FTSE 350: Sifting sectors to beat the market

Last year, total returns of 25 per cent for the shares selected was ahead of the FTSE 350 index’s 17.3 per cent, although the cash holding diluted overall portfolio performance to 22 per cent. Not enough time has elapsed to read much into results, and 2018 was disappointing, but over three years the annualised rate of total returns has been 9 per cent, versus 7.1 per cent for the FTSE 350 index. Of course, it can’t be ruled out that in 2017 and 2019, the monkey (me) just got lucky.

2019 "Best of FTSE 350" performance (24.01.2019 to 21.01.2020)

Table source: Investors Chronicle and Bloomberg

This year’s sector by sector picks

Not all sectors are created equal, so to avoid the title 'Best of FTSE 350' being a misnomer, there are some parts of the stock market I’ve avoided altogether. That said, this portfolio isn’t just a relentless pursuit of quality – it’s about balancing the risk of expensive shares in excellent companies, with cheaper shares in potential turnaround stories or growth opportunities that need a catalyst.

No telecommunications businesses cut the mustard in my opinion. Whereas the decision to sidestep this sector is based on quality being thin on the ground, consumer staples are avoided because there is insufficient value. For example, drinks business Diageo (DGE) has for years been one of the best UK companies to own, but it’s just too pricey for the growth and the dividend yield on offer. 

The first sector to pick from therefore is consumer discretionary. Choices here are also expensive, but I have faith that the phenomenal run of businesses such as Games Workshop (GAW), JD Sports Fashion (JD.) and WH Smith (SMWH) will continue. All have delivered outstanding return on capital employed (ROCE), which is a backward-looking measure, but a highly reassuring one. Looking forward, I don’t believe Games Workshop has saturated the market for its products and the smart business focus and astute acquisition strategies of both JD Sports and WH Smith give me confidence.

Diversify risk premiums not just sectors

Financials is another strong sector of the UK market and I include another quality growth stock in the London Stock Exchange (LSE). Despite a lofty valuation, this is a great business. In the long term there may be a threat from decentralised stock exchanges powered by blockchain technology, but I don’t believe this risk will materialise in the next 12 months.

There are value financial shares, too, which diversifies the risk of expensive holdings with a different premium. Fintech disruption and low interest rates hampering profit growth means UK banks will probably never again be attractive as they were 15 years ago. Yet there is value to be had, and my pick for this year is Standard Chartered (STAN), which is strategically exposed to higher-growth markets. Going on the price/earnings growth (PEG) ratio – a forward-looking measure of value – it is cheap relative to other UK banks and is less restricted by its ratio of loans to deposits.

Insurer Prudential (PRU) is also a business with significant oriental interest. While there is something of an iceberg risk in terms of what China’s debt bubble could mean for the financial system in Asia (and globally for that matter), a détente in the Sino-US trade dispute this year should be good for the region in general. My belief is that the cheaply-rated Prudential, which is valued on a little below 10 times forward earnings for next year and on a reasonable PEG of 1.8, will be well placed to benefit thanks to its structural shake-up last year.

The Sars-like virus identified in China could yet be a dangerous black swan for any Asian-focused business. It must be stressed, I've come across no evidence of such a risk materialising for the activities of Prudential or Standard Chartered, but investors should always keep abreast of left-field threats as they develop. 

The energy sector is a large component of the UK market, thanks largely to giants such as Royal Dutch Shell (RDSB) and BP (BP.). With the growing prominence of environmental, social and governance (ESG) investing, this part of the market is unfashionable. This creates an opportunity and for the third year in a row, I plump for Shell. It isn’t hugely expensive, the enterprise value (equity plus debt, minus cash) to ebitda (earnings before interest, tax, depreciation and amortisation) multiple is 4.8 times, which is only slightly more than BP and makes it cheaper than other riskier energy stocks. For what it’s worth, Shell is doing better on environmental, social, and governance (ESG) metrics than global peers, and arguably governments and asset owners (while being firm) need to treat big energy companies as part of the solution to the challenge of climate change.

Mining companies will also play a role in ESG portfolios as, like it or not, they provide the raw materials for the infrastructure needed to revamp global policies. Once again, however, I’ve gone for specialist gold miner Polymetal (POLY) as my pick in the sector. The theme being played here is a belief that investors will look to gold as a hedge to mainstream asset classes. Unlike holding physical gold, Polymetal pays a dividend and its PEG values against one- and two-year forecasts suggest the shares aren’t hugely expensive for the profit growth forecast.

Finding growth at a reasonable price is a well-attested strategy – advocates include legendary investors such as Peter Lynch, Jim Slater and John Neff – and I’ve attempted to find businesses that fit this mould. Information technology is a sector that has some quality but very expensive businesses, so my pick here is registrar and custody solutions provider Equiniti (EQN). It is expected to see an increase in operating profit, but the valuation of just over 12 times forward earnings seems reasonable. The decent level of free cash flow (£50.7m) is a positive quality sign, too.

The industrials sector is large and sprawling with a few different businesses represented. Like much of the market, quality industrial companies are expensive. The two picks from the broad sector this year are PayPoint (PAY), classified as diversified support services, and International Consolidated Airlines (IAG).

PayPoint is not especially cheap, but it has outstanding quality characteristics, with ROCE of 97 per cent and excellent conversion of operating profit to cash. The high PEG suggests future growth expectations are in the price, but this is a business with a good strategic niche at the heart of convenient retail payments infrastructure, and it isn’t as expensive on a forward PE basis as other quality industrials.

By contrast, IAG is the portfolio’s most speculative value play. It is priced on seven times forward earnings, at a PEG of 0.7, which perhaps reflects cynicism towards a notoriously difficult industry for stock pickers to call. The business has been something of a specialist in consolidating national carriers and, although such airlines have a reputation for inefficiency, IAG has achieved better cash returns on its invested capital (CROCI) than easyJet (EZJ), which is rated by the market on a higher multiple of forward earnings.

I’m less enthusiastic about my 2020 healthcare pick compared with previous years. The best companies are a crowded trade and this year I’ve gone down to having just one sector holding. Healthcare equipment specialist Smith & Nephew (SN.) and pharmaceutical giant GlaxoSmithKline (GSK) both did brilliantly last year, but I’m only choosing to run the latter position on account of the dividend. Still yielding around 4 per cent and rated on a forward PE ratio of just under 15 times, the risk of holding GSK is bumps in the road of its long-term strategy, rather than how expensive it is. I’m treating it as an income holding and hoping the rest of the market doesn’t lose faith.

Utilities are another sector I’m not keen on, but at least there is less political risk following December’s general election result. Last year’s successful holding in Pennon (PNN) is maintained, as its waste management business helps diversify the risk of regulation affecting water profits and therefore the dividend (which is 3.7 per cent). In common with the rest of the sector, it is worth monitoring how the company manages its debt position (net debt is now around six times ebitda).

Commercial property is a hugely complicated sub-sector. The UK market faces significant upheaval including the decline of high-street retailers, demand for warehouses and logistical hubs thanks to the ubiquity of Amazon (US:AMZN), and the changing nature of usage and demand for property assets in town centres. Real estate operating company BMO Commercial Property Trust (BCPT) is rated at a 14 per cent discount (difference between market capitalisation of the company’s equity and the value of assets it manages) and pays a 5 per cent yield. Debt is roughly a quarter of the company’s enterprise value, which isn’t excessive for a listed closed-end property fund.

Once again, this year I’m maintaining some non-equity positions to help manage the risk of a concentrated shares portfolio. These will include cash and an exchange traded fund (ETF) tracking short-dated UK government bonds. Overall, it should be remembered that this portfolio is an academic exercise in using ratios to help pick a concentrated portfolio, it’s not meant as a list of share tips. As a portfolio, risk is very different to the FTSE 350 index weightings and my cash and gilt holding is there as a safety rope if this experiment unwinds badly in a major correction. Even barring that eventuality, there is great scope for mistakes – not least missing positive narratives in this report that will inevitably feed into higher returns for some companies I’ve overlooked.

2020 FTSE 350 sectors portfolio

Table source: Investors Chronicle