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FTSE 350: In hope of a better year for stockpickers

Last year was a rotten one for stockpickers as - unusually - smaller companies failed to outperform
January 29, 2015

A year ago, stockpickers had every reason to celebrate. Index investing may be all the rage, but 2013, even more than 2012, was a year that rewarded stock selection, particularly in the lower echelons of the stock market.

Not so 2014. A flight to quality hammered those taking bets on smaller companies - particularly those traded on Aim. We cannot know how the portfolios of UK private investors fared last year, but we have something of a proxy: the performance of open-ended funds. According to Morningstar, the average fund returned 0.1 per cent over the year to 9 January. If you'd put your money into the Vanguard All-Share tracker, you'd instead be up 0.9 per cent.

Perhaps the most powerful reason why investors became more cautious was simply mean reversion: they could scarcely have become more upbeat. In our introduction to the FTSE 350 review last year I wrote: "Perhaps the most worrisome aspect of the current market situation is the bullish consensus. Investors' pessimism a year ago was one of the principal drivers of return in 2013. If that logic is extended, 2014 is likely to disappoint." That logic proved on the money. Extending it once again, 2015 should prove more rewarding.

At a sector level, however, there was little evidence of mean reversion: the sectors that underperformed in 2013 continued to underperform. The miners failed to find a bottom as the key iron-ore price fell further. In fact, their overcapacity problems, which have been compounded by a slight slowdown in global growth, spread to the oil and gas sector. As has been exhaustively documented, that caused the price of Brent crude to plummet in the second half.

Less widely understood is that the collapse in commodity prices will affect many more companies than simply BP (BP.) and Shell (RDSB) and their drilling partners in the Oil Equipment & Services sector. Numerous engineers have also grown fat in recent years supplying niche products to drillers and miners for capital investment projects that are now being aggressively cut. And investors are worrying about the capital position of emerging-market bank Standard Chartered (STAN), which has a lot of commodity loans on its books.

The shake-out continues. It did not pay to be contrarian on commodities last year, and my best guess is that it will not pay to be contrarian this year. Even if the oil price rebounds, improving the prospects of the major producers, their suppliers will surely continue to suffer in a more risk-averse environment. The days of big spending on big capital projects seem unlikely to return any time soon.

A related theme for 2015 is deflation. UK consumer prices rose just 0.5 per cent last year - the lowest rate of inflation since the turn of the millennium - and economists expect further falls. There is some talk that this could entrench a dangerous deflationary mindset, whereby consumers delay spending in anticipation of lower prices, but the evidence so far points to the contrary: by buoying real wages, low inflation is benefiting retail sales. Sales volumes were 2.3 per cent higher in the fourth quarter of last year than in the third quarter, the strongest quarterly growth rate since 2002. "2015 should be another stellar year for the consumer recovery," concluded Paul Hollingsworth at Capital Economics.

Housebuilders are a perennially popular way to play this UK recovery theme. Along with many retailers, these fell prey to a sell-off in the second and third quarters as investors fretted about rising interest rates and falling mortgage volumes. But they bounced back strongly in the final quarter, even as house-price inflation slowed. With a chronic supply-demand imbalance in the housing market, smaller builders starved of bank finance, and significant levels of government support - which is too popular to face much risk of being rolled back following the general election in May - the trading backdrop remains very favourable.

Conditions for the retailers are much more competitive, particularly in the supermarket sector - last year's second-worst performer. The key reason for this is well-rehearsed: Britons have learnt to love discounters. It is not obvious when investors should get back in. Like-for-like sales figures in the final quarter of 2014 were still negative, but better than in the third quarter. If that becomes a trend, it might signal a buying opportunity.

This is one story to watch carefully this year. It is instructive that the top-performing stock in the FTSE 350 last year was that of the hedge fund manager Man Group (EMG) - a company that started the year looking something of a no-hoper. Calling the recovery of a long-time underperformer is risky, but it can be hugely profitable.

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