Hermes’s Mark Sherlock says his focus on high-quality companies will pay off as US interest rates start to rise.
The manager of the Hermes US SMID Equity fund said the strong performance from US small- and mid-cap companies since the financial crisis “has led some people to question whether there is value left in this area of the market”.
But he said the rally had been led by lower quality companies, with higher quality stocks having been “de-rated”, although he claimed this should start to change.
In a webcast, Mr Sherlock pointed to analysis of the companies in his benchmark index, the Russell 2500, segmented into quintiles based on a firm’s ‘return on equity’ (ROE).
A high ROE generally indicates a higher quality company, but the analysis of the index found the companies with the lowest ROE had delivered by far the best returns in the past five years.
Stocks in the bottom quintile for ROE delivered nearly double the performance of those stocks in the top quintile; 203.8 per cent compared to 109.2 per cent.
Mr Sherlock said the “influx of cheap money”, caused by ultra-low interest rates and quantitative easing, was the reason supposed lower quality stocks had done so well in the past five years.
He said this cheap money had “disproportionately affected” lower quality, highly leveraged companies.
The manager said this outperformance of lower quality “definitely has been a headwind” for the fund’s performance because he focuses solely on buying high-quality stocks.
In spite of this headwind, the strategy has outperformed its benchmark and sector in the past five years.
However, Mr Sherlock said a tipping point would arrive soon in which higher quality stocks start to outperform, which he said should happen when US monetary policy tightens and the cheap money that has boosted lower quality assets disappears.
“We believe the tide is turning,” said Mr Sherlock. “The US Federal Reserve has turned off the taps and we are entering a period of tighter liquidity.
“Investors in the medium term will renew their focus on the quality of the investments they are buying and so our quality focus may turn into a tailwind.”
Along with the broader US equity market, small- and mid-cap companies have struggled so far in 2015 as the strong rally in the country’s markets in the past two years wore off.
However, Mr Sherlock said evidence collected since 1963 found smaller companies tended to perform better than larger firms in periods of interest rate rises, with small caps delivering 13 per cent per annum in such periods compared to 8.1 per cent for large caps.
He added that smaller companies should be able to withstand the impact of a stronger dollar better than large caps, given 80 per cent of small-cap revenues come from within the US as opposed to just 54 per cent from large caps.