Stout (pictured), manager of the £1.3bn Murray International IT, believes that the recent rally in equity prices is a result of expectation rather than improving fundamentals and that it is unlikely that earnings growth will justify the sharp rise. He says it is impossible to pinpoint when there will be a pull-back in the market, but that when this materialises, passive investors will have nowhere to hide.
“Absolute returns in 2013 were extremely strong for financial markets, but this was based on only hope and expectations,” he explained.
“If you look at underlying earnings growth, it was negative in Europe, only 5 per cent in the US – and only 2 per cent if you take away share buy-backs – and a similar level in the UK and to some extent Japan.”
Performance of indices over 1yr
Source: FE Analytics
“The markets obviously expect there to be a huge recovery in ratings based on improving economic growth, but we’re going to have to see one hell of an upgrade for the rises we saw to be justified.”
“I won’t be investing in what is essentially a speculative punt. Hope and expectation have often been the drivers of returns. The reality phase has always been associated with a market correction. No one likes reality.”
Stout explains that the reason why economically sensitive and financially stretched areas of the market – such as banks and domestic cyclicals – performed the best last year was because they were buoyed by yet more quantitative easing.
Regionally, the US and Japan were the standout performers, even though earnings growth was relatively muted in these areas.
“We’re not a US or a Japan fund – we’re a global fund,” he said. “This fund is always going to be diversified.”
“Now there’s a real benchmark danger as it’s so extended. One thing I can tell you for sure is that a passive investor will capture all of the downside from here.”
“The two best performers last year looking at sectors were financials and consumer discretionary, and the expectation is that all is well in these areas. Hope and expectation don’t help equities – they can go up and up for a long time, but they mean nothing without fundamentals.”
“We saw that in 1998 to 2000, and if you look at my performance back then I was well behind the bubble.”
FE data shows that the Murray International trust significantly lagged behind the rallying market that ultimately led to the dotcom crash. It is well ahead over the longer-term, though.
Performance of trust and benchmark over 20yrs
Source: FE Analytics
The trust uses a composite benchmark, split 60/40 between the FTSE World ex UK and FTSE World UK indices.
“If you look at the index and think 'I want a piece of that', then the US is the biggest component, and it’s had the best run. If there is a pull-back then you will capture it all. If you’re diversified, you’ve got a much better chance of protecting against the downside,” he added.
Stout says the trust’s priority is to protect investors’ capital during market falls and increase it during the better times.
He underperformed his benchmark last year for the first time in 11 years – examined in closer detail in a recent FE Trustnet article – but this wasn’t enough to derail his trust from a cumulative perspective over the long-term.
The manager points out that the stocks he tends to favour – namely, those with strong balance sheets, predictable earnings and reliable dividends – are cheaper than they were a year ago.
“I have no idea whether 2013 will be the year that markets turn,” he said. “All I can do is predict the underlying earnings and dividends of companies.”
That said, he points out that there have actually been some downgrades in the US so far this year, which should be of concern to investors.
Tim Gregory, head of global equities at Psigma Investment Management, agrees. He points out that a lot of companies have already had set-backs this year, and big improvements need to be made in the coming weeks.
“Glancing back to last year, as the S&P 500 enjoyed one of its best rallies in many years, pretty much everything got revalued upwards to a point where the S&P 500 now sits just above 15 times the 2014 earnings forecast of $120,” he said.
“First defensives rallied strongly and then cyclicals, pushing ratings higher and suggesting to us that companies would need to post solid results to justify their new higher earnings multiples, or face the consequences of a market now likely to be far less forgiving of results that do not pass muster.”
“US retailer Sears Holdings announced that same-store sales for the quarter ending 6 January declined by 7 per cent,” he added.
“This news, accompanied by an inevitably weak earnings outlook, was sufficient enough to also push the stock down by 13 per cent.”
Murray International IT has ongoing charges of 0.71 per cent, but also has a performance fee. As well as aiming to deliver capital growth, the trust aims to deliver a sustainable and growing yield – it currently stands at 4.2 per cent.
Although Stout is generally quite cautious at the moment, such is his confidence in his stockpicking skills that his trust is 15 per cent geared.