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David Coombs: Looking for earnings growth in developed markets

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The start of this year found emerging markets leading the sell-off in risk assets. This trend was driven by several factors, not least of which was softer economic data out of China and the US. Combined with the tapering of bond purchases from the US Federal Reserve, the result was sharp headwinds for the emerging markets.

Growth in earnings is likely to be the key driver of equity market returns this year, therefore, although we note that while the latest reporting season has been broadly positive, results have been mixed and peppered with profits warnings.

However, this is the ideal environment for stockpickers to generate alpha – a theme that will permeate our thinking over the next 12 months.

There are three funds in particular that we play this theme through. The first is the Miton UK Multi Cap Income, which has a small and mid cap bias (33 per cent is held in Aim). The fund is managed by the highly experienced Gervais Williams.

We view this fund as a small/mid cap fund but with a dividend discipline. It has a broad approach and has now hard closed at £400m owing to reduced liquidity in smaller cap stocks. We expect this constraint to preserve performance.

The momentum behind growth and employment in the US is key for the trajectory of quantitative easing and interest rate rises, but we expect the Federal Reserve to err on the side of growth and we remain comfortable with our overweight position.

The concentrated Legg Mason Clearbridge US Aggressive Growth Fund remains a favoured alpha-generator in this market, and a good satellite to complement more index-aware US funds. This strategy targets companies that exhibit growth potential in excess of the S&P 500, and is fully unconstrained.

The managers have a strong valuation discipline and will not pay more than a price/earnings to growth ratio of 2 when initiating a position – a strong differentiator with some managers who are willing to overpay for growth. 

We are underweight Europe, but are focused on valuation opportunities. For pan-European small cap exposure we like the Baring European Select Trust, run by Nicholas Williams. His growth-at-reasonable-price strategy is well positioned to benefit from a European recovery. The definition of GARP used is where the growth forecast exceeds consensus, and the current valuation falls between 90 per cent to 120 per cent of the market’s P/E valuation.

The fund targets outperformance versus the HSBC European Smaller Companies index. Debt-to-equity and ROE are important metrics used to determine the quality of a company.

About 75 per cent of asset allocation is driven by stock selection, with the balance resulting from macro analysis. 

We expect developed markets to continue to be characterised by low rates, subdued inflation pressures and low-to-moderate growth. Since the start of 2013, emerging markets have underperformed the US by 35 per cent and spreads on emerging market debt have widened significantly over Treasuries. We hope to take advantage of value in these markets.

David Coombs is head of multi-asset investments at Rathbone Unit Trust Management

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