Why quality growth funds like Fundsmith are feeling the pain
The third quarter of this year represented a major milestone for the UK fund management industry although it’s one it would probably prefer to keep quiet.
According to the Investment Association, in the three months from July to September, UK-registered equity funds saw their biggest quarterly outflows since records began as £4.6bn of cash was withdrawn. In September alone £1.7bn was withdrawn, the biggest monthly redemption since the Brexit vote in 2016, with customers pulling £676m from UK equity funds specifically.
Interestingly, these outflows included some of the most popular ‘quality’ funds held by lots of retail investors. Among the largest individual casualties of these outflows were Lindsell Train UK Equity Fund (B18B9X7), which suffered outflows of £551m, and Jupiter European Fund (B5STJW8), which saw outflows of £725m according to estimates from fund-rating firm Morningstar, perhaps compounded by the exit during the summer of its fund manager Alexander Darwall.
These two funds, as well as many other products with a quality bias and which invest in companies around the world including Fundsmith Equity (B41YBW7), Smithson Investment Trust (SSON) and Scottish Mortgage Investment Trust (SMT), have seen a drop in the price of their funds or shares in recent months. Investors should therefore try to understand what’s going on in the market.
As with the overall market, outflows from ‘quality’ funds were concentrated in September just as UK and European growth stocks underperformed the market and value stocks outperformed.
While the same rotation out of growth stocks into value stocks took place in the US stock market, the effect was less spectacular. Also, the outperformance of smaller value stocks was less pronounced in the US.
Dan Rasmussen, founder of hedge fund Verdad Capital, has compiled two charts to illustrate the impact of this rotation on four different investment strategies: US stocks, US small cap value stocks, international (non-US) stocks and international small-cap value stocks.
The first chart shows the five-year annualised return for each of the strategies up to 31 August this year. The second chart shows the returns from 31 August to 31 October.
The difference is startling and begs the question ‘can international stocks and in particular international small cap value stocks continue their outperformance of the past two months?’
ARE ‘SAFE HAVENS’ NO LONGER SO SAFE?
JPMorgan Asset Management forecasts that global growth will be no better than ‘modest’ over the next 10 to 15 years and warns that investors need to ‘rethink safe havens’.
Growth is seen averaging 2.3% over the next decade, down from last year’s prediction of 2.5%, but more importantly inflation is expected to fall short of most central banks’ targets, which combined with ‘much lower starting yields’ means fixed-income returns are likely to be much lower, even into negative territory.
The forecast for equity market returns is 6.5% a year in dollar terms but developed markets are only expected to return 5.7% while emerging markets could return 8.7% annually in local currencies.
Safe havens in the UK equity market have been ‘quality’, ‘defensive’ growth stocks such as Unilever (ULVR) and Diageo (DGE), which are seen as having good earnings visibility, good cash flow generation and in theory are not susceptible to business cycles.
These stocks were relentlessly bid up over the summer to the point where at the start of September they were trading on close to 25 times expected earnings.
Also, businesses like DCC (DCC) and Rentokil (RTO), which tend to have steady earnings streams, had their cyclical tendencies air-brushed out allowing investors to propel them to similar valuations to the ‘quality’ growth stocks.
These kinds of stocks are still cyclical and when they disappoint the subsequent de-rating can be brutal.
Investment bank UBS says that while stocks with the lowest valuations are around 10% ‘cheap’ against historical averages, the most expensive stocks are as much as 30% more expensive than their historical average.
It says these stocks ‘are amongst the worst performing if growth weakens further and lag if the cycle turns up. Thus, we avoid high growth and defensive stocks with big multiple overhangs’.
Bloomberg notes that the top high-flying US stocks started this quarter priced for profit growth of a staggering 25% every year for the next decade, while the actual rate over the past five years was more like 12%.
In contrast, the cheapest stocks are discounting a trend growth rate over the next 10 years below the rate they experienced over the past five years, compounding the mispricing of value relative to growth.
WHAT DOES THIS MEAN FOR INVESTORS IN ‘QUALITY FUNDS’?
The message is clear: anyone owning some of the funds we mentioned earlier in the article such as Fundsmith should expect more volatility in the near-term than they might have been used to.
Anyone investing in ‘quality’ funds should be prepared to ride out any ups and downs along the way. If you’re not comfortable with this situation then now might be a time to rethink your investments.
Someone with a ‘buy and hold’ approach may still be happy owning ‘quality’ funds but make sure you check the fund manager’s style doesn’t drift in the search for better returns if market conditions start to favour a different type of investment.
DISCLAIMER: Editor Daniel Coatsworth owns shares in Smithson referenced in this article.