Some of the most-loved pockets of the stock market are at a risk of de-rating in 2020, even though investors continue to buy into them, according to River & Mercantile’s William Lough (pictured). 
After several years as the most out-of-favour asset class following the Brexit referendum, sentiment towards UK equities has started to shift back making relatively cheap companies look more appealing.
However, Lough – manager of the £73.2m ES R&M UK Dynamic Equity fund – said that investors need to be more careful.
“The risk in the UK market, I would argue is more towards businesses which are in the quality phase of the cycle and have been able to compound growth at relatively attractive rates,” he said.
“But the multiples that people are putting on those profits are very high and perhaps people have forgotten that in the end markets for these stocks are cyclical.
“So that is stuff which is a bit more cyclical than people expect and has been lumped into the quality-growth and basically given any multiple because they think that it will always grow.”
The fund manager said two stock examples of these risk companies are FTSE 100 technology company Halma.
Lough said Halma was a “phenomenal businesses” but had hit its “blue sky valuations,” his term for holdings where “more things could go wrong for the enterprise than could go right at that point”.
The manager said Halma is currently delivering high single-digit organic sales growth, but in order to justify the current share price they have to keep up high levels of return “without any blips” for a decade.
Halma stock price over the last 5yrs
Source: FE Analytics
High valuations for tech names have been a prevalent story in the US market where the S&P 500 has been driven in recent years by just a handful of companies. While not much of this “hyper growth” has been seen in the UK – where there are considerably fewer large tech companies - mispricing risks have occurred.
“What I’m trying to do is find companies that actually have robust franchises, where they’re not overearning versus the cycle, and they’re not at peak returns in the cycle,” he said.
“Buying peak returns and peak valuations is something that has shown up in a cycle over the past and is not historically a very good strategy.”
However, this does not give a good overall picture of the UK stock market, Lough said, and he is – in fact – very optimistic about the opportunities to be had.
“There are so many more positives than negatives for the UK equity market as we sit today,” the ES R&M UK Dynamic Equity manager said. “It’s a broad market, in terms of the types of opportunities
“It’s a market which has very strong rule of law, so it’s an attractive jurisdiction for investors even after Brexit which investors need to remember.”
The Conservative party’s landslide victory in the December general election gave greater clarity for international investors about the path of Brexit and saw the left-wing Labour party swept away, boosting sentiment.
“The UK has just faced three years of quite a lot of uncertainty and whatever anyone thinks about Boris Johnson, he’s just won a very sizable majority,” said Lough. “The sort of majority that is pretty rare in developed economies.”
Performance of FTSE 100 and IA All UK Companies sector over 1yr
Source: FE Analytics
Although a predominantly bottom-up investor, Lough believes an improved UK outlook has provided a platform for pockets of opportunity to come through as both investors and consumers who have been holding back their cash and spending will now put that to work in a more stable market.
“You have these catalysts for better performance, with an improving economic backdrop and a starting valuation which is very attractive across the board and in relative terms,” he said.
Looking at stock-specific opportunities, Lough highlighted supermarket giant Tesco whose “arrogance” at taking their position in the market for granted caused a decline and he bought them during their “positive growth” rebound.
Typically classifying stocks into four categories - Growth, Quality, Recovery and Asset-Backed – Lough said he considered Tesco a ‘recovery’ stock transitioning to a ‘quality’ one and is the second largest holding in the portfolio.
Another example of a stock going through a “growth positive trend” is west London property investment and development company Capital & Counties, a recovery or asset-backed holding.
Lough said the firm’s disposal of its Earls Court interest for £425m had been a positive catalyst that has allowed it to move on and refocus on its “high quality” Covent Garden site.
“When you’re looking at something like the UK opportunity [set], if there was one defining feature that I’d be looking for in investments it’s companies that have been able to use the difficulties of the last three years to cement and strength and their market position,” he said. “And that is a classic feature of the best cyclical franchises.
“Within the UK specifically it is the case that even after a kind of a relatively decent bounce in share prices in the last quarter of last year I think there is there is plenty of opportunity today in UK domestically facing companies.”
Performance of fund vs sector & benchmark under Lough
Source: FE Analytics
Since being appointed lead portfolio manager of the fund in April 2018, ES R&M UK Dynamic Equity fund has made a 14.35 per cent gain compared with a 16 per cent return for the average IA UK All Companies peer and a 16.02 percent return for the MSCI United Kingdom IMI benchmark.
The fund has an ongoing charges figure (OCF) of 0.93 per cent and a yield of 2.60 per cent.