When you’re caught in the eye of the storm, it can be difficult to point your investment compass in the right direction. The current is now changing as the era of easy money comes to an end and inflation stirs.
After years of uncertainty that drove investors to the safety of the market’s ports in a storm — quality stocks such as pharmaceuticals, consumer staples and utility companies — we are finally seeing the long-anticipated rotation towards value plays — companies regarded as undervalued by investors.
Quality stocks have come under pressure as bond yields rise, denting the relative appeal of their reliable dividend streams. Meanwhile, companies whose fortunes are more closely tied to the economic cycle held up better in the recent sell-off.
For many years, a backdrop of falling yields and record low interest rates has driven income-starved investors to quality or defensive companies — those in the consumer staple and utilities sectors that boast safe, predictable returns, but with higher yields than most of the bond market.
Now the pendulum is swinging back and volatility is spiking as investors adjust to the changing landscape. Some may question the sustainability of rotation to the more cyclical parts of the market but there’s no getting away from the fact that yields are on the move after the loose monetary policy of the past decade. This is bound to show up in the relative performance of different investment styles.
Look at a chart of the FTSE All Share over the past 10 years or so and you’ll see that the rise in the index has been shadowed by the rise in the consumer staples index (the archetypal bond proxies). Most of this climb was without any meaningful earnings growth, but simply a re-rating driven by easy money looking for a safe home.
As inflation starts to re-emerge, the one-way pressure on bond yields is reversing, while earnings growth has also returned. Investors no longer need blindly to chase stable growth and reliable dividend yields.
Yet many investors seem to be positioned for this trend to continue indefinitely — viewing their quality defensive holdings — names such as Nestlé and Unilever — as the jewels in their portfolio crown. Why would I ever sell these, questions the quality-focused investor?
Granted, companies that boast strong cash flows, steer clear of debt and have pricing power should be able to increase prices regardless of what’s happening in markets or the broader economy. But it would be remiss to ignore the glaring dislocation between quality, growth companies and value plays.
The sands are shifting and professional investors are taking note. Fund manager Leigh Himsworth of the Fidelity UK Opportunities Fund is tilting his portfolio to more interest-rate sensitive stocks, financials such as asset manager Liontrust and wealth manager Brooks Macdonald, as well as companies with shorter cash cycles that quality-focused investors have shunned.
The return of inflation also bodes better for highly-geared companies. As debt tends to be fixed, a business’s borrowings will be eroded as inflation takes off. Companies with fixed debt and growing niche offerings should do well. Think supermarkets, leisure stocks, cinemas, pubs and holiday providers, especially when wages rise.
Of course the road to monetary normality is likely to have a few twists and turns. It still makes sense to look for companies with dependable earnings. But this should not be confused with buying defensive “Nifty Fifty” bond proxies. This will be the wrong place to be if interest rates are rising. Instead, seek out niche players with pricing power that can make the most of inflation. Food companies supplying supermarkets are one example: Mr Himsworth holds Cranswick and Dairy Crest.
Food retailers themselves can also benefit from an inflationary environment. We may buy a tin of beans today at a certain price, but the retailer only pays the supplier 60 days later at the old price. As consumers, we don’t know which goods are susceptible to inflation and retailers can use this to their advantage, sneaking through price rises across the board.
It is not merely a question of value versus growth, but also of valuations. “The irony now is that the cheapest sectors in the market — the ones investors have largely shunned — are the ones that are most positively exposed to yields going up — banks and the energy sector,” says Stephanie Butcher, manager of the Invesco Perpetual European Equity Income Fund.
She says her portfolio has been pushed to the value end of the market because these companies have de-rated so much over recent years. Equally, she believes the price being paid for companies such as Nestlé, Unilever and Anheuser-Busch Inbev, for example, leaves very little room for error.
She holds a number of names in the energy sector such as Royal Dutch Shell, Total and Statoil and points out that there are structural factors supporting them: cost-cutting, reducing capital expenditure and focusing on return on capital. Dividends are no longer in question and they’re starting to talk about buybacks.
Banks such as ING Group, Caixa and Intesa have both structural and cyclical factors supporting them. On the structural side, the regulator has insisted that banks have more capital. They are less volatile and more transparent. Their capital positions are robust, the dividends are attractive and then there’s the cyclical kicker: rising interest rates.
Intuitively, it makes sense to pay for quality, not least when the economic outlook remains anything but certain. But it can be easy and tempting to take comfort from a successful period of outperformance. Complacency can leave you dangerously exposed when patterns of market leadership change.
Despite the strong stock market run, there’s still a lot of opportunity. It’s in the areas that haven’t been leading the market over recent years. There’s value in value.
FT Money reader event: Why don’t women invest?
Claer Barrett, FT Money editor, and Maike Currie, Fidelity investment director and FT Money columnist, will be among the speakers at a lunchtime event entitled “Where are all the female investors?” in the City of London.
To be held at Fidelity’s offices at 12 noon on Tuesday March 6, free tickets are available to the first 50 FT Money readers who register at fidelity.co.uk/women.
Inspired by Ms Currie’s recent column and timed to mark International Women’s Day, the event will host a selection of female fund managers including Stephanie Butcher of the Invesco Perpetual European Equity Income Fund and Alexandra Jackson of the Rathbone UK Opportunities Fund. The panel will also debate how the asset management industry can encourage more female investors. There will be an opportunity to ask the panel questions.
This event is intended as a general discussion and does not constitute investment advice. Full terms and conditions are available via the weblink above.
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