Poor stock selection, a move to micro-caps and the success of the healthcare sector are among some of the reasons why FE Alpha Manager Jenny Jones and co-manager Robert Kaynor’s Schroder US Mid Cap and Smaller Companies funds have underperformed in 2018.
The £2bn mid-cap fund has been a good performer over the past decade, sitting in the second quartile of the IA North America sector.
And since Jones took charge of the fund in 2005 it has been the fifth-best performer returning 448.40 per cent, as the below chart shows.
Performance of fund vs sector and benchmark under manager tenure
Source: FE Analytics
However, more recently performance has not been so strong. Despite a top quartile return in 2016, the fund, which has a clean ongoing charges figure (OCF) of 0.91 per cent, is in the bottom quartile over three years following two fourth-quartile showings in 2017 and again so far in 2018.
“Our performance is primarily driven by stock selection but there are times when market factors are at play that will exacerbate the good or the bad,” Kaynor said.
“I think we would say we are in a bit of a ‘perfect storm’. We have gone through a period of very poor stock selection and we are negative in nine of the 10 sectors [we invest in] which is unprecedented.”
Over the past 15 years, he noted that the fund has typically always been in positive territory for most sectors, making this an “uncharacteristic” time.
However, there are market factors at play that have impacted these returns and also hit the stock selections that the pair have made.
In the first quarter of this year, Kaynor said that one of the things that disappointed the team was that when volatility increased, the stocks that they own to act as “steady eddies” (that will hold up better and continue to grind out returns in times of market stress) actually underperformed their other buckets.
“That was a function of the big move up in interest rates and everything with leverage was sold,” he said, noting that the market did not distinguish between stocks that justified having debt through a solid, stable business model, and those that did not,” he said.
“We would argue that our ‘steady eddies’ are a little bit more levered but they have a much more stable base of cash flows.
“It didn’t matter and in the initial move up in the US 10-year Treasury from 1.8 to 2.8 per cent anything that was levered was sold and we were surprised that these companies didn’t hold up better in this environment.”
Jones added that a lot of their companies re-fixed their debt three or four years ago, meaning they were largely unaffected by this move – but were still hit.
“When people sell anything with debt it is an opportunity, but it is also painful for us,” she added.
Once this had played out by the end of the first quarter, the next factor the team was hit by was a move to the micro-cap end of the market, where they are typically underweight.
“We had a huge move in micro-cap stocks because there was increasing fears in trade tensions and investors wanted domestic exposure and the smaller the company the less likely it is to have a foreign source of revenues,” Kaynor said.
“If you think of the Russell 2500 the bottom 1,000 names make up the micro-cap where the average market cap is $300m. Our minimum market cap is $750m so we missed that.”
However, potentially the biggest impact to the portfolio this year has been the improvement of stocks with negative earnings, as opposed to those with positive earnings.
Performance attribution of Schroder US Smaller Companies fund over YTD
Source: Schroders
Over the past 13 years companies with positive earnings have dramatically outperformed, yet year-to-date this has been flipped on its head.
“We see more companies coming public now with negative earnings than at any time since 1999. Then it was your dotcoms and telcos – in 2018 it is biotech and there is certainly tech in there as well,” he said.
“We are seeing what we would call science experiments – pre-clinical biotech companies – getting billion-dollar valuations in the public markets.”
Indeed, the strongest sectors in the market so far this year have been healthcare and technology, with a big drop off before the next-best financials sector.
Around half of the healthcare sector is made up of biotech and pharma names that have grown strongly, yet only 19 companies have positive earnings growth. “It tells you that it is a narrow market and it is a growth-led market,” Kaynor added.
Indeed, Jones added that if you look at the return of biotech and specialist pharma, the median return is actually down 1.7 per cent.
“Most of our growth friends who are managers are dying because they have a weight but they don’t have the two or three that have sent this part of the market surging,” she added.
Kaynor noted: “The amazing thing about that spread is you can have a small handful of stocks in this space that are up 500-700 per cent and driving up the average return.
“It is not about neutralising your weight with a basket of stocks, it is more about buying lottery tickets that pay off and that is a dicey proposition.”
Source: Schroders
The fund has a “dramatic underweight” to the sector for this reason, according to Jones, but does invest in companies with an existing product in a market niche.
This way the team can wait on a new product, whether it need approval from the Food and Drug Administration (FDA) or is going through clinical trials but remain secure with product that has a tangible value in the business.