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Steady States

The US market had an incredibly strong run from early March until early June, with the Russell 2500 index up by an impressive 51.3 per cent. The rally was sparked by the announcement of the US treasury public private investment programme and was sustained by positive signs of stabilisation in leading indicators of economic activity.

A rise in ISM manufacturing and new orders as well as better than expected housing data and durables goods all boosted the US equity markets during this period.

It is important to note that this rally was led by low-quality stocks (such as companies with no earnings) and the smallest-capitalisation groups.

We do not think that markets will re-test their March lows but we are not convinced that this rally represents the end of the bear market and would not be surprised to see another period of weakness.

However, for the rest of the second quarter, US equities have essentially been treading water as concerns about the health of the economy resurfaced. Market concerns over higher mortgage rates and a drop in industrial production and in retail sales all combined to stall the rally.

In addition, Congressional deliberations over healthcare legislation hit the market with the net result that the Russell 2500 finished the second quarter up by a still impressive 20.3 per cent as mid-cap and smaller stocks did particularly well.

From a valuation perspective, we have gone from a point of extremely attractive valuations in February to a point of less compelling valuations now. On an absolute basis, US small and mid-cap stocks remain below their historical average but the same is true for US large-cap stocks. In comparison with large caps, the US small and mid-cap space is now beginning to look at least modestly expensive.

Looking at the US mid-cap market, we believe that healthcare is the most attractively valued sector but it is also quite a treacherous area to be invested in. This is because it is still far from clear what the final healthcare legislation, which is currently being debated in the US Congress, will look like.

On top of this, taxes are likely to be imposed to pay for the new healthcare programme, which is another significant unknown that we are monitoring carefully.

With this in mind, we have been adding some what we call “steady eddies” to our portfolios, given our concerns over the current environment, as these tend to do better in times of uncertainty.

As the name suggests, “steady eddies” are predictable, high-quality companies. They have consistent results and low variability in revenue and earnings. They tend to be stocks to hold for the longer-term where we believe upside is more limited but so is downside.

Growth in these types of companies is still strong, however, likely to be around 8-12 per cent at the bottom line. Their financials will also be solid – strong free cashflow, strong balance sheet and earnings that consistently meet or exceed estimates. Due to this consistency and generally lower risk, valuations might be higher than those of “mispriced growth” stocks.

Mispriced growth stocks are a prime hunting ground in the US mid-cap sector – their product or service offering is normally at an early stage of its lifecycle and end-market demand is strong. The management team should be strong and talented while the balance sheet is healthy and cashflows are improving. Combined with “turnarounds” – companies that are out of favour in the market for one reason or another – and where we have identified a potential positive catalyst that has not yet been priced in, we look to blend these three types of stocks to lower overall volatility and enhance performance.

We cannot promise that this recent US market rally represents the end of the bear market but the outlook is still compelling for US mid caps. In our view, investors with an allocation to the US should strongly consider exposure to this under-appreciated and dynamic area of the market.

Crucially, we believe that a focus on fundamental research from an experienced and proven investment team should provide strong returns over time.

Jenny Jones is manager of the Schroder US mid-cap fund

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