In this article, Laura Foll, Portfolio Manager of Henderson Opportunities Trust explores whether now is the time to dial down exposure to stocks.

Look at the relative performance of the FTSE 100 index over the last 12 months and you would think the UK was leading the world economically. It is up nearly 4% as I write against America’s S&P 500, which has fallen over 10%.1

Of course, these broad numbers hide a much more nuanced story – and perhaps some investment opportunities. too.

The FTSE 100 has been “fuelled” by the performance of the natural resources companies that dominate it. BP is up 31% over the past year; Shell up 46%; Glencore up 33%.2

We believe that over the long-term strong growth tends to come from small and medium-size companies. But their performance can be volatile, and large-cap and natural resources companies can act as stabilisers within a portfolio.

That philosophy has made a big difference to our performance this year, and I cannot remember a time when, as multi-cap managers, we held such a large exposure to these “stabiliser” companies. But in recent weeks we have been asking if it is time to rotate back towards the small and mid-cap stocks that have had such a difficult time.

Too gloomy?

The Alternative Investment Market is down nearly 27% in the past year; the FTSE 250 is down 13%.3 Experience tells us that smaller companies go through these periods of darkness but have a tendency to spike up sharply when they reach the other side – usually triggered by a change of sentiment.

The current market narrative is dominated by doom. Central banks are raising their inflation expectations as well as interest rates; economists point to inverted yield curves, while the International Monetary Fund has just declared that the outlook for the global economy has “darkened significantly”.4 Global recession appears imminent.

We cannot rule out more share tumbles, but markets seem to have largely priced in these expectations. I cannot imagine a more dismal scenario than we beheld at the beginning of the Covid crisis. Markets crashed. This year many stocks have experienced similar corrections.

Take sofa manufacturer DFS. In 2020, when the Covid crisis struck, its share price fell nearly 60%, from £2.82 at the beginning of the year to £1.16 just three months later. By June last year its shares had recovered strongly – to a high of £3. Today they are £1.57. The falls are similar for M&S – down 53% during Covid, followed by recovery, and then down 43% to today.5

There is a perception in the market more broadly that the price/earnings compression has happened and next there may be substantial earnings downgrades.

But this does not tally with the messages we hear when attending company meetings and calls. Reflecting on share price performance, managements seem quite bemused – and sometimes frustrated. Demand so far seems resilient, and we are impressed by how many companies have price escalation clauses within their contracts.

De-rated stocks

One area that has de-rated materially is building materials companies. Even if house prices were to fall, housebuilders would have to carry on building homes – otherwise their earnings dry up. So they will still need bricks and other materials.

One of our holdings in the Henderson Opportunities Trust is Sigmaroc, which produces heavy building materials for the UK and Europe. Its share price is down more than 40% over the past year, but this is a company with a history of smart acquisition and organic growth. We await its latest set of results but the past five years have been impressive – EBITDA up from £6m to £49m and earnings per share more than doubled.6

HOT

Source: Sigmaroc FY21 Annual Report7

Energy price rises will hurt many people, but they will hurt most those whose finances are already stretched. There are many people whose savings went up considerably during lockdown and whose earnings have risen not far behind inflation. The UK savings ratio is still higher than it was between 2017 and 2019.8

Vertu motors has seen its share price fall 21% so far this year.9 But it is still trading satisfactorily, and the shift to electric vehicles is encouraging more people to buy new cars.

Vertu is paying a good dividend – over 3%. Brickmaker Ibstock, another company we like and whose share price is down around 13% in the past year, is paying nearer 4.5% in dividends. Epwin Group, a UPVC window manufacturer, is delivering over 5%.

We are told to sell cyclical stocks as we enter recession. But markets appear to have priced in a significant amount of bad news, with the median FTSE 350 share down almost 20% this year.10 And maybe – just maybe – this time round a recession may not be as painful for many of these companies as in times past.

We are not calling the bottom, but for us it has made sense to pocket some of the gains we made from energy shares and begin moving gently back into some of these cyclical areas in readiness for their recovery. In the meantime, we will happily take those dividends – we call it being paid to wait for the rebound.

Laura Foll is co-manager of the Henderson Opportunities Trust and the Lowland Investment Trust.