InvestmentsApr 15 2021

Investing in future winners

Supported by
7IM
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Supported by
7IM
Investing in future winners
Pexels/Sharon McCutcheon

Equity markets have rebounded strongly from the falls of February and March 2020, to deliver significant outperformance to investors.

Most of the returns have been generated by a few US technology stocks though, which have been riding high on the back of the global shift to remote working.

“The Covid-19 crisis exacerbated market concentration within the S&P 500 [index], resulting in a cohort of just a handful of tech stocks making up more than 25 per cent of the index. These stocks drove markets higher as investors looked for clarity on future earnings and jumped onboard the ‘stay at home’ theme,” says Shane Balkham, chief investment officer at Beaufort Investment.

But in relying on this small subset of stocks for future returns, investors’ equity exposure may not be genuinely diversified.

Looking beyond the stocks that are currently performing well to those that might deliver outperformance in the future can be challenging, as Adrian Lowcock, head of personal investing at Willis Owen, acknowledges.

He adds: “Sometimes you do need to say, ‘OK they’ve done very well, but they’re not going to perform year in, year out relentlessly’.”

For investors, overcoming the psychological barrier of breaking away from the herd can be difficult.

However, this is an important part of diversification as Ben Kumar, senior investment strategist at 7IM, explains: “Being prepared to hold something that is different from the consensus can feel uncomfortable, but that uneasiness is also the sign that not everything in the portfolio is pulling in the same direction, which is what diversification is all about.”

Time to diversify

There are a few ways to achieve diversification, such as by investing across geographies or asset class type.

Lowcock suggests that being diversified by region is an “easy win”, although can be complicated by the fact that companies are becoming more “globalised”.

“The one that often gets overlooked – and this is where multi-asset does come in and adds quite a lot of value – is by style. And this absolutely talks to backing the next winners, if you like, or the next phase of the cycle because investment style does come in and out of favour,” he says.

Even in environments where one style has dominated, those approaches that lagged will not have lost investors' money and typically still have generated a positive total return, he adds.

Minesh Patel, a chartered financial planner at EA Financial Solutions, agrees: “When clients are seeking to invest in a balanced equity portfolio that is genuinely diversified, they should invest in multi-asset funds that invest in a range of investment styles: growth, value, momentum. They will then invest in a range of companies that are not so closely correlated.”

On the income trail

Equities can also contribute meaningfully to income as well as to growth in a multi-asset portfolio, as Tom Mills, senior investment analyst at Hargreaves Lansdown, observes.

“The level of yield offered by fixed income has reduced, which means that more defensive, high-grade government bonds don't currently offer high levels of income,” he says.

Many UK companies were forced to suspend or slash dividends during 2020 in light of the pandemic’s financial impact. In the US, many companies managed to maintain dividend payments and some UK companies have since reinstated payouts.

“Even though the coronavirus pandemic caused a significant reduction in dividends in 2020, equities can offer relatively competitive levels of income through company dividends,” says Mills, who points out that UK shares are offering a dividend yield of 3.1 per cent, compared with the UK 10-year gilt yield of 0.8 per cent. For comparison, the yield on UK corporate bonds is around 1.8 per cent.

But, he adds: “Investors should be mindful not to over-reach for yield, as equities add risk to a portfolio compared with fixed income.”

For Willis Owen’s Lowcock, the role of equity income in multi-asset portfolios remains important, given that “it’s one of the few assets that can grow, it’s almost inflation-proof to a certain extent”.

Metrics

Some of those future equity ‘winners’ that investors identify may well be companies with intangible assets.

Something that investors have been increasingly calling into question is the relevance of traditional metrics in accurately measuring equity valuations.

Christopher Cowell, quantitative investment strategist at 7IM, says: “When we look at the some of the most successful companies in the world – as proxied by market capitalisation – a significant portion of their worth is derived from intangible assets, such as intellectual property, brand and human capital.”

Despite this, traditional accounting methods have failed to keep up, remaining focused on assessing the intrinsic value of a company based upon its physical assets, he adds.

“By failing to properly account for the value that is created by intangibles, accounting standards are rendering traditional company valuation metrics, such as price-to-book and price-to-earnings, increasingly irrelevant,” Cowell says.

“This is true to a certain degree,” Beaufort Investment’s Balkham adds. “However, we have equal confidence that there are a growing number of stocks for which the growth assumptions embedded in their price-to-earnings and price-to-sales ratios are simply too optimistic.

“The same arguments that were used at the height of the ‘technology bubble’ to substantiate extreme valuations are being bandied around again today.”

Lowcock and Patel agree that where traditional metrics can be useful is in comparing companies in one sector against each other.

In some cases, it is more about a company’s journey than its profitability, says Lowcock.

“You don’t buy a Tesla based purely on metrics, you buy a Tesla if you believe in the vision.”

Ellie Duncan is a freelance journalist