2018 was a challenging year for the fund, the worst relative return since 2009. As at the end of Q3 the fund was around 2% ahead of benchmark for the year, but Q4 was extremely poor, and we finished 7-8% behind. It’s very rare for the fund to have a drawdown versus the benchmark of this magnitude, but previous instances include 2Q14, when growth stocks sold off aggressively, and in the weeks after the EU referendum result. On both those occasions, we used the opportunity of significant share price weakness to increase exposure to names that had been sold off too aggressively.
In 4Q18, I think we suffered from a combination of the sell-off in technology/growth stocks and elevated Brexit and political fears. From a UK perspective, this proved to be a toxic combination. UK domestic cyclicals performed poorly. Whilst modestly underweight this part of the market, the outflows from UK equity funds seen across 2018 has meant that the UK market has been weighted towards selling, and this likely accelerated given the Brexit and political turmoil in Q4. As such, lots of UK stocks sold off aggressively, particularly highly rated and cyclical names. AIM stocks were particularly badly hit.
The fund has good exposure to AIM, so our positioning here wasn’t helpful for relative returns. We had many stocks in the portfolio that declined by 30%, 40%, 50% in the final quarter, names such as boohoo, Fever Tree, Blue Prism, Burford Capital and Ashtead. As for domestic cyclicals, our positions in Barratt Developments, Taylor Wimpey, Purplebricks, OneSavings Bank and Charter Court Financial Services also performed particularly poorly.
It is quite clear that the (global) stock market was trying to price in an increased risk of (i) a US and global recession, (ii) a policy mistake by the Federal Reserve (Fed) and (iii) the trade war between the US and China exacerbating economic weakness. Obviously, all of these issues are interconnected. There was much focus on the yield curve through Q4 and whether or not it would invert. To me, fears of a US recession were overdone. However, investors sought the sanctuary of safe haven stocks. So we had a situation where bond proxies offering 6-7% earnings per share (EPS) growth trading on 20-25-times price-earnings (PE) multiples, names such as Unilever, RELX and Diageo, held up very well yet faster growing structural growth stocks (but trading on much higher valuations) sold off precipitously.
I enter this year feeling more optimistic. There’s only so far our highly rated stocks can fall before their valuations look very compelling, particularly in comparison with slower growing, highly rated bond proxies. With some of our growth names having declined by 30-50% it’s highly unlikely that they’ll decline by that amount again. Not unless they disappoint on trading. In that regard, we’ve had no issues. On the back of Asos’s profit warning, boohoo’s share price fell by 15% despite issuing its own reassuring trading update. Blue Prism was similar. Its trading update was ahead on revenue growth, yet the market wasn’t interested, and likewise, Burford Capital. However, these stocks and others are now recovering. They look very good value now, in my view.
I believe the markets want to move higher. Fed Chairman Jerome Powell’s pronouncements along with the payrolls data have been well received. The near-term risk of recession is low, in our view (the payrolls support this) but the economic outlook has softened. Powell has said that the Fed is prepared to be flexible with policy in response to the economic data, including with its balance sheet. China also appears willing to provide policy stimulus. That being the case, we could rally further. An outcome to the Brexit negotiations that is seen to be market friendly – even if ultimately not optimal from a long-term economic perspective – will be received very well, in my view. UK equities, and obviously domestic cyclicals in particular, could rally aggressively in that event.
In summary, whilst 2018 wasn’t a great year for us I feel more optimistic about our prospects in 2019. The fund trades at only a modest premium to its benchmark (a couple of PE point turns) but given its exposure to fast-growing companies such as boohoo, Burford Capital, Fever Tree, etc. it should rapidly unwind that premium. I would argue, however, that the fund’s premium is justified given that it’s expected to deliver much stronger earnings growth than its benchmark. In terms of activity, we’ve been adding to names that have been heavily sold off and increasing exposure towards the UK domestic cyclicals given how weak they’ve been and our expectation that we won’t end up with a No Deal Brexit.