News Column

Is it time for investors to switch back to medium-sized businesses?

July 12, 2014

colin mclean; colin mclean

Headlines report stockmarket indices near all-time highs, and the IMF predicts Britain will be the best performing major economy in 2014. Comforting, but that is not how it feels for most investors; many portfolios have been struggling in recent weeks.

Gains in shares have been quite narrowly based this year, as attention has rotated to areas that were left behind in 2013. Big companies have propelled indices to new highs, while medium-sized businesses have fallen. Is it time for investors to change strategy?

Certainly, the setback has been painful. Companies that disappointed have seen big falls, but even those reporting in line with expectations have typically fallen 15 per cent. Hardest hit have been UK consumer businesses, but the change in trend has been marked also in industrials and technology.

There has been a sharp sell-off in medium sized companies - the area that many institutional managers and private investors focus on for stockpicking. But, after a strong run, suddenly in March the party ended without warning. Many of these shares had simply become over-owned by institutional investors.

Buyers were exhausted, and stockmarket interest switched to the next attraction.

This year's new favourites include pharmaceuticals, tobaccos, mining, defensives and so-called quality growth stocks.

This has been encouraged by signs that in mining and pharmaceuticals, industry restructuring is underway that could release value.

The bid approaches for pharmaceutical groups AstraZeneca and Shire have highlighted overlooked growth potential. Yield considerations may lie behind other moves.

Although the record of the last decade is poor in mining and pharmaceuticals, their recovery may have some justification. Mining is one of the most under-owned sectors but is continuing to restructure. Pharmaceuticals should see more mergers.

These sectors may have fallen too far in 2013, and merit a return of interest.

In order to raise money for reinvestment in more stable sectors, institutional investment managers have been taking profits in cyclical businesses with more economic sensitivity.

There has been little hard evidence to justify the falls in cyclicals, although a few retailers have disappointed.

But the reversal reflects more concern on UK interest rates and weaker real wage growth. The governor of the Bank of England Mark Carney has added to this uncertainty, with confusing and contradictory announcements on economic policy.

The remainder of this year may be a tougher environment for consumer businesses, unwinding some previously favourable trends. The strong pound is a deflationary factor on consumer spending, making it hard for retailers to show real growth.

Markets may not have seen the end of stockpicking in medium sized companies - investment fashions come and go. Against a background of material long-term outperformance by medium sized companies over the FTSE 100, there have been periods of similar setbacks - 2011 was the last reverse, and 2008 before that.

Each time it has not paid managers to try to time this rotation, but instead to focus on underlying corporate profits.

Repeatedly, medium sized companies have returned to favour after each period of de-rating, and this has driven the performance of many active funds and stockpicking managers. Volatility is the price that must be paid for long term performance. Many of the biggest global businesses are struggling to achieve real growth, lacking the agility of medium sized and smaller companies.

Much of the portfolio rebalancing may already have taken place.

Businesses exposed to economic growth are better placed than defensives to benefit from any acceleration of recovery in Europe and the US.

Many industrials and consumer stocks are reporting good progress.

Only when central banks conquer deflationary pressures will there be scope to tighten policy and slow global growth.Investors should be wary of being drawn in to the rotation that is a characteristic of stockmarket mood changes. Medium-sized companies are likely to return to favour before long.

Colin McLean is managing director of SVM Asset Management


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Source: Herald, The (Scotland)


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