But, as asset prices across the world have been lifted higher by loose money (There have been 26 rate cuts so far in 2015, Bank of America Merril Lynch pointed out on Friday) so increasingly the good house on a bad block approach has been used to justify buying equities – especially for those investors that are in need of an income. In relative terms, the argument goes, equities remain the best of a bad lot of options.
The problem with this approach is twofold. First, it pushes valuations of the whole block higher than they probably should go on the way up and second, leaves the buyer rather exposed on the way down.
In UK equity terms, it could go some way to explaining the FTSE 100’s success in finally conquering the 7,000 level, despite its significant bias toward commodities and financials stocks. But, it also is beginning to raise eyebrows, especially in the lead up to next month’s election.
For Hugh Yarrow, fund manager of the Evenlode Income Fund, it is an unavoidable fact that valuations are rising. And, he points out: “a strong bull market is like a bucket of cold water on the prospect of generating future returns.
He adds: “While we are big advocates of owning cash generative businesses with pricing power over the long run, even the best business is not a good investment if the starting valuation is too high.”
This view has led him to take profits in a number of his large-cap holdings, including Novartis, Smith & Nephew, Reckitt Benckiser and SABMiller. And, replace them with smaller companies that fulfil his quality criteria.
Simon Moon, co-manager of the Unicorn Income Fund, also has a strong bias toward small caps explaining: “With the FTSE 100 trading at all time highs, small caps present one of the true pockets of value.”
Schroders’ value team is also of the view that valuations are too high now, especially in certain areas of the large cap space.
As Kevin Murphy, co-manager of the Schroder Income Fund explains, at a UK stock level, dispersion currently centres around stability. Memories of the 2008 crash remain fresh, he told journalists in London last week, and as a result many of those buying equities are looking for security – companies that have predictable earnings and good dividends. On the flip side of that, those companies that remain the cheapest are those where there is uncertainty.
It is for this reason the team owns Tesco, Sainsbury’s and Morrisons as well as banks like HSBC and Lloyds. The group also remains concerned about the small coterie of megacaps that dominate the UK dividend space.
Jason Stather-Lodge, CIO at OCM Wealth Management, is also of the view that UK large caps have largely peaked in price terms and is expecting earnings to stagnate. As a result the group has removed all of its exposure to large caps.
“We have about 20 to 30% in cash. We are very underweight the UK. We have around 7 to 8% in the market, down from around 20% and that is in mid-caps,” he told Portfolio Adviser.
But, at the moment, OCM has no exposure to UK small caps, looking instead to Europe and the US.
Stather-Lodge explains, however that this not to say he doesn’t see value in that market.
“There is a compelling case to be made for UK small caps. The business cycle is saying that now is a good time to move into the market, but the election makes it too risky.”
“You are seeing large outflows of money from the UK on the election uncertainty and that is going to continue. Unless you get a stable government and, importantly, a formal parliament, it is going to be mayhem for sterling,” he says.
As a result, he says, it makes more sense for now to be invested in US and eurozone small caps, where (at worst) you miss a bit of a run up in the UK sector. “Once there is a stable government, however, he says, the firm will begin again to look at small caps.
Brian Cullen, manager of the SW Mitchell UK Fund agrees that the outlook for sterling remains a risk for UK investors, which is why he is focussing on companies with a large exposure to Europe. “This used to be a contrarian call, but that has changed in recent months.
“Where six months ago I was strongly exposed to the UK domestic recovery, it is a lot more now focused on special situations,” he adds.
Moon, however, sees things, slightly differently, while agreeing that there is unlikely to be a significant build up in investment in small caps until the outcome election is clear, he adds: “There is a clear contrast between the importance in which investee companies see the outcome of the election and the weight put on it by investors.”
