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Taking stock

For the past few years, a lot of fund managers have sought to emphasise their stock-picking prowess. Whereas previously they spoke proudly of the quality of their macroeconomic analysis or their thematic processes, more recently it has been about stocks and, in particular, the wide range of money-making opportunities that exist in mid-cap stocks, not just here in the UK but also in the US, Europe and Japan.

As is often the case, the marketing story started life as an attractive stockmarket opportunity. The tech bubble saw swathes of old economy companies ignored as a tight-knit band of names captured all the attention.

Many of the ignored companies were mid and small caps. These went on to become the bargains of the early part of this decade, especially after economic growth started to pick up in 2003 and the operational and financial leverage that often characterises smaller companies started to work in their favour.

Unfortunately, investment opportunities that pay off tend to attract imitators and eventually easy assertions and marketing hype started to take over from investment sense. The result has been a growing band of born-again stockpickers often doing little more than making sure they are fishing in the mid-cap pool, with a particular focus on cyclicals.

Today there are reasons for thinking this simple solution to investors’ needs has passed its sell-by date. Valuations for smaller firms now exceed those on large caps almost everywhere, whereas historically they have traded at a discount because of their lack of liquidity. Stockmarket volatility has picked up, with the change especially apparent for mid caps. Liquidity is being repriced by managers as they face up to less benign economic conditions and acknowledge a greater need for manoeuvrability. Higher interest rates work against companies that are more highly leveraged. None of these developments are mid-cap friendly.

That said, we do not think conditions have changed so much that no exposure to mid caps is warranted. Rather, we think we are back in an environment where genuine stockpicking skills will again come to the fore. Judicious selection from different parts of the market will be well rewarded but errors of judgment will be harshly treated. A naive strategy focused only on mid-cap cyclicality is unlikely to deliver results in this world.

Looking to the future, we anticipate an increasing number of companies will deliver results that are at odds with expectations as the economic slowdown takes hold. These disappointments will probably be (at least partially) pre-empted by stock price weakness and will probably be met by further selling. After a three-year drought, shorting is back as a money-making strategy for hedge funds.

Already, we have seen signs of these developments taking hold. During the current results season, the market has rewarded companies that have delivered on promises. However, companies which disappointed have been shown little mercy.

Other recent performance trends are suggestive of a change in market leadership. Mid caps underperformed when markets were weak in May and early June and have continued to underperform as the broader indices have picked up again. Similarly, more defensive developed markets have outperformed emerging markets during the latest upturn.

We suspect some of these trends have further to run as evidence of a less clement economic backdrop builds. In addition, we may also see investors displaying a greater willingness to extend their investment horizon and pay a bigger premium for growth that lies further ahead. Companies with immature business models that are capable of growing despite a slower economy will have appeal, particularly if somewhat lower bond yields are also part of the picture.

The change of market emphasis is also apparent in the performance of some of our holdings. Rensburg UK Equity Income, for example, has seen a sharp improvement in its performance, as investors have started to see attractions in the higher quality more stable companies that it invests in.

Bill McQuaker is multi-manager director at Henderson Global Investor


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