Cautious investors have been flocking to defensive stocks, but cyclicals are a big opportunity for investors right now, according to Julie Dean, who manages the Cazenove UK Opportunities Fund (read our tip).
Ms Dean has posted market-beating returns through her expertise in business cycle investing, putting the fund consistently near the top of the UK All Companies sector for its performance over one, three and five years.
"We try to understand how corporate profits change with the business cycle," she explains. "Companies don't operate in a vacuum whatever they do - to some extent, they will be influenced by changes in the cycle which impacts their corporate profits. There are typically four periods of the business cycle which it moves through as the rate of economic growth changes."
To help determine how companies might perform, Ms Dean and her team divide the FTSE 350 - their main hunting ground - into seven groups rather than following sector divides, which she says are not homogenous and do not help them determine the behaviour of stocks within the cycle. These are:
■ Commodity cyclicals;
■ Consumer cyclicals;
■ Industrial cyclicals;
■ Growth;
■ Financials;
■ Growth defensives; and
■ Value defensives.
Not surprisingly, the three cyclical areas experience the greatest change. For example, consumer cyclicals benefit when people have more disposable income expanding their topline more. However, these companies tend to have high fixed cost bases, which they cannot vary.
"We try to determine where we are in the cycle and when we want exposure to higher beta (more volatile shares)," explains Ms Dean. "And if we think growth is slowing, we want exposure to shares that are far better able to defend their profits. A change in the economy hits their top line less and they can control expansion. I try and tilt the portfolio at turning points when the rate of change is greater and sell out of beta at the top of the cycle. Successful business cycle investing is slightly contrarian because you enter and exit the cycle early. If you buy a share after the price turns you get less return. I would sooner be in early than late, but you could get a bit of underperformance."
So where are we now? "We are just beginning to turn up, so are in a recovery phase," says Ms Dean. "So cyclicals are your opportunity (in particular, industrial and consumer ones) because investors buy defensives when they are fearful and have been for a while, meaning some of the prices, especially for growth defensives, have become very extended. If the recovery continues, there is a lot of risk in the price of expensive defensives."
The fund is currently overweight both industrial and consumer cyclicals, which respectively account for 15.7 and 14.8 per cent of assets. Another significant overweight is financials, 28.2 per cent of the fund, with key shares including RSA (RSA), Jupiter (JUP) and Lloyds (LLOY).
"At the moment, we are in a state of flux and some of the cyclicals are starting to outperform," she continues. "For example, if China is recovering, Morgan Crucible (MGCR) may start to improve (its performance was minus 15 per cent relative to the FTSE All-Share between July 2011 and the end of last year), and Bodycote (BOY) has started to do well as the market anticipates change."
She says that any cyclical share prices are already anticipating a recovery in profits, but there is little room in prices for earnings disappointment. Those companies that can still deliver earnings upgrades in a more expectant environment should outperform those that cannot. And earnings upgrades against the current backdrop of very low market volatility ought to be positive for market levels.
"We will stick with companies that have continued to invest through the crisis period and should be starting to see an improvement in returns - at least during the first part of the year. Stocks such as GKN (GKN) and DS Smith (SMDS) should see a higher quality of earnings and benefit first if demand at last sees some improvement," she says.
"It doesn't matter to me if a company is deemed high quality because it can still go through periods of underperformance. For example, Diageo (DGE) is not a bad company - it is one of the best businesses from a business school point of view - but between 2003 and 2007 it underperformed (relative to the FTSE All-Share) because its rate of earnings growth was less than the market average."
Low volatility
Another feature of this investment approach is that its volatility is relatively low, in line with the fund's aim of less volatility than the average UK All Companies fund.
"All the time we are trying to move investors' capital away from high risk to low risk - what active management should do," says Ms Dean. "I always try to buy low and sell high - it's what all fund managers should be doing. The greatest determinant of your return is the price you buy (and sell) at. It is also about what you don't own and missing the big disappointments."
Despite a strong economic focus, the fund only derives 20 per cent of its return from business cycle allocation - 80 per cent still rests on strong stock selection. "The business cycle is a guide to where we are going: once we have thought about that we seek the right stocks," she says.
Although she analyses a number of factors in stock choice, she singles out earnings changes as very important. "If you can buy a share with an earnings change when the relative price is low then you benefit from an earnings rise and how much the market is willing to pay for that," she says. "It is great if you can buy something about to have above-market earnings growth."
