Which cheap sectors are best left in the bargain basement?

We all know that the holy grail for investors is finding something really cheap, which will go on to deliver earth-shattering returns on the long run. The sort of investment which, in five years’ time, qualifies turning around to those who doubted you and saying, ‘ha! I told you so’. The trouble is, cheap can sometimes just get cheaper.

We get under the bonnet of three very out-of-favour sectors and ask Elite Rated Managers: is it an opportunity, or is it best left in the bargain basement?

Retailers

From Poundworld filing for bankruptcy, right up to John Lewis announcing that its profits slumped 77% in the year to the end of January, there is no doubt that the high street is undergoing a generational change, thanks to the rise of online shopping and the ‘Amazon effect’. But can high streets evolve enough to tear people away from their smartphones and set foot in physical stores, or are traditional retailers dead and gone forever?

Bryn Jones, who runs the Rathbone Ethical Bond fund, believes investors are fearful for a reason and has been cutting his exposure to the sector.

“When interest rates are rising, the consumer tends to struggle with costs and their spending falls. As a result, consumer-dependent businesses also struggle with reduced earnings and their own higher expenses. We also have Trump’s trade tariffs, and higher inflation will squeeze this sector. Retailers that are not prepared to embrace new technologies will struggle,” he said.

The overriding view from BlackRock – which is home to the BlackRock UK Absolute Alpha fund – is that it’s important to avoid any area which is particularly exposed to the fragile consumer.

“This is an unforgiving environment and we believe those companies with weakness in their business models will be quickly exposed,” the team said.

“That said, we believe there are opportunities. In the wake of Brexit, investors were very nervous on the outlook for the UK economy and the share prices of companies that draw most of their sales from the UK were hit hard. The high street is not dead, but it is changing. This is an environment that exposes weakness. The key is not to avoid it altogether, but to put the right tools in place to select the likely winners.”

Hugh Sergeant, who runs the R&M UK Equity Long Term Recovery fund, only buys out-of-favour stocks, but is avoiding retail.

“Retailers can’t demand as much money for their products – in other words, their pricing power is dwindling. Their ability to turn capital into profits is also weakening, they’re unattractively priced, many now have rising debt levels. A number of the companies have certainly ticked the boxes for Buffett’s “ABC of business decay” – arrogance, bureaucracy and complacency,” he warned.

Our view at FundCalibre is to take a very cautious approach to retailers indeed.

Long-duration bonds

A lot of investors are scared about holding long-duration bonds. This is because, if interest rates or inflation rises, it will eat into the value of their capital. The longer you have to hold a bond for, the greater impact this could have over time.

Aitken Ross, co-manager of Liontrust Monthly Income Bond fund, said his portfolio has been structurally short-duration since its 2010 launch. However, the managers will leave no stone unturned and are willing to hold bonds with either long or short durations if the company is right.

“Economic growth is decent and the number of companies failing to meet their loan obligations – or defaulting – is low. This is a supportive environment for credit,” the manager said.

Torcail Stewart and Lesley Dunn, who run the Baillie Gifford Strategic Bond fund, adopt a similar approach. Their portfolio has a slightly lower-than-average duration at the moment, but this varies among individual bonds and they are willing to hold a longer-duration asset if they have enough conviction.

At FundCalibre we are cautious on bonds because we believe they’re very expensive, but there are still some good individual opportunities out there. Our favour would be for bond fund managers with a keen focus on capital preservation and the ability to invest in all types of fixed income.

Emerging markets

Emerging market equities have struggled over the last six months. This is partly because of ultra-high levels of inflation and interest rates in some parts of Latin America. Asia Pacific equities are also lagging, due to trade war fears and the fact many countries in the region – such as Taiwan or South Korea – import their goods to the US. But does this present a buying opportunity?

The multi-asset team at M&G, which runs several funds including M&G Episode Income, said forecasting the true impact of tariffs is very difficult – particularly in such an interconnected world.

“Today we can see why investors would be fearful: trade wars are dominating commentary, it is easy to picture negative scenarios, and an intensification seems inevitable,” it said. “If there is no intensification, or more importantly, if other positive developments occur that we may not even be thinking about today, then the market reaction so far is likely to be overstated and represent an opportunity.”

Peter Ewins, who runs the F&C Global Smaller Companies fund, has added small amounts to Asia-orientated emerging markets over the last year.

“While in the near term Asian emerging markets are threatened by the US/China trade spat, over the medium term, providing this abates, we feel these markets present a good opportunity for investors with a long term mindset,” he said.

“There are a growing number of listed companies with decent track records in the public domain, and the recent sell-off has made valuations look more attractive.”

At the moment, the team at FundCalibre does think there are some very select buying opportunities within emerging markets and that, compared to developed markets, equities are more attractively priced. But there are plenty of headwinds on the horizon, so we believe it is best to approach with caution.