The US Federal Reserve is preparing to increase interest rates, with some analysts pencilling in a hike as early as March. In the UK, the Bank of England has already raised borrowing costs, first in December, then again this month.
What’s been spurring the central banks into action, of course, is the spectre of rising inflation, which in the UK has been running at 30-year highs of above 5%. With ongoing supply chain challenges in a wide range of areas, the big question is how long this will last.
Markets have responded to this backdrop by embarking on a huge and sharp shift out of growth stocks, such as technology businesses, and into value shares, including financial institutions and industrials, which tend to have a history of financial performance but have been out of favour recently.
This so-called rotation trade is perfectly sensible. Growth companies are valued based on their expected earnings in, say, 10 years’ time; and rising interest rates drive up a business’s cost of capital and erode the future worth of those earnings. But for me, selling out of whole sectors in this way risks throwing out the baby with the bathwater.
In the current climate, we can actually make sense of inflation risks, supply chain issues and varying costs of capital by making an assessment of individual companies to find out which ones have a sustainable competitive advantage. This is why I think that stock-picking – based on fundamental analysis – is the best approach.
Just because a company’s share price is going up doesn’t automatically mean that it’s a good business. It might just be this year’s fashion, or a perceived place of safety when markets are volatile.
And some businesses were always going to struggle. As an example, 44% of the companies listed on the Nasdaq stock exchange in the US have lost 50% of their value during the pandemic. But the wider index continued to rise last year and has only begun to fall over the past few months.
What this tells us is that the overall value of the index has been supported by the tech giants, such as Amazon, Microsoft and Apple, and a good deal of the other constituent companies are overvalued or poor quality.
I know that I will sometimes underperform the wider market because of the conviction-based approach to stock selection that I take. I don’t own oil majors, retail banks, telecommunications groups or property businesses, for example, mainly because I don’t see that they have a sustainable competitive advantage.
I always say to people that if they’re looking for the kind of income that these sectors can sometimes generate then they probably shouldn’t be invested in my fund, which is based on companies’ underlying quality.
At any one time, I’ll have no more than around 32 or so holdings, but if I’m right about their quality then their weighting (of perhaps 3% apiece) in the portfolio means they will meaningfully contribute to performance.
Where to look
I think that the UK and European markets are fundamentally attractive places to look for value, particularly when set against the US, where in some cases valuations have become unsupportable.
Because I manage funds that invest in both the UK and Europe, I think I get to see the best of both worlds. It means that I can transport ideas between the two markets. In luxury retail, for example, in the UK there is essentially Burberry, but in Europe I can pick Richemont, LVMH or Ferrari, to name just a few.
When, three years ago, I had the opportunity to rethink the composition of BMO UK High Income Trust, it gave me the chance to go looking for value. I held on to British American Tobacco, which I inherited when I took over the fund in 2017, not because I’d argue that it’s the best company in the world – it has a horrible product – but because it has pricing power, is growing, and has a very strong balance sheet following two acquisitions.
I bought Compass, the caterer, which suffered heavily when lockdowns shut the hospitality sector, but is fundamentally a great business. Beazley, the speciality insurer, is another example. It also got hit by cybersecurity risks and Covid-related claims, but I see these as one-off issues. I bought both companies are very attractive prices.
Berkeley Group, the housebuilder, is also a very interesting business, which is now generating large amounts of cash and returning it to shareholders. And I included some European names, including Deutsche Börse, the exchanges operator, which should benefit from the derivatives business it writes as interest rates rise.
These are just some of the stocks that I bought – Wizz Air was another, for example – but the point in each of them is the same. They might suffer at the hands of wider events, but they are all fundamentally high-quality businesses that I believe contain value.
Past performance is not a guide to future performance.
The value of an investment is dependent on the supply and demand for the shares of the Investment Trust rather than its underlying assets. The value of an investment will not be the same as the value of the Investment Trust’s underlying assets.
Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.
Small Caps so far in 2022 – is this a longer-term opportunity?
Small caps have sold off, underperforming the wider equity market in the opening months of 2022. Lucy Morris discusses the top-down economic and market factors driving this underperformance and looks at how individual companies are reacting as well as looking at the factors that may trigger a recovery in performance.