Investors should not rush into the value trade as the low economic growth and interest rate environment over the past decade could continue for some time, FE Alpha Manager Terry Smith has warned. 
The manager of the five FE Crown-rated Fundsmith Equity fund said investors were too quick to back a rotation into value stocks last year and give up on quality stocks.
Investors began to move into more cyclical areas of the market in the back half of 2016 due to the outperformance of the style following the election of Donald Trump as US president in early November.
Many economists had forecast that Trump’s economic policies would stimulate more rapid growth in the US economy – something that was slow to materialise in the first half of the year.
As such, the £13.9bn fund had a strong start to 2017 although it struggled in the second half as continued sector rotation away from quality stocks into value and growth began to take hold, as illustrated by the below chart.
Performance of fund vs sector and benchmark in 2017
Source: FE Analytics
“The sectors in which we are invested mostly fell out of favour and share prices of those companies underperformed, whilst other sectors which we do not own performed well — in particular the bank sector,” Smith said.
Despite the second half slide, the fund outperformed both its IA Global sector average peer and the MSCI World benchmark last year by 7.95 and 10.17 percentage points respectively and Smith said early predictions of his demise have been premature.
“I can now trace back five years of market commentary that has warned that shares of the sort we invest in, our strategy and our fund would underperform,” he said. “During that time the fund has risen in value by over 175 per cent.
“The fact that you would have foregone this gain if you had followed their advice will of course be forgotten by them if or when their predictions that our strategy will underperform the ‘value’ strategy of buying cyclicals, financials and assorted junk pays off for a period.”
While past performance is not necessarily a guide to future performance, Smith noted that the key word is ‘necessarily’ and that his fund still has scope to outperform for some time to come.
The manager noted that commentators also predicted a number of event outcomes that proved to be incorrect, including that the UK would vote for ‘Remain’ in the Brexit referendum, Donald Trump would not become US president and Angela Merkel would sweep to victory in the German elections.
“The fact that they have been shown to be comprehensively wrong does not seem to stop them from giving us the dubious benefit of further predictions,” he said.
“They seem to have forgotten that their role is to report events accurately and have decided that instead they need to influence the outcome to one they desire,” he explained.
While he does not make macroeconomic-based investment decisions, Smith said he does still look at the wider picture and noted that there is nothing to suggest his quality growth style looks set for a period of underperformance.
Although some believe that policy makers are about to embark on an interest rate hiking cycle that should boost cyclicals such as the banking sector and hit ‘bond proxy’ stocks, the manager said this may not be the case.
He noted that that the period since the financial crisis of 2008 to present day is most similar to that following the long depression of 1873–96, with deflationary pressures keeping markets and growth subdued, dissuading central banks from raising interest rate.
“If the closest analogy for the events which we have experienced since the financial crisis is the long depression, we may be barely half way through it simply on the basis of elapsed time,” he warned.
“In which case, the period of sluggish economic growth and low interest rates which we have experienced over the past decade may persist for some considerable time.”
Fundsmith Equity has been the best performing fund in the IA Global sector since its launch in 2010 as the low growth environment has boosted quality stocks such as the ‘expensive defensives’ – also known as the ‘bond proxies’.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
The manager said he expects the current market conditions to continue as the unsupportable expansion of credit that sparked the financial crisis of 2008 has yet to be resolved.
“What seems to have happened over the past decade is a prolonged experiment in borrowing your way out of a debt problem. There is in fact more debt in existence now than there was in 2007,” he said.
“Maybe it will work, although I am amongst those who would bet against it, but it certainly is not the sort of circumstance which would suggest that a ‘normal’ economic recovery or a rapid rise or ‘hike’ in interest rates is likely.”
The other criticism of the fund by market commentators, Smith said, is that it is now full of aforementioned ‘expensive defensives’.
As such, stocks in the portfolio are on much higher valuations, which should will limit their share price performance in the near term.
However, he said that the valuation of the portfolio’s stocks are not that much higher than the market, especially when their relative quality is taken into account.
“All this may prove is that everything is expensive or at least highly rated, and there are plenty of pundits and fund managers who have indeed suggested that we are in a so-called ‘bubble’ which will end badly with everything falling a long way,” he said.
“So far, they have only managed to demonstrate the difficulty in making predictions and implementing actions based upon them.”
And even if they are eventually proven right, the manager asked why cyclical stocks and financials should prove to perform better than his high-quality stocks.
“The events of 2007–09 suggest that the opposite is true,” he noted. Indeed, from the start of 2007 to the end of 2009 the MSCI World Growth index outperformed the MSCI World Value index, as the below chart shows.
Performance of indices from start 2007 to end 2009
Source: FE Analytics
He added that such cyclical companies over time do not tend to generate returns on capital above their cost of capital to reinvest, something that is key to the stocks in his portfolio.
“If you invest for the long term in companies which can deliver high returns on capital, and which invest at least a significant portion of the cashflows they generate to earn similarly high returns, over time that has far more impact on the performance of the shares than the price you pay for them,” he said.
“Yet I have been asked far more frequently whether a share, a strategy or a fund is cheap or expensive than I am asked about what returns the companies involved deliver and whether they are good companies which create value or not.”
Smith’s style of investing requires a long-term perspective to allow the portfolio to capture compounding returns of these stocks.
He said: “Our [investors’] inability to take a really long-term view – particularly through the periods when our chosen strategy and companies are not performing as well as less good companies, which are enjoying their period in the sun – is our greatest enemy.”