Piling into low-quality cyclical stocks just because a market correction has brought them down to more attractive valuations is one of the biggest mistakes investors can make in the current environment, according to Rathbone’s Julian Chillingworth (pictured).
The chief investment officer says the resources and energy sectors are prime examples of where investors need to be careful, as the bounce in these areas over recent weeks could be the result of overconfidence as macroeconomic data stabilises.
The growth versus value argument has found itself at the forefront of investors’ minds recently, given that the FTSE World Growth index has continuously outperformed the FTSE World Value index over one, three, five and 10 years and, on an annualised basis, has outperformed eight times over the last decade.
Performance of indices over 5yrs
Source: FE Analytics
While some investors believe this could continue, many others believe in the ‘mean reversion’ theory, which means it is only a matter of time before the scales rebalance and value starts to outperform.
In addition to this, higher market valuations have led investors on a hunt for lower-priced stocks and Chillingworth says this has caused them to buy into less-than-favourable areas of the market.
“I think there’s been quite big switch globally away from investing in what are loosely termed as momentum plays, so some of the more highly-rated IT and tech names – the Amazons and Netflix of this world – and they in valuation terms became more expensive,” he explained.
“Because investors were looking for safety and pushed those valuations a little too far, there’s been quite a lot of money coming out of those areas and going into the more cyclical areas, as people are just looking simply at value but perhaps haven’t analysed whether they’re buying good long-term value or whether they’re cheap for a very good reason.”
The concept of ‘buying the dips’ is often used as an investment thesis, but Chillingworth isn’t the only investment professional to warn against placing too much emphasis on this when building a portfolio. 
Martin Bamford (pictured), managing director of Informed Choice, says investors should hold a combination of value and momentum stocks in order to spread risk and maximise long-term returns in their portfolios.
“Any reactive approach to portfolio construction exposes investors to the risk of buying the dips,” he said.
“Instead of buying based on market valuations relative to historical pricing, investors are better advised to establish an asset allocation strategy at outset which suits their long-term investing goals and then rebalance back to this position at set intervals, regarding of what the market is doing at that time. This removes the emotion and psychology from investment decisions.”
Another danger related to impulse-buying deep value plays, according to Chillingworth, is that investors can find themselves enticed by the high yields they have on offer.
For instance, more than 10 per cent of the FTSE 100 index – which is of course heavily weighted in mining and oil & gas stocks – is yielding upwards of 6 per cent.
However, yields increase if the value of the underlying holding falls as well as if the dividend payments simply rise. To avoid this risk, the CIO says that investors need to keep thinking back to a stock’s cash flow and whether it’s sufficient to pay the dividend that is on offer.
“Perhaps the market should be sending a message to you as an investor that obviously if a dividend yield is high, it’s high for a reason because the return you’re getting is above-normal in terms of the dividend yield and so consequently you’re being paid because the risk is higher,” he continued.
“I think with anything that is quite cyclically exposed, investors need to be wary. For instance, in the quoted arena we don’t hold anything in deeply cyclical industries such as steel production, cement production or any similar stocks. Those are all areas that are very economically sensitive so you need to be aware of those.”
“Any companies that are incurring quite a high level of debt should be avoided as well as they may struggle to pay if interest rates were to rise at all – those might be companies that have got quite a lot of investment in factory plants and equipment, for example, or are operating on very thin margins.”
In contrast, Chillingworth says the market areas he thinks will continue to do well over the medium term are technology companies, telecom businesses and consumer stocks that are producing products people will want or need over a longer term time scale.
These include the likes of Unilever, Diageo, Nestle, Procter & Gamble and public relations firm WPP. Many of these stocks have already had a strong run, but the CIO thinks this could continue.
Performance of stocks vs index over 5yrs
Source: FE Analytics
Patrick Connolly, head of communications at Chase de Vere, says too many investors place too much emphasis on short-term performance, whether it’s buying shares or funds because they are already delivering or strong performance or targeting those that are in doldrums but are cheaply-valued.
“By adopting either of these approaches, investors are in danger of taking too much risk. They could buy shares or funds just as they peak or invest in areas which could be depressed for some time to come,” he said.
“The reality is that nobody can consistently call short-term market movements. The best approach is therefore to take a long term perspective, try not to be too clever and try not to be overly influenced by short-term performance.”
