The managers of the Guinness Global Equity Income fund have sounded a note of caution on US mid caps despite having introduced a bias towards cyclical stocks in their $320m (£250m) portfolio.
Managers Matthew Page and Ian Mortimer hold more than half their fund in US equities but said they had not been tempted by small- and mid-cap stocks because of fears over debt piles.
The recent rally in global stocks has been driven in part by firms lower down the market capitalisation scale, but Mr Page said he was wary. Many companies have taken on debt, sometimes just to buy back shares, and could now struggle to raise margins and earnings to pay down those borrowings, according to the manager.
“The amount of leverage, not in large-cap stocks but in small- and mid-cap names, concerns me – especially in the US,” he said. “In the S&P 400 index the average net debt to EBITDA is approximately 4 times, which is where it was in 2001 [before the market correction].”
Instead, the managers have been looking to “high-quality” cyclicals, as they back markets’ shift away from defensive sectors amid a pickup in growth and inflation expectations – despite admitting that value here was “less clear cut than it was 12 or even six months ago”.
High-quality defensive stocks have seen valuations soar following years of strong performance, Mr Page noted.
The Guinness duo’s strategy of maintaining a valuation discount to the MSCI World index saw them introduce better value cyclical stocks such as recruitment firm Randstad and retailer VF in the final quarter of 2016.
The pair’s moves coincided with a shift in fortunes for both defensive and cyclical sectors in 2016. In the first half of the year, the MSCI World Utilities index, as a proxy for defensive stocks, delivered a total return in sterling terms of 25.1 per cent, while the MSCI World Financials index, as a proxy for cyclicals, returned 1.3 per cent, according to FE Analytics.
But in the second half of the year, the financials index delivered 31.4 per cent while utilities rose by only 0.2 per cent.
“The longer-term trend has been selling down defensive sectors and shifting that into where we saw value, which is high-quality cyclicals,” said Mr Page.
The upturn in cyclical stocks has stemmed from increasingly frequent indications that global economic activity is picking up. This is expected to lead to higher profits in cyclical sectors, whose returns fluctuate based on the stage in the business cycle.
However, one defensive sector in which Mr Page said there was now growing value was healthcare, which he said had “taken a beating in 2016”, largely due to concerns about political interference on drug pricing.
Mr Page said more and more healthcare companies were appearing through his stock screening process and, in the final quarter of 2016, Swiss pharmaceutical giant Roche was added to the portfolio.
But the manager said the healthcare sector was an outlier compared to the general trend of greater opportunities appearing in quality cyclical companies.
The Guinness Global Equity Income fund has underperformed relative to its peer group in recent months in spite of its shift to cyclicals, as the fund still has exposure to defensive sectors such as consumer staples.
In the past six months, it has delivered a return of 6.2 per cent, compared with the IA Global Equity Income average return of 9.5 per cent, according to FE Analytics.
But the fund has outperformed the sector average by 13.1 percentage points in the past three years and by 14.7 percentage points in the past five years.
