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Seeking value

John Baron explains why the portfolios are increasing exposure to UK ‘value’ stocks
March 10, 2017

The column last month (‘Backing Britain’, 10 February 2017) made the case for increasing exposure to the UK market, at the expense of the Far East. This reflected the fact that the UK is close to its lowest level relative to the rest of the world in sterling terms for nearly 40 years, despite both its economic and earnings growth comparing well relative to other countries. Sentiment trails fundamentals.

But it will be important to nuance this increased exposure to maximise returns, for markets generally may be at a tipping point. For most of the last decade, growth stocks have outperformed value and, as economies gradually recover, there is now scope for value stocks to start catching up. This rotation will not be smooth but it will be robust, regardless of company size – and investors would be wise to be positioned accordingly.

The perspective of 40 years – again!

While definitions can only be general, stocks considered value tend to be those that are more tied to the economy, have lower ratings than the average because the market has underpriced their worth relative to prospects and/or value of assets, and usually have higher yields. By contrast, growth stocks promise solid earnings growth which is less dependent on the wider economy, are usually more highly rated, and typically yield less as a result.

Given economic growth has been hard to generate because of high debt levels, it is understandable that growth stocks have performed well in relative terms. Indeed, their ratings are now standing at levels well above their long-term averages, spurred on by the demand for predictable earnings in this low-growth environment.

The extent of underperformance by value stocks has been highlighted in recent research, which suggests they are now more unpopular than at any time during the past 40 years. This holds true for both shares in the UK and globally, but the underperformance is most pronounced in the UK. Indeed, by some estimates, around 90 per cent of unit trusts investing in the UK have a growth bias.

Herein lays the opportunity. Within a market which itself in relative terms is at its most unpopular during the last 40 years, lie value stocks which are also at their nadir. This could be a powerful combination – so much so, all seven investment trust portfolios on the website www.johnbaronportfolios.co.uk are implementing this strategy where appropriate and, in the process, increasing already above-average income levels.

 

 

The perspective of time can be one of a private investor’s greatest advantages, provided it is allied to patience. It is common for most ratings to revert to norm – the real challenge is identifying the catalyst. And here, economic growth rates may be the key. The backdrop may be changing for key economies, particularly the US and the UK.

As highlighted in a recent column (‘The ‘Tyranny of the masses’ fills the policy void’, 9 December 2016), President Trump’s proposed policies and the welcome fall in sterling courtesy of Brexit are contributing to renewed confidence about both economies and the prospect of faster growth rates – both in absolute and relative terms. The political establishment’s predictions of gloom following a ‘Leave’ vote have proved false.

Faster economic growth should favour most value stocks, as the predictable earnings of growth stocks becomes less valued and their high ratings revert more closely to their long-term relationship with earnings. When sentiment starts to shift, particularly among the large institutions, the rotation may be remorseless. And it will not just be confined to the larger stocks, at a time when smaller companies in general look attractive – especially those that offer decent and progressive yields.

It is important to highlight that the portfolios, while increasing their exposure to value stocks, will ensure balance is maintained between the two. There will still be a place for growth stocks, including those able to commercially benefit from disrupting established business models, achieving scientific breakthroughs, or simply creating and maintaining wide moats.

 

 

Portfolio changes

During February, both portfolios top-sliced City Natural Resources (CYN) after a very strong run. CYN was becoming something of an outsized holding. It is important portfolios maintain their balance, and taking profits are seldom the stepping stones to ruin.

The Income portfolio used the proceeds to add to its existing holding of The Merchants Trust (MRCH). This not only adds to the portfolio’s value exposure but is also part of a more general strategy to increase exposure to UK equities, for the reasons outlined in my last column.

Likewise, the Growth portfolio increased its exposure to Chelverton Small Companies Dividend Trust (SDV) and introduced JPMorgan Mid Cap (JMF), having top-sliced New City High Yield (NCYF). Meanwhile, the portfolio’s property exposure was nuanced by reducing exposure to Standard Life Property Income (SLI) and adding to TR Property (TRY). The website mentioned on the previous page has a fuller explanation of all individual portfolio changes.

WMA benchmarks

Any changes to how indices are constituted are important to understand. Although the portfolios have made a strong start to the year, they adopt a long-term approach when assessing sentiment and fundamentals, which is best monitored by benchmarks over a minimum of five years. It is therefore imperative that benchmarks achieve continuity when monitoring portfolios over long periods.

Ever since their introduction in 2009, the portfolios have been monitored against the ‘Growth’ and ‘Income’ benchmarks provided by the Wealth Management Association (WMA) – the industry standard. Last month the WMA changed its indices provider from FTSE to MSCI. Speaking with the WMA, it has confirmed the historical data of the MSCI WMA indices was created using the same historical asset allocation weightings as was used for the FTSE series, and so returns are very closely allied.

Speaking also with the MSCI, the change is ushering in improvements in the indices, including the recognition that bond exposure should not exclusively focus on conventional government bonds (gilts) but include corporate bonds and index-linked gilts – a welcome move.

Accordingly, the portfolios are now using the MSCI WMA data – effective from 1 January 2017 for ease of comparison. The breakdown of the asset allocation weightings for the various indices, which is determined by the WMA in conjunction with its members, can be found on the WMA’s website: www.thewma.co.uk.