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Ride a recovery with less volatility via Federated Hermes US SMID Equity

Federated Hermes US SMID Equity looks well positioned to play a US recovery
January 7, 2021

Federated Hermes US SMID Equity has recently under performed

But its manager’s long-term record is strong

And the fund is well positioned to benefit from any US recovery

IC TIP: Buy at 294p
Tip style
Growth
Risk rating
High
Timescale
Long Term
Bull points
  • Defensive approach
  • Relatively low volatility
  • Rigorous ESG screening
Bear points
  • Recent underperfomance

The US stock market is home to many of the world’s best businesses so is a crucial inclusion for many growth portfolios. But as the big tech companies that dominate the US large cap space have performed very strongly since last March and sit on lofty valuations, it could be time to look at other areas of this market. "The US stock market is expensive but we have been here many times before and, if earnings recover in 2021, valuations could come back in without a correction,” says Adrian Lowcock, head of personal investing at Willis Owen. “Much of the US market hasn’t rallied and performance has been concentrated on a few tech giants." 

While there are many clouds hanging over the US, such as huge debt levels and rising unemployment due to the pandemic, this economy has a history of bouncing back. The US is packed with entrepreneurial companies that should rehire as and when consumer confidence returns. If an enhanced stimulus bill passes, it might be more supportive of US mid and small-caps than large tech companies. US smaller companies have also tended to outperform larger companies in the aftermath of recessions, which should bode well in the near to mid term if the vaccine roll out goes to plan.    

Although there are reasons to be optimistic, due to the uncertain environment a fund which focuses on resilient smaller companies could be a better way to tap into any US economic recovery. Options include Federated Hermes US SMID Equity (IE00B8JBCY79) run by Mark Sherlock, alongside Michael Russell, Henry Biddle and Alex Knox. They aim for growth over the long-term but have more of a value bias than other smaller companies managers. For this reason, the fund’s performance has lagged its benchmark, the Russell 2500 Index, and the Investment Association (IA) North America Smaller Companies sector average in some recent years.  

The fund's managers’ try to identify what they consider to be high quality companies, for example, ones with stable earnings, sustainable growth and strong balance sheets, but which they also think are undervalued. They pick investments according to their individual merits, rather than because of sector considerations, from a watch list of about 200 companies that meet their criteria.

They also have a strong focus on companies’ environmental, social and governance (ESG) attributes, in keeping with Federated Hermes' wider approach. They look to identify companies where they think that active engagement could reduce under performance resulting from poor ESG behaviours, and encourage companies to act responsibly and improve sustainability. Federated Hermes combines proprietary research with a number of scores from third party data providers to come up with its own assessment and compares companies with their peers on an ESG basis.  

While Federated Hermes US SMID Equity under performed in 2020, its managers say that it is well positioned for a normalisation of a market in which fundamentals reassert themselves as drivers of performance and valuations become more relevant. The managers recently commented that “we remain diligent around valuations and believe long-term investment in companies across the market with a durable competitive advantage, bought at a discount to the intrinsic value produces the best risk-adjusted returns for our clients.”

The chart below shows how the fund’s forward price to earnings ratio has changed over the past five years, compared with the S&P 500, a larger companies index. Smaller companies often have higher valuation ratios as they tend to be younger and faster growing, but the fund has become relatively more attractive on a valuation basis compared with this index.

Federated Hermes US SMID Equity is fairly concentrated for a smaller companies fund with 58 holdings. 30 per cent of its assets are invested in industrials, its largest sector weighting relative to its benchmark. Industrials have been relatively badly hit by lockdowns across the US this year but have scope to bounce back when vaccines are rolled out. 

The fund’s largest holding at the end of November was Brooks Automation (US: BRKS), a provider of automation, vacuum, and instrumentation solutions for markets including semiconductor manufacturing, life sciences, and clean energy. The firm specialises in producing materials at very low temperatures and has performed strongly in recent years. 

Financials are the fund’s second largest sector allocation, an area which performed very weakly over the past year amid concerns of rising credit losses related to financial stress and concerns that interest rates will remain lower for longer. But Mr Lowcock says that Federated Hermes US SMID Equity could be well positioned for a recovery in 2021 due to its overweight position in this area. 

Holdings in this area include Wintrust Financial (US:WTFC) which provides a range of services that aim to be an alternative to the big banks. The fund also holds Reinsurance Group of America (US:RGA), a global life and health reinsurance company with a specialisation in mortality risk and Sterling Bancorp (US:SBT), a regional bank which provides services to corporates and individuals. While these holdings have been a recent drag on performance, if the economy picks up and sentiment on interest rates changes these should do well.  

During the sell-off last year Federated Hermes US SMID Equity's managers sold positions which had relatively high leverage ratios and completely exited the energy sector.

New buys last year included PTC (US:PTC), a programme lifecycle management business and Power Integrations (US:POWI), a manufacturer of analogue and mixed-signal semiconductor components with a market leading position in power efficiency. They have also recently added asset-light homebuilder NVR (US:NVR) on the grounds that it provides high quality exposure to an industry they believe has been undershooting on supply for the past 10 years. 

This fund's performance last year was a little disappointing as it only slightly out performed the Russell 2500 during the rapid market fall in February and March, and significantly under performed it during the subsequent market recovery. And the extent of any economic and market improvements depend on president-elect Joe Biden’s first 100 days, including whether he announces additional fiscus stimulus and to what extent. 

However, Darius McDermott, managing director at Chelsea Financial Services, still holds this fund in “high regard.” Given the potential for more market disruption as countries struggle to contain the coronavirus, the fund's cautious strategy could pay off and it is well positioned for an economic recovery.  Federated Hermes US SMID Equity's manager’s long-term record is strong. And Mr Sherlock and his team’s focus on looking for consistent, growing revenues and cash flow might enable this fund to produce strong returns over the long-term with less risk than racier small companies funds. BUY. MM

 

Federated Hermes US SMID Equity (IE00B8JBCY79)
Price294pMean return9.98%
IA SectorNorth American Smaller CompaniesSharpe ratio0.44
Fund typeOeicStandard deviation20.45%
Fund Size$852.31mOngoing charge0.84%
No of holdings*58Yield0.00%
Set-up date*26/09/2012More detailshermes-investment.com
Source: Morningstar 05/01/21 *Federated Hermes

 

Performance
Fund/benchmark1 year total return (%)3 year cumulative total return  (%)5 year cumulative total return  (%)
Federated Hermes US SMID Equity5.0224.3182.84
IA North American Smaller Companies sector average22.447.24127.34
Russell 2500 index13.531.99100.91
Source: FE Analytics, 05/01/2021

 

Top 10 holdings
Brooks Automation3.00%
PTC2.78%
Teradyne2.74%
Wintrust Financial2.62%
Fortune Brands Home & Security2.51%
Silicon Laboratories2.41%
Terminix Global2.41%
Brunswick2.29%
AMN Healthcare Services2.20%
Power Integrations2.19%
Source: Federated Hermes as at 30 November 2020

 

Sector breakdown
Industrials29.84%
Financials20.94%
Technology18.62%
Healthcare12.05%
Consumer discretionary11.56%
Basic materials1.81%
Utilities1.24%
Other3.94%
Source: Federated Hermes as at 30 November 2020