It may have been a wobbly few weeks in stock markets, but the S&P 500 is only back to where it was at the start of the year. Parts of the market still look expensive, with the AI trade in particular drawing high expectations and high valuations. It is a noisy environment, with abrupt shifts in economic policy and heightened geopolitical tensions, including the risk of escalation involving Iran and the ongoing conflict in the Middle East with the US. Looking for segments of the market where expectations are low and valuations unambitious may be one of the best defences available to investors.
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Funds with a valuation discipline
A good starting point could be funds where a valuation discipline is embedded in the investment process. This could be a fund such as TM Redwheel Global Equity Income, which looks for higher-quality companies, but with rigour on valuations.
Manager Nick Clay says that any investment approach needs to be forward-looking: “Business models that once looked almost immune to disruption – including those built on intellectual capital and recurring revenues – are now being challenged.”
He believes that two extra ingredients are essential when assessing companies: valuation and a repeatable way of judging whether disruption is temporary or permanent. To ensure this, for inclusion in the fund, every holding must yield at least 25% more than the MSCI World Index at purchase, and any stock whose prospective yield falls below the index must be sold within six months. “That discipline ensures that the portfolio compounds a premium income stream relative to the market and prevents style shift towards overpriced growth stocks,” he says.
He says the fund may lag in periods of euphoria in markets, when investors are happy to pay any price for perceived quality or growth characteristics and when narrow themes dominate index returns. “But when volatility returns – as it appears to be doing – and crowded trades unwind, the strategy’s focus on starting yield, durability and valuation has historically helped it protect capital and continue compounding income.” That should make it a good option for the current environment.
Exposure to real assets
There has been a lot of discussion of the ‘HALO’ trade in stock markets. A type of anti-AI trade, it stands for ‘Heavy assets, low obsolescence’. This focuses on companies with strong asset-backing that are largely immune to the march of AI. It includes areas such as energy infrastructure, utilities, resources, or even property companies. As one Saxo analyst described it: “the ‘you still need this on Monday morning’ businesses.”
Companies that derive their revenues from regulated industries or global governments are the bread-and-butter of the TM Gravis UK Infrastructure Income fund. Manager Will Argent says: “We want predictability of cash flows to help underpin the income and dividend generation we need.” In an uncertain environment, cash flows that aren’t based on the whimsy of consumers or businesses are likely to be better appreciated.
That’s not to say that UK infrastructure is necessarily boring. Will points out that the fund is still exposed to a range of mega-trends: “energy transition and energy security feature in the portfolio, alongside digitalisation, demographic change, the circular economy and resource efficiency.”
The portfolio holds a broad range of utility providers, power companies, plus digital infrastructure and logistics groups. It also has exposure to hospitals, the London super-sewer, data centres, and big renewable infrastructure assets such as wind farms. These are all critical services, and largely immune to either economic wobbles or AI disruption and, whilst not immune to economic cycles or changes in interest rates, their stable cash flows can offer a degree of resilience during periods of market volatility.
The Cohen & Steers Diversified Real Assets fund is a purer expression of the HALO trade. The fund focuses on companies with tangible assets, generating real cash flows, in contrast to some of the fuzzy expectations associated with the technology sector.
Manager Vince Childers says there is a valuation argument for the assets they hold today: “All core real asset classes appear significantly more attractively-valued to us, with listed infrastructure and natural resource equities the most attractive.” These assets have also tended to deliver returns with significantly less volatility than wider stock markets.
He points out that real assets have historically outperformed in inflationary environments, and this remains a risk: “There are ample potential catalysts for a resurgence in inflation, which warrants a permanent allocation to real assets. These include resilient economies, tight labour markets, fiscal uncertainty, geopolitical tensions and commodity market imbalances.”
The small-cap opportunity
There seems little doubt that enthusiasm for the Magnificent Seven is ebbing. Not a single one of them is above water for the year to date. However, investors still need growth options in their portfolios. They just need to find cheaper ones.
Small-caps around the world have been largely overlooked. With large-cap companies powering ahead, there has been little incentive for investors to take on the additional risk of smaller businesses. As a result, small-caps now look relatively cheap on a global basis.
There’s no shortage of strong UK smaller-company funds, including WS Amati UK Listed Smaller Companies, WS Raynar UK Smaller Companies and IFSL Marlborough UK Micro‑Cap Growth. For investors seeking growth without taking on the valuation risks often associated with large-caps, global small-caps could be an attractive option. Those wanting a more regional focus might consider T. Rowe Price US Smaller Companies Equity or Fidelity Asian Smaller Companies.
Adding more sustainable options
Sustainability has been an unfashionable label in recent years, but the concept remains sound. A sustainable approach brings discipline, and forces a long-term perspective. Sustainability funds have been a beneficiary of broadening market leadership in recent months and their tougher period may be drawing to a close.
Peter Michaelis, manager on the Liontrust Sustainable Future Global Growth fund, says he expects economic momentum to continue to broaden, with more sectors benefiting from lower interest rates. He adds: “This should, in turn, support small- and mid-cap stocks, which have struggled as the wider economy has weakened. We expect the broadening to extend to areas such as housing and non-residential construction…We take encouragement from the recent turnaround in the healthcare sector, which we believe could be replicated across parts of the construction sector.”
Another option is the Pictet Global Environmental Opportunities fund. This is a unique environmental fund which invests in global equities. Unlike many of its peers, this fund goes well beyond climate change and addresses a full range of global environmental challenges.
In uncertain moments, buying expensive areas with high embedded expectations becomes increasingly risky. HALO or not, global investors are increasingly focusing on areas where cash flows are predictable and valuations realistic. It may be time to join them.
