A changing of the baton is taking place in US equities, with small and mid-cap stocks set to outperform in the coming year as mega caps stare down the impact of trade tensions and rising rates, according to Bell Asset Management’s chief investment officer, Ned Bell.
At the same time, the prospect of higher rates is resulting in a style shift that is seeing investors rotate away from growth stocks and toward quality stocks, he says.
Speaking exclusively to The Australian, Mr Bell said his fund had been veering towards small and mid-cap companies “because that’s where the best opportunities are, by far”.
“The huge boom in passive investing has created valuations in the large-cap stocks that are just too expensive. Amazon, Facebook, Netflix are all on five-year highs. One of the things we’ve found is you can still play those same sorts of themes, say the cloud computing theme, but through companies in the $10 billion to $20bn range — there’s plenty of them.
“We’ve been taking profits in large cap us stocks since mid-last year and that’s not because we’re losing confidence in those companies — we just think the valuations are too high. And we’ve been rotating into two areas: small and mid-caps globally and European equities, because they are very cheap.”
The mega-cap end of town was facing the biggest risk from rising rates, with retail money likely to flow out due to rising volatility, Mr Bell warned.
“We’re not necessarily hugely bearish on the market — we think the market will do quite well — but there’ll be a changing of the baton. So we think the next 12 months, especially in the US, small mid-cap stocks are going to do really well but as higher rates bear down on us, what you’ll find is some of those mega caps start to really lose momentum … It’s really momentum driving those large-cap stocks rather than the underlying fundamentals.”
Forecasting a boom in small and mid-cap stocks in the US, Mr Bell said valuations in that part of the market remained attractive.
“Small and mid-cap stocks haven’t been caught up in the whole passive investing boom … and I think they need to catch up to the large-cap names if the economy continues to do well. Come the third and fourth quarters of this year you could find a simultaneous growth uptick in sales growth estimates and earnings estimates and you’ll skip the valuation re-ratings.”
Recently returned from a research trip to the US, Mr Bell said he was hearing more and more that wage pressures were starting to build. “That’s quite interesting and it’s not something that I think is on too many people’s radars,” he said. The negative was that wage pressures would hurt earnings, he said, but for the first time in quite a while, the health of the US consumer was very strong.
Even more encouraging was the return of capex investment, which implied strong conditions in the next year or two that was pushing sales growth higher, he said.
“So there’s some really good signs coming through and we’re hearing the same messages from these companies, which reiterate a lot of the positioning that we’ve got.”
While US growth stocks have been phenomenal performers in the past few years, Mr Bell said he was seeing a style shift towards quality stocks, mainly due to rising rates.
“I got the sense from being on the ground that a transition is under way and quality stocks are going to perform,” he said.
“The high-end growth stocks are very expensive and I think people are getting more and more nervous about that little bubble. No one quite knows what might shake it up but there’s a little bit of nervousness around how those high-end growth stocks will react in a rising interest rate environment,” he warned.
Software company Arista Networks was among the stocks Bell had been buying, as it was a “great play on the boom in cloud computing”. “They’ve got a solution which is arguably quite a bit superior to that of Cisco and Juniper and they’re gaining market share in an industry that is growing incredibly strongly,” he said.
Another favourite right now is gaming company Electronic Arts, which Mr Bell said was a good play on the gaming model that was moving towards a Netflix-type subscription model. On the defensive side, global reinsurer Marsh and McLennan had been a consistent outperformer, he said.