Most of the UK banks are down double digits year-to-date.”
Within this, he said that there are different beasts. Lloyds, for example, is very much a pure Brexit play as it is heavily linked to the domestic market.
Barclays, meanwhile, is more of a dollar earner so should perform slightly differently and emerging market banks such as Standard Chartered and HSBC are not particularly exposed to Brexit at all but could get carried along with the rest of the basket.
This should create opportunities and is an example of how the manager is using the sector to take advantage of both Brexit outcomes.
Another area he is keen on is the mining sector, particularly the more broad-based commodities suppliers such as BHP Billiton or Rio Tinto.
“It is interesting with all of this volatility we have been going through that actually copper and aluminium have been swinging all over the place – they are metals that can clearly be traded,” Custis said.
“But the bulks like iron ore and coal which are less susceptible to trade have been pretty resilient all the way through this period of volatility. This suggests to us that the underlying demand patterns are pretty robust.
“Ultimately, it is a play on global growth and if the IMF [International Monetary Fund] is right in bringing down global growth expectations then with that as a backdrop the miners may struggle a little bit,” the manager added.
Despite this, miners remain on low price-to-earnings (P/E) multiples, making them attractively-valued compared to a lot of other stocks in the market.
Coupled with a high free cashflow yields and management teams that have a propensity to continue to return money to shareholders and to ‘sweat’ the assets more – i.e. not spending more on new sites – the investments look like a “pretty good bet”, according to Custis.
The final area he remains interested in is consumer staples, although it does not have the same broad-based valuation argument as the others.
“We have felt that the valuations were a bit extended but obviously they have come back quite a long way,” the Lazard manager said.
“They have still performed pretty well this year. Diageo is still on an all-time relative high so we still think there is some scope there for these shares to underperform for a bit – particularly if we get this swing back into value.”
However, there are still some interesting opportunities within the sector that are worth holding – even if they may appear highly valued.
Performance of stocks over YTD
Source: FE Analytics
One example is Unilever, which Custis said he bought on the day that US peer Kraft made its bit for the company.
While he liked the stock he could never justify its inclusion as portfolio holdings have to have a 2 per cent upside potential to merit inclusion.
“The Kraft bid – while in and of itself only lasted less than 48 hours – would motivate management to start restructuring the business and therefore there was a greater chance of value that could be realised,” he said.
Another name holds is British American Tobacco, which remains on lower valuations than its US peers. While the sector is struggling with the transition to next-generation products, cigarettes are still 96 per cent of the business.
“The market is looking over there when the core business – while it is in slow decline and we all accept that combustibles are declining – it is a measured decline and that rate is not increasing,” he added.