Overlooked opportunities in mid-caps
I’m sure most people have heard of middle child syndrome – some have no doubt experienced it...
From Hollywood to the Big Apple to the Lone Star State, America has got legendary growth stories in its DNA. And in its recent stock market history. Powerhouse companies like Facebook and Apple seem to offer proof the US really is the “land of opportunity” where anyone with a dream and the dedication to see it through can become a superstar.
Investors benefit from this kind of conviction. Year-to-date the US remains the key driver of global, developed market returns. But the boundless enthusiasm of a few years’ ago has abated and for some good reasons. The sheer size and influence of the US market mean it will probably always be a core holding in a diversified portfolio; however, it may be time to look at the options with a fresh focus.
To understand why, we can take the recent example of Apple’s year-on-year quarterly revenue fall – its first in over a decade. Three weeks later, Apple shares are down nearly 10%*. They’ve lost 27% of their value in the past year**, as successive product updates have failed to inspire investors.
I remember a former colleague who used to state emphatically that the best way to ‘wow’ people was to under promise and over deliver. I can still picture her shouting across the office whenever she felt anyone was getting a little carried away on the commitment front. I reckon this same logic plays out on the stock market.
Unfortunately, the valuations of many of America’s largest companies have moved in the opposite direction. Share prices have increased so substantially in recent years that they promise much in the way of future earnings growth. When these companies can’t deliver, there isn’t much wriggle room; share prices tumble.
The thing is the S&P 500 (the US’s main stock market index) is currently holding around all-time highs and it is propped up in large part by its technology giants and a handful of other mega-cap stocks. The affectionately named FANGs (Facebook, Amazon, Netflix and Google) have all seen supersized share price growth since the global financial crisis. At the moment, there’s no sign of Facebook, Amazon and Google slowing down. But the shine has come off Netflix and its shares have followed Apple’s fate.
What you may not intuitively think about is that these kinds of valuations significantly increase the risk of your investment. We invest to make money, and it’s a lot harder to do so when you’ve bought something that’s already pretty expensive. The risk of losing money, on the other hand, increases.
Looking at the volatility of emerging market shares, it’s easy to understand that these are higher risk investments whose value could easily be worth less tomorrow than it is today. Because the US market has been broadly moving in only one direction—up—people may have become a bit too relaxed about the potential downside.
To be honest, if everything was hunky dory on the economic front, market observers might be less concerned. But data is mixed.
There are positives, for sure. Unemployment has come down a long way and more and more jobs are being created. This is starting to flow through to wage growth, albeit slowly, as the competition to attract and retain good candidates increases.
On the other hand, despite salary rises and lower petrol costs consumer spending is not picking up, which means retail and services businesses are finding it hard to grow revenue. And another key driver of the US economy, manufacturing, is struggling on the back of the lower oil price, which has hurt the shale industry and therefore the multitude of manufacturers that serviced its needs.
It’s not an all-round encouraging environment in which to operate and as a result many companies, instead of investing their profits in initiatives to help them grow, have been either paying out unsustainably high dividends or buying back their own shares. This has kept shareholders happy in the short-term, but its effect on earnings is starting to show.
Apple and Netflix weren’t the only ones to disappoint in the April 2016 reporting season. Corporate earnings across the S&P 500 were down.
The piece of the puzzle that the world is now waiting on with bated breath is the next interest rate move from the US Federal Reserve (the Fed). Being the world’s largest economy (just!), the US has to think about more than just its own needs when determining whether or not to raise rates. The decision will have flow on effects throughout developed and emerging markets.
Last December, we saw the first rise since the global financial crisis. At that time, economists generally were predicting another two or three rises this year. Now that number looks less and less likely, especially after downgraded global growth forecasts from the International Monetary Fund and an intensely rocky start to the year in global markets.
Given the strengths in the US employment market, many believe we should see at least one more rise in 2016 – but then again, probably not before the UK’s Brexit referendum in June, as the Fed will want to see the outcome of that vote on markets before potentially further rocking the boat.
When they eventually do raise rates (and eventually they must), it may be the trigger many analysts have been worried about for shares prices to falter. One of the main reasons the US market has remained so popular over the last couple of years, despite growing concerns around its high valuations, is that nothing else has looked that appealing either.
With interest rates around the world at all-time lows, or indeed negative, traditional ‘safe haven’ assets like government bonds have been shunned in favour of the largest, most stable stocks on the S&P 500. These companies have earned the moniker ‘bond proxies’ as investors increasingly treat them as a ‘safe place’ to park cash, rather than a share market investment.
But if the income on US treasury bonds, for example, were to start rising again in line with rates, we could expect to see money flow out of shares. If corporate earnings don’t provide a good enough reason for investors to remain enthusiastic, a whole lot of people may suddenly start to wonder exactly what it is they’re left holding. Cue sell-offs.
A final hesitation on the horizon right now is of course the upcoming federal election. Campaigning so far hasn’t really made much impact on the stock market I would say, but now we have the candidates for both major parties more or less locked down, we might start to see caution creeping in. With the rather extraordinary happenings in the political sphere this time round, it’s safe to say the US could move in two drastically different directions depending on the November 8th outcome.
Businesses that were considering new ventures may well sit the next few months on the sidelines, while investors likewise hedge their bets in offshore markets.
As I said upfront, though, America still looks bigger, better and shinier than many other options – especially if you’re a long-term investor. And once you know the themes, there are some exciting ways to play it.
Despite their tendency at the moment not to reinvest for growth, US companies are generally higher quality than the rest of the world when you look at return on equity. And after a couple of years of rising steadily, the US dollar has fallen against a basket of major currencies over the past few months, which is good news for both exporters and US companies bringing home profits earned abroad.
The Elite Rated Brown Advisory US Flexible Equity is one fund that has consistently beaten the S&P 500 over long periods of time. With decades of industry experience, its two co-managers look for medium to large companies they consider undervalued with room for share price recovery. This gives the fund good growth prospects and it has performed well in both up and down markets.
Another fund that is of interest for those who want to invest outside of the FANGs is the Elite Rated Schroder US Mid Cap. Its manager, Jenny Jones, has run the fund successfully for 11 years and has proven herself time again with her ability to pick winning stocks. The fund holds up well in tough markets, aided by Jenny’s disciplined approach to diversification; it holds a mix of “steady” less cyclically sensitive stocks, undervalued businesses, and businesses that have hit rock bottom and are in “recovery mode”.
The Elite Rated Legg Mason ClearBridge US Aggressive Growth fund also stands out for its concentrated portfolio of stocks. This means that the two managers pick companies they have a high conviction will beat the S&P 500. Their top ten holdings typically make up 50% of the total portfolio. This approach is backed up by the quality of the supporting analyst team and their extensive research, often monitoring companies for years before investing.
*Google Finance, AAPL stock price, 26/04/2016–18/05/2016, accessed 18/05/2016
**Google Finance, AAPL stock price, 19/05/2015–18/05/2016, accessed 18/05/2016