The outperformance of the US technology sector has been a significant and enduring trend in share markets over the past decade. The outperformance of these stocks means they have grown as a percentage of investors’ portfolios. Just five stocks, Facebook, Amazon, Alphabet, Apple and Microsoft account for nearly a quarter of the S&P index – so index or tracker funds that follow it have this proportion too. The broader technology complex, including tech and e-commerce stocks residing in other sectors, accounts for about 40%.
While there is a lot going for the technology sector, there is now considerable concentration surrounding the US, and indeed global, indices. Investors must ask themselves if they are comfortable with this, especially as one of the key drivers of valuations across the sector could be going into reverse.
The persistent strong share price performance from the sector is partly down to impressive growth in earnings and successful execution of business strategies. However, another less obvious factor has also been at play – falling bond yields. Why does this matter for tech companies? In short, they can be ‘jam tomorrow’ businesses investing to secure big future profits as opposed to near term ones. Higher inflation and interest rates have the effect of making the value of those profits worth less in today’s terms. Having benefitted from falling interest rate expectations over the past few years, technology and growth stocks more generally could encounter a strengthening headwind if these start to rise.
In recent weeks, markets have started to price in more inflation and tech stocks have stalled. As I suggested in my article on Technology sector stumbles here, the shift in expectations has been subtle but a significant change nonetheless from the ‘lower for longer’ narrative that investors have been used to for the past decade. It may not be probable, but it is certainly possible that inflation picks up very significantly, a scenario in which many investors’ portfolios could be poorly equipped as they lack significant exposure to areas that cope well with inflation and interest rates rising.
An inflationary scenario calls for an entirely different investment strategy from a low inflation one. If inflation and interest rates are rising then it’s likely because the economy is running hot, so areas that might perform better are more economically sensitive sectors such as financials and industrials, as well as smaller and medium-sized companies that can harness this growth in a particular sector and industry niches.
For those looking for diversification in the US market where tech dominance is most prevalent, one fund with a pragmatic approach to seeking out the best opportunities is Premier Miton US Opportunities. The fund can access ideas from across the size spectrum and is well spread across a variety of different industries. With a portfolio skewed towards small and medium-sized companies, no ‘FANG’ stocks and an active share of around 95% it could make a good diversifier to funds more aligned with the index.
The managers, Hugh Grieves and Nick Ford, also run a ‘concentrated’ portfolio of around 40 stocks, which increases risk compared to funds with a greater number of holdings but ensures their highest conviction ideas contribute meaningfully to performance. Arguably, the stock specific risk is no more than the index because typically no position accounts for more than 3% of the fund with a hard limit at 5%.
The managers aim to identify ‘superior’ businesses that display resilient characteristics such as high barriers to entry, an asset light business model and significant recurring income that allows continual reinvestment. Various industries generally fail to meet these criteria such as airlines, biotech and miners. Once identified, the managers aim to be patient, buying at an attractive price to optimise potential reward for risk taken.
The combination of these criteria generally means companies in the fund’s portfolio trade at a valuation premium to the market. This is not a ‘value’ fund. Instead, it offers a compromise between ‘growth’ and ‘value’ attributes and the flexibility to explore a wide range of the US market to find the optimal balance.
Unlike some, Ford and Grieves admit that they don’t have any informational edge over other market participants over forecasting shorter term earnings, so they focus firmly on a company’s attributes such as earnings growth, free cash flow, profitability and extent of borrowing as well as determining general long term prospects.
Presently, the managers foresee significant inflation ahead for the US economy owing to the extent of Central Bank stimulus and difficulties across many supply chains where underordering during the pandemic could see supply struggling to keep up with a sudden increase in demand. They worry that most economists are underestimating the growth ‘surge’ that will occur and that Federal Reserve policy will increasingly be exposed as out of touch with reality. In this environment they emphasise the vulnerability of the tech heavyweights that dominate the index and that far better opportunities exist among America’s vast number of smaller and generally far less well-known companies.
Recent performance and portfolio activity
A key driver of the fund’s recent outperformance is its exposure to small and medium-sized companies. The managers had been building up exposure since March 2020, and since then these have performed strongly as is often the case in economic recoveries.
The fund's top performers have included Monolithic Power Systems Inc, Floor & Decor Holdings, Goosehead Insurance and Pool Corp. US smaller companies are more geared towards domestic economic growth, with less sales from international markets. Having underperformed going into the downturn, valuations became attractive with many investors having shunned the sector in favour of the larger-cap technology stocks. The fund managers believe the rotation into smaller companies has just begun.
There has also been a rotation into economically sensitive sectors within the fund in recent months. Examples of new positions include Norwegian Cruise and Western Alliance bank, a lender to the hotel sector, demonstrating the managers approach of dipping into ‘quality cyclicals’ when they deem appropriate.
This fund has a genuinely active approach in the US, which we believe can add value above low-cost tracker funds. Even if the managers’ thesis doesn’t play out – and big tech continues to outperform – the fund provides useful diversification with its wide-ranging remit to invest across companies of all sizes and a flexible, pragmatic process. However, the strategy will underperform if mega caps, notably the technology cohort, lead the way. We are pleased to add it to our list of preferred funds for new investment.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.
Premier Miton US Opportunities – added to the Preferred List
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