Alastair Mundy, manager of the Investec Cautious Managed fund, tells Maria Merricks why he believes equity markets are moving higher on fear.
Q What is your equity investment process?
Our strategy focuses on out of favour stocks which are cheap relative to our assessment normalised earnings (i.e. adjusted for cyclical ups and downs in the economy). Currently, given the relative strength of corporate earnings and still fairly expensive normalised valuations, we have chosen to apply this strategy patiently.
One of the exercises we typically conduct as potential investors in an underperforming company is to speculate over the likelihood of its performance reverting to mean.
We are particularly aware of the risks as well as the benefits of this approach – that the past is no guide to the future and the company we are investigating might need to accept a lower level of profit as the new standard.
“ There won’t be many hiding places if you believe equities are overvalued ”
When looking at an underperforming company, we try to detach ourselves as much as possible from the industry and the biases that come with years of disappointment.
We ask ourselves what returns an industry or company with certain characteristics could generate given the barriers to entry and exit, cashflow requirements, market share and pricing power, and what other investors would pay for the shares if their earnings did recover.
Q What have been the key drivers of your performance in the past five years?
Our equity-centric approach has typically provided much of our long-term performance. The other assets, while generating positive returns, have done much to dampen the overall volatility of the fund.
Q What have been your best and worst investment calls of the past 12 months?
Our exposure to gold mining stocks has been painful this year, affected both by the fall in the gold price but also by operational problems and low cash flow generation within the companies themselves. The shares are now very depressed and we believe they are significantly oversold.
Our equity portfolio has, in general, performed well. Specifically, cyclical stocks, such as Grafton and Travis Perkins, bounced back from low valuations to better reflect the expected improvement in the UK economy, particularly the residential building and repair market.
We have also benefited from our exposure to Japanese equities, which have moved higher on improving corporate prospects and a growing belief in economic improvement.
Q You have a high weighting to short-duration bonds. Is this a call on rising interest rates?
We believe it is unwise to lock into long-term interest rates at levels which are still close to multi-decade lows. Although it is hard to forecast interest rates rising significantly in the near future, a buyer of bonds at current yields has very little margin of error.
Q How is the remainder of the fixed interest part of the portfolio currently positioned?
We hold index-linked bonds, with short- to medium-term duration. We believe any inflationary scares, which, admittedly, look unlikely at the moment, would increase their attractions.
The portfolio also has an exposure to Norwegian government bonds, which are quite short-dated. Norway’s financial position remains superior to most countries and, therefore, appeals as a reasonable safe haven for investors.
Q Where are you finding the best/worst opportunities in equity markets?
We seem to be in a minority of investors who are actively negative on US equities. Alternatively, the market believes that earnings and valuations can grow significantly from here, even though they are at all-time highs. In our view, the market seems to be ignoring history and not expecting mean reversion in margins and valuations in favour of an ‘It’ll all be different this time’ argument.
Equity markets have moved higher and participants seem eager to justify it. Apparently, economic news is improving (depending on your chosen statistic), equities are cheap (providing you do not mind using a company’s peak profits to come to this assessment) and sentiment is good (we prefer sentiment to be poor).
We wonder whether equity markets are moving higher on fear rather than greed: the fear of missing out on returns when other asset classes appear extraordinarily unattractive. We would, therefore, expect to find better opportunities in the equity market when sentiment is poorer.
Q What is your outlook for 2014?
We think the biggest theme for 2014 is the lack of hiding places if one believes equities are overvalued. Investors have been scrambling around to find attractively valued stocks and so quality of the opportunity set has deteriorated. As such, the theme for 2014 is possibly the benefits of inactivity.
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