Sector rotation ensures that devotees of every investment style can share the limelight at some poin...
Sector rotation ensures that devotees of every investment style can share the limelight at some point in the economic cycle. The improving outlook for economic activity, coupled with diminishing aversion to risk has handed the lion share of the performance prizes so far this year to cyclical sectors, smallcaps and other value plays.
In contrast, it was particularly striking that over the course of the latest quarter to 30 June the FTSE 350 Lower Yield index (usually a good proxy for growth stocks) suffered a 1% setback and that the three most highly rated sectors, pharmaceutical, support services and software services, were the weakest in the market, trying hard to avoid the wooden spoon.
It is hardly surprising that certain premium rated sectors have been vulnerable to profit taking in the current climate. Since they are traditionally prized as sources of security and reliability any unexpected bad news will come as an intense disappointment; witness the violent response to the downgrading of Rentokil-Initial earnings target or adverse reaction to the slight setback to drug launches from Glaxo Wellcome.
Nevertheless, all this has come as something of a shock to those growth oriented fund managers who might have become excessively complacent after an outstanding performance record in 1998 when growth was the only game in town. At least, these episodes should promote greater vigilance and a more critical attitude to stock selection. Basic investment disciplines, which may have been allowed to slacken, should be more rigorously applied.
A similar pattern can be observed in both North America and Continental Europe. For example, on Wall Street, highly rated stocks, like Coca-Cola and Procter & Gamble, have seen some of their premium erode after delivering earnings disappointments. At least US technology stocks have made something of a comeback after their earlier drubbing.
But closer analysis reveals some significant variations which appear to run against the grain. The love affair with telecoms (the star sector in 1998) has defied all attempt to dampen its ardour; the launch of Vodafone Airtouch and a continuing stream of positive developments has ensured that the sector has extended its performance surge.
Since the start of the year the sector's price earnings relative has widened from 217 to 235. Similarly, the welcoming response to GEC's breathtaking acquisition campaign has boosted the electronics & electrical equipment sector (price earnings relative 174).
Having endured prolonged period of poor form, the media sector has renewed its claim to premium status with a total return of 25% since early January. Positive surprises have boosted individual growth stocks in other sectors; prominent examples include ARM holdings, Dixons and Powderject Pharmaceuticals.
Another key feature of the year to date has been the relative resilience of smallcap growth stocks. The dramatic outperformance of the FTSE SmallCap index (total return so far of 30% against 11.7% for the market as a whole) has extended well beyond cyclical industrials and other economically sensitive areas. For almost all recognised growth sectors smallcaps have outperformed their FTSE 350 index equivalents since the start of the year.
To take three examples, quoting smallcap against the FTSE 350 index equivalent; IT software up 22% against 7.2%, media up 51% against 25% and support services up 29% against -6.5%.
More fund managers have woken to the possibility of paying a more realistic multiple for growth among less well researched 'emerging' companies, which are usually at an earlier stage of their life cycle than their larger counterparts.
We have frequently drawn attention to the advantages of making the effort to seek well based emerging companies. There are some parallels in the US where smaller technology stocks are attracting particular attention. This phenomenon has not run its course; managers of growth funds could profit by spending more time trawling outside the FTSE 350 Index.
John Hatherly is head
of Research at M&G Investment Management
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