A colleague recently reminded me about a piece of text we have used for years in documents for intermediary clients to describe the shape of performance likely to be delivered by our funds.
In answer to the question, “In what market conditions would you expect the fund to underperform its benchmark?”, we have consistently replied, “In relative terms, we expect our investment approach to deliver outperformance of the FTSE All-Share in most conditions, the key exception being late-stage, momentum-driven bull markets, where valuations and fundamentals can be temporarily ignored”.
We are now nine years into the current bull market, which commenced as the financial crisis passed through its most intense phase in early 2009.
Bull markets have been known to last longer than this one in the past but I believe it is fair to characterise the current environment as a late-stage bull market – and there is no doubt momentum has been driving market behaviour for some time now.
So where to from here? Investors need to tread carefully now. Markets have been good for a very long period of time and there is bullish sentiment towards risk assets all over the place. But valuations across a wide range of assets have increased significantly during this bull market and, as a result, there is considerable risk.
Valuations and fundamentals can be – and indeed have been – ignored temporarily but, in the long run, they are all that matter in determining the performance of financial assets.
That is why they are central to my investment approach. I have never witnessed a market in which all stocks are over-valued at the same time and I do not think I ever will. There are always pockets of value, and when a bull market becomes long in the tooth, as this one is now, the stretch between the cheap and expensive stocks can become extreme.
Healthy UK economy
Firstly, the market consensus has misread the outlook for the UK, where the economic fundamentals are improving, not deteriorating. Looking forward, I see a healthy UK economy with more people in work, more wage growth, less inflation, more investment spending, better public finances and a continued recovery in manufacturing and exports.
Indeed, I expect the UK economy to grow by around 2 per cent this year. Not a spectacular rate of growth but a considerably better outcome than the recession some of the more pessimistic commentators are forecasting and what appears to be priced in to valuations.
And if the UK economy performs better than people think, it is logical to expect that some companies exposed to the UK economy will also perform much better than people think.
With this in mind, the valuations of many housebuilders, construction businesses and retailers are simply too cheap and growth expectations far too low.
Secondly, healthcare is a sector that has been in a bear market for a protracted period now, despite the overall stock market’s steady march forward. That said, the fundamentals for this industry have been steadily improving and demand drivers such as demographics continue to provide an attractive long-term backdrop.
Innovation is key here. Across diagnostics, devices and drugs, there are businesses developing technologies that will deliver better therapies and, in turn, better outcomes for patients and for shareholders.
Thirdly, there is a compelling opportunity in disruptive technology more broadly. Whether it is in healthcare, financial technology, energy or artificial intelligence, there are some very exciting businesses with incredible long-term prospects.
Some are at a very early-stage but others, having been around for up to 20 years already, are not that young anymore and are now on the verge of delivering their commercial goals.
Bringing all this together, my portfolio has a greater domestic bias than it has done for many years, providing exposure to these themes. It is a deeply unpopular portfolio at the moment because the excitement in this late-stage, momentum-driven bull market has been elsewhere. But when markets behave in this way, with sentiment replacing fundamentals as the key driver of share prices, it simply stores up performance for the future.
I have rarely felt as excited about what lies ahead for the funds as I do right now.
Neil Woodford is head of investment at Woodford Investment Management