Investors in UK equities could see a substantial switch in the relative performance of value stocks at the expense of defensive and income stalwarts in the coming year, according to FE Alpha Manager Martin Walker, manager of the Invesco Perpetual UK Growth fund.
Over the past two years investors have flocked to defensive ‘quality’ type stocks within the UK market due to a growing demand for company’s dividends, a decline in sentiment for fixed income and mounting unease that the global recovery is more fragile and prone to volatility than was previously thought.
According to FE Analytics, the MSCI United Kingdom Quality index has massively outperformed the MSCI United Kingdom Growth and MSCI United Kingdom Value index since November 2013.
Performance of indices since 17 September 2013
Source: FE Analytics
Also in the market weakness of the past six months or so it has been value that has sold of the hardest with the index falling a whopping 12.21 per cent thanks to the poor performance of sectors such as oil and mining, compared to a much more subdued 3.59 per cent fall from quality and a modest gain from growth.
Performance of indices over 6 months
Source: FE Analytics
This could all be about to reverse according to Walker, who is underweight defensives in the Invesco Perpetual UK Growth fund such as pharmaceuticals and big tobacco, saying there is potential for “quite a big rotation” in the equity UK market in 2016.
“Sentiment and the relationship between value and quality looks quite stretched and sentiment is very, very, very negative in areas like resources, for example, and cyclicals generally,” Walker (pictured) said.
“Sentiment on the macro is also fairly negative. To be very negative on China is also a consensus view. There is dark muttering of a recession in the US which all feels a bit wide of the mark at this stage.”
“The perception that we are in a deflationary period now seems to be consensus as well and so whether it is market sentiment or the macro there is the potential for a rotation because we are at quite an extreme point.”
“Quite a lot of [defensive] stocks look expensive and the reason for that is that value is concentrated in some of the largest stocks in the market for example oil and banks - both 12 per cent each of the market. Annoyingly it [value] is concentrated in very few shares.”
This changing dynamic will come at the expense of some of the largest and most popular names in the index, Walker says, as many have seen their price to earnings ratios reach unsustainable levels.
“Will you make money in investing in a highly rated, highly loved companies from here? That is much more of a stretch. But for business that have no 'friends ' currently just having a few more will mean absolute upside.”
Relative to the value part of the market, quality is up 28.41 per cent since it began to rally just over two years ago, a period where Walker says the market has come to expect a prolonged deflationary environment. This could likely change, inducing the rotation in value stocks.
Performance of indices since September 2013
Source: FE Analytics
“You’re talking about a whole new set of stocks to hold in that environment, that wouldn’t be great news for the bond market given that most bonds are not index-linked and then if inflation is eating some of your return then yields might need to rise.”
Or, he says, the rotation could be prompted from a sell-off in the bond market due to rising US interest rates although, should it not occur, he thinks the risks are minimal for value stocks compared to the potential for substantial gains.
“In a bond bear market you don’t want to own bonds and you don’t want to own bond-like equites. What you want is to own those exposed to nominal growth.”
“In previous cycles when rates have turned or yields curves have steepened then empirically you see that resource and industrial, financials sectors have done quite well and tobacco, food producers and healthcare have tended to underperform.”
“If this doesn’t happen then at least the current scenario is already reflected in the share price because the consensus already believes the opposite of what I think.”
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A number of fund pickers have also told FE Trustnet over recent weeks that now is the time to focus on value funds over more quality growth orientated portfolios, given the huge difference in performance between the two and the possibility of higher interest rates.
Nevertheless, market commentators say value funds should only be for investors who can stomach volatility.
“I think a balanced portfolio of active funds should contain a mix of styles and both growth and value funds,” Rob Morgan, pensions and investment analyst at Charles Stanley Direct, told FE Trustnet last week.
“Now could indeed be an opportune time to add to value for the long term, whilst being aware of what value could mean – e.g. mining, energy, supermarkets and so on. These are areas that have appeared cheap for some time and it could take a while for a turnaround to happen.”
FE Alpha Manager Walker has headed the Invesco Perpetual UK Growth fund since 2008, since which it has delivered a return of 70.65 per cent, beating both sector and benchmark, and placing the fund in the second quartile.
Performance of fund, sector and index under Walker’s tenure
Source: FE Analytics
The manager who has generally had a tilt towards value has seen strong outperformance in 2011, 2012 and 2013 when the fund was either top or second decile but also relative underperformance in certain years such as 2015, 2010 and 2009 when the fund was bottom quartile.
Nevertheless, the Invesco Perpetual UK Growth’s performance profile and Walker’s disciplined style have earned the fund a spot on the FE Invest Approved List.
Walker’s largest positions are generally either banks or oil names. His top 10, for example, includes HSBC, BP, L&G, Shell and BG, which combined make up about a quarter of his portfolio. This has hurt performance somewhat this year, though.
The FE Alpha Manager has also dipped into mining and supermarkets names which have had a pretty dire performance and he remains keener on the former than latter.
“It is still too early for supermarkets. Tesco's share price currently reflects a more realist price than it did when the shares were above £2. I’ve been too early on some of them [miners and commodities firms] but the investment thesis remains compelling.”
“Glencore, for example is till generating significant cash flow even at spot commodity prices and given that it has cancelled its dividend and is reducing debt on its balance sheet, just by not paying a dividend and generating cash flow should significantly de-gear the balance sheet.”
The Invesco Perpetual UK Growth fund has clean ongoing charges of 0.91 per cent.