After years of outperformance the growth style has begun to come under pressure over the past year, as value strategies have started to perform more strongly after years of underperformance.
Indeed, quality growth managers have outperformed since the financial crisis in 2008 as investors have sought to invest in so-called ‘bond proxies’ such as tobacco stocks.
Yet, with many bond proxy stocks at record valuation levels some industry commentators believe the value style could be in line for a prolonged period of outperformance.
As such, funds with a high weighting to the ‘expensive defensives’ may come under more pressure in the near-term. In this series, FE Trustnet looks at some of the best performers over the past five years that have a strong growth bias and ask market commentators what they are holding alongside to diversify these.
This week, we focus on Fundsmith Equity, run by FE Alpha Manager Terry Smith. The five crown-rated fund has been a top quartile performer over three and five years but came under pressure in the second half of 2016.
Performance of Fundsmith Equity vs sector and benchmark in 2016
Source: FE Analytics
As the above graph shows, the £9.3bn fund's 28.16 per cent return failed - albeit only just - to beat the MSCI World index, which rose by 28.24 per cent during 2016: the first calendar year it has not done so in since launch in 2010.
Adrian Lowcock, investment director at Architas, says fund managers with a specific style bias such as Terry Smith will naturally go through peaks and troughs.
“Even Terry Smith has been fairly surprised with the strength of performance up until 2016 and any fund that has a particular style bias will have periods where it underperforms the benchmark,” he said.
“I think it was a matter of when not if he would have that period of underperformance.”
Investing in a fund with a value bias rather than a growth bias may help investors diversify and give them the best chance to outperform in any market environment.
“If you want a fund that perhaps would help complement the fund then I think something like the Schroder Recovery fund by Nick Kirrage and Kevin Murphy,” the analyst said.
“It’s a very different and complimentary to the Terry Smiths of this world. He’s that sort of compounding growth story so buying into companies that are going to continually grow over time and have the big markets – so he is not about valuations but about the long-term story.”
Meanwhile, the Schroder Recovery fund has a “deep value bias” focusing on valuations and “good fundamental analysis” to avoid value traps and make positive returns.
The fund has performed well over the last five years despite a difficult environment for value investors, sitting in the top quartile in IA UK All Companies sector.
“Just because one does well doesn’t mean the other would do badly that’s not a certainty but I wouldn’t expect them to perform strongly at the same time,” Lowcock said.
Performance of Schroder Recovery vs sector and benchmark over 5yrs
Source: FE Analytics
The £920m fund has a high weighting to financials, mining and oil stocks, areas which Fundsmith Equity has little-to-no exposure to.
Its top three holdings are all banks (HSBC, RBS and Barclays), but while some remain unsure on the prospects of the banks, Lowcock is unconcerned.
“Banks are part of what you get in the value space and banks have been fairly cheap but if you’ve got partly this cyclical rotation story then banks would be a beneficiary of it,” he said.
For those not willing to take on the risks associated with banks and the value style in general, Chelsea Financial Services managing director Darius McDermott says Rathbone Global Opportunities may be an option.
“We still have great faith in Terry Smith’s ability for the long-term but in a heavily-driven momentum/cyclical type of market then you would think that Terry might underperform as he did in the fourth quarter of last year.”
“As we know Terry invests in large cap quality companies so it depends how we look to compliment it. [This] is also a growth fund but it does have a mid-and small-cap bias,” he said.
McDermott says as a result, while Fundsmith Equity tends to hold companies with high price-to-earnings ratios, the Rathbone fund run by FE Alpha Manager James Thomson focuses on this less.
“It does have large caps in there as well but it is massively underweight the names that Terry Smith will be overweight which is why I have picked it as a blend,” McDermott said.
On a macro level, he adds that there is no reason that mid- and small-caps won’t have a good year.
“There is a question on UK mid- and small-caps because of Brexit and domestic issues but globally mid- and small-companies tend to outperform over all long-term periods,” the analyst said.
Another option for investors could be the Sanlam FOUR Stable Global Equity, McDermott says, which has a very similar mantra to Fundsmith Equity.
“They screen the same sorts of quality metrics that Terry Smith looks for but they have a much keener valuation discipline,” he said.
“Terry will run his winners – if he thinks he has got a great company, it’s a great compounder and it just gets more and more expensive – as long as it’s growing and it’s earning Terry will continue to hold them.
“The SanlamFOUR fund likes those same companies but then has a valuation filter which means that on average their PE is considerably lower than Fundsmith.”
Finally, Andy Parsons, head of investment research at The Share Centre, says investors should look at First State Global Listed Infrastructure for diversification from Fundsmith Equity.
He said this approach allows investors to drill down into many aspects of infrastructure - a sector Terry Smith’s fund has little exposure to.
“You’re complementing it because when you look at sectorial splits Terry’s big three themes are consumer staples, healthcare and technology,” he said.
“That’s definitely not what you’re going to get in infrastructure when you pick up the three biggest there are electric utilities, highways and rail tracks and I think it is oil and gas transportation.”
Performance of First State Global Listed Infrastructure vs sector and benchmark over 5yrs
Source: FE Analytics
The fund outperformed last year, returning 35.89 per cent beating the MSCI World by 7.65 percentage points, proving to be a diversifier to Fundsmith Equity.
“We are talking about global development and particularly given the rhetoric around infrastructure spending maybe coming out of the US from Trump,” Parsons said.
While neither fund is expected to outperform during a market rally, he says both should be considered core parts of the portfolio.
“These are core global holdings in your portfolio. Investors can always find a third holding if they wanted to put some real excitement and explosive potential volatility in there but if you are trying to build a core nucleus of a portfolio we would never say to go for just one fund, we would suggest a couple and we see First State sits very nicely alongside Fundsmith,” the analyst said.
Additionally, he says there is a much broader geographical spread in the Global Listed Infrastructure than the Fundsmith Equity fund.
“The Global Listed Infrastructure is only 48 per cent US whereas Terry is 64 per cent. Terry’s got about 20 per cent in the UK, Global Listed Infrastructure only has about 8 per cent in the UK.”
However, he says these funds should be held for the long term rather than for one year or any other shorter timeframe and notes that despite the ‘underperformance’ of the Fundsmith Equity fund in 2016, it still produced a solid return.
“We don’t worry about one year. It is about longer term investing. Managers will go through peaks and troughs,” Parsons said.
“The fact that it still returned just shy of 30 per cent and underperformed – what investors have to appreciate is you’re not chasing the return. If someone is providing you 30 per cent returns a year that is a very good, strong, handsome return."