Don’t worry: the following article contains no fashion advice (and a brief glance around the office suggests we are not well placed to comment on this front). Instead, this is your run-through of the investing styles that worked in the UK equity market in 2017.
Momentum: The trend is your friend.
At least it was in 2017. The momentum effect describes the tendency for stocks to trend in the same direction, with historical “winners” outperforming and historical “losers” underperforming. Market participants demonstrate a number of systematic behavioural biases including anchoring and herding, which manifests in delayed reactions to new public information and trends in earnings forecasts. Collectively, these biases can lead to earnings and share price momentum. This momentum effect is a powerful one and it was especially strong in the UK equity market this year.
2017 has seen a significant polarisation of the market, an Ernest and Young report on profit warnings1 highlighted that FTSE Industrial sector profit warnings are at their lowest for six years, whereas General Retailers’ profit warnings are at their highest since the financial crisis. Furthermore we have seen a rise in multiple warnings from “companies caught on the wrong side of economic, sector and digital trends and those who lack the financial or operational agility to adapt”.
Can this momentum persist? Momentum is not just a short-term phenomenon, it has produced long term outperformance and has been an incredibly consistent style. With continued supportive global PMIs, weak sterling and low market volatility, we think there is no reason to expect a change in sector leadership in 2018.
Quality: Not all earnings are created equal
Quality investing seeks to identify companies with stronger fundamental characteristics, taking a holistic view of company quality – including earnings sustainability, management and operational strength. It favours companies with high returns, operating in attractive end markets, with barriers to entry and strong management controls. It avoids those with high levels of hard-to-measure accruals and weak capital discipline. Having underperformed in 2016, quality investors had a better time in 2017 (J.P. Morgan Asset Management as at 31 December 2017).
An uncertain domestic backdrop is likely to lead investors to favour companies most able to withstand short term pressures. In this scenario we would see a flight to companies with greater pricing power, margin buffers, management strength and strong capital discipline. With this in mind it is easy to see quality remaining an important style factor in the year ahead.
Smaller companies: Small is beautiful
Like that bespoke suit in your wardrobe, the mid-cap allocation in your portfolio is a timeless classic. Since 1955, when records began, UK mid- and small-caps have outperformed in roughly two out of three years2. In fact, since 2000 smaller companies have outperformed their larger counterparts in 90% of the world’s largest markets2. 2017 was another of those years in the UK, with the FTSE 250 ex.IT. +18.3% and FTSE Small-cap ex.IT +15.6% vs. the FTSE 100 +12.0% (Source: Bloomberg as at 31 December 2017).
So why has this small-cap effect continued? Investing in small- and medium-sized companies offers some structural advantages, including:
- Flexible business models more able to adapt to change
- Less well-covered stocks with the potential to identify significant market mispricing
- Greater Mergers & Acquisitions opportunities on both the buy and sell side
The small cap-effect is a phenomenon that has persisted across both time and geography, and given the structural reasons identified above, there are no signs that it’s set to end anytime soon.
Timothy Lewis is an analyst in the J.P. Morgan Asset Management International Equity Group – Behavioural Finance Team, focusing on small- and mid-cap.
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1Diverging Fortunes – Analysis of UK profit warnings, Q3 2017
2Numis Smaller Companies Index 2017 Annual Review – Numis/ Elroy Dimson, Scott Evans and Paul Marsh – London Business School.