Investors in cyclical and growth stocks - even challenged businesses - can reap rewards, despite the volatile markets. It just takes a long-term perspective and good timing.
Growth stocks are particularly exposed to the market’s swings of mood. Typically premium rated, they are sold off sharply when investors turn cautious. For example, shares of ARM, the software business, have experienced falls of 5% or more on seven days this year, and gains of a similar scale twice as often. Yet only in one brief period did ARM fall below its long-term moving average, showing the consistency of the underlying uptrend despite this volatility. Burberry, the luxury goods group, has been almost as volatile, but with a similar underlying consistency of trend.
For a growth fund manager – emphasising fundamental analysis and earnings revisions – the pattern should be seen as offering regular opportunities to buy on dips.
This year, sentiment has often ignored underlying business progress, and these two companies remain misunderstood by many analysts and institutional investors. (Strategy continues below)
The underlying trend in this type of growth business reflects not only better than expected earnings, confounding sceptics, but also a reappraisal of the right price for growth. In a slowing global economy, consistent growth merits a bigger premium. When interest rates are low, future earnings should be discounted less. Premium ratings for stocks with superior organic growth and scalable business models, can be justified. Businesses with strong brands or technology are better able to resist pressures on their margins. These types of stocks should be core holdings in long-term growth portfolios.
This pattern of growth with volatility has also been shown in 2011 by some more defensive stocks. In food, Tate & Lyle and Associated British Foods have outperformed and, even shares that have been long-term disappointments like GlaxoSmithKline, have had their time in the sun. It shows that growth investors should not ignore valuation when there is the potential for resilient businesses to be turned round by restructuring. History shows Glaxo to have been a poor long-term investment, but at the beginning of 2011 its yield and potential for buybacks were overlooked.
This year it has paid for portfolios to recognise dividend yield and defensive merits. The low growth in sectors such as food, tobaccos and utilities has greater attraction when global growth is weak. Volatility in these sectors has reflected recurring investor concern that the shares have become over-owned. At times when aversion to risk is greatest, these defensive shares have appeared too popular. One sign of crowding into defensives is when managers start talking about “quality stocks”, as if these shares had some magical ability to perform. Investors should use the opportunities when these shares are over-bought to take profit. This can provide funding to rotate into stocks that are more sensitive to swings in the business cycle, as well as special situations.
”A balanced growth portfolio can include more economically-sensitive stocks on the basis of management strategy and valuation”
It is the timely buying of cyclicals and special situations this year that has boosted performance for brave managers. A balanced growth portfolio can include more economically-sensitive stocks on the basis of management strategy and valuation. Croda, the chemicals group, came through the last recession without an earnings downturn, helped by its focus on speciality higher margin products combined with an innovative culture. Yet it may suffer earnings downgrades in the coming year, if global growth slows. This risk means it is a stock that a manager may wish to take a tactical view on. Similarly, Ashstead, the equipment rental business, has been much more volatile this year. The summer sell-off saw an excellent opportunity to use this type of stock, which tends to rise and fall more than the market, to bring more economic exposure into a portfolio. It also offers exposure to the dollar, with 85% of its revenue from its American subsidiary. We expect the dollar to strengthen further as the American economy proves more resilient than Europe.
While businesses with strong organic growth like ARM and Burberry might be held over a full investment cycle, there are opportunities to be more tactical with cyclical businesses. These can be brought into a portfolio as they hit extreme lows of sentiment and valuation.
There will also be some opportunities in challenged sectors, where fundamental analysis indicates management can take share from their competitors. Results this year have shown that in some sectors the strong are getting stronger. In retailing, Next and Kingfisher are examples. Where an investment manager has a strong conviction on the potential for outperformance in a stock even in a challenged sector, this can help to limit a portfolio from becoming too defensive.
The next year will be challenging for growth, particularly in the eurozone as deleveraging accelerates. America and Europe are likely to print money to stimulate, but it will not be enough to make banks attractive investments. There are opportunities in growth stocks and cyclicals, but managers must use market volatility to their advantage.
Margaret Lawson is an investment manager at SVM Asset Management