Active Management - Diversified Core & Momentum Satellite

Wednesday, 12th October 2016 11:28 - by David Harbage

Most readers will appreciate the merits of diversification – of assets or within a particular asset class – and then tend to increase exposure in certain areas according to their assessment of where best value or opportunity resides.

For instance, cautious investors seeking to maintain the purchasing power of their money and protect their £ based assets from inflation might choose inflation linked British Government stocks. Provided negligible income is not a critical requirement, such securities have performed well in recent years – albeit their worth has been driven by ever lower, short and longer term interest rates. The prospect of domestic inflation picking up next year, in response to more expensive imports (notably US$ priced oil) to circa 3% represents a further positive on the horizon for this asset as compared to conventional gilts.

 But we digress. An exchange traded fund (ETF) will probably represent the lowest cost and most reliable means of owning a particular asset; for example the i shares FTSE100 ETF (ticker ISF, total expense ratio of 0.07% per annum) would provide exposure to that index of leading UK businesses with a clear multinational bias. Certainly, adopting some belief in the stock market’s ability to efficiently price such ‘blue chips’ has been a rewarding strategy in 2016 to date. Sterling’s weakness since the Brexit vote, most obvious against the US dollar, has been the prime driver of companies which earn most of their profits overseas. While UK pension funds have received a boost in capital terms (with dividend income set to benefit from a currency conversion boost next year), most overseas investors will have seen little, if any, capital movement as the UK equity market has barely risen in dollar or euro terms over the past three months.

Given this blog’s focus on equity investment (which hopefully is not the sole asset class represented within an individual’s plan for long term savings), and an expectation that readers will be interested in individual company shares, the writer might anticipate a mix of index tracking and active (i.e. those which might outperform) investments. The former passive index trackers could be perceived as the more reliable (in performance terms) diversified ‘Core’ and, as such, represent the greater part of a portfolio. The latter, smaller portion which could be described as a ‘Satellite’ might comprise a number of funds – such as investment trusts specialising in smaller companies – or particular sectors of industry or specific listed businesses in which the investor might have particular knowledge or conviction of outperformance of the wider market.

Hindsight is undoubtedly the best fund or money manager. Certainly in terms of selecting company stocks for the Satellite, which are capable of adding value relative to the performance of the wider market or Core of the portfolio. Since the UK’s referendum on its membership of the European Union, the FTSE100 index has risen by 11.6% - from 6,336.1 on the 23 June 2016 to 7070.9 as at the close of business today (after falling below 6,000 in the week following the vote). By contrast, the more domestic FTSE250 index progressed a more pedestrian 4.3% - from 17,333.5 on 23 June 2016 to its current 18,073.2 (after falling below 15,000 on Monday 27 June). The larger caps’ greater exposure to non-sterling revenue and profits has been the prime differentiator over this short period of time and, if sterling continues to weaken against the US dollar and the Euro, then multinational or overseas earners are likely to outperform UK-specific businesses.

Some equity investors who follow a Core & Satellite approach will adopt different time horizons for each: a ‘buy & hold’ policy for the Core index tracking (or highly diversified) portion, with the intention of owning such investments for the long term and, by contrast, taking a much shorter term perspective for stocks or other securities within their Satellite portfolio. These investors could view the latter as incorporating stocks or favoured ideas which have very immediate or current appeal (to them) or are enjoying positive momentum (in the wider market). An example of a strong consensual view would be the previously mentioned preference for international firms over domestic businesses. When sentiment turns on a particular trend – for example the recent advance in oil prices, after a period of weakness – then an active alert investor might wish to capture the development, by either closing a negative position or adopting a new positive one. In the example of oil, this might take the form of opening a new ‘long’ exposure to the anticipated rising price of the commodity (via an ETF on oil or buying a specific oil company) or by exiting a previously successful short exposure (perhaps established by using a spread bet on the commodity or on an oil exploration stock). Either way, this investor could be viewed as being a trader - in that he or she is endeavouring to capture some of the ‘ups’, ‘downs’ or ‘hotspots’ and thereby outperform the wider market – if only in the Satellite portion of the portfolio.

Beyond the trader seeking to capture the market’s favourite trends or momentum, there will be others adopting higher risk-reward strategies by endeavouring to study the movements in share prices (or other assets such as currencies or commodities) and thereby anticipate when an oversold or overbought situation arises (where a change in direction is emerging) or where an existing trend is being reinforced (and therefore likely to continue for longer). Often, by using geared financial instruments – like spread bets or contracts for difference (CFDs) – such chart-following, known as technical, traders will view these apparently anomalous valuation or pricing situations as opportunities to ‘add value’ beyond any Core long term positions they may possess.

Many famous long term investors like Mr Warren Buffet have argued the case for buying ‘out of favour’ or unloved company shares – usually in traditional, relatively simple straight forward businesses. Often these are undervalued by stock markets because such firms do not appear to offer exciting growth prospects. Currently, there are a number of reasonably successful sectors of British industry that bear a neglected appearance – something which may well continue in the short term while the worth of sterling remains the ‘main show in town’. As an example, house builders would come into that category, but seekers of company stocks displaying more immediate momentum will almost certainly be looking elsewhere; uncertainty surrounding the relative worth of the pound could remain an issue until the terms of the UK’s trade with Europe becomes clearer, (perhaps not emerging until the summer of 2019). Some active traders may decide to ‘go long’ on the perceived positive momentum stock (perhaps by purchasing the physical stock of an overseas earner) and ‘go short’ on the unloved asset (perhaps via a spread bet or CFD). Another trade for the Satellite part of the portfolio could be to buy the favoured uptrend security and counter it by selling the wider market (perhaps going short on an equity index, deemed to be overvalued or about to fall from favour, using a financial derivative instrument).   

So where in the UK market should followers of momentum look, if domestic businesses are viewed as unfashionable? Identifying businesses with significant overseas profits is easy enough, but finding attractively valued ones is increasingly difficult. The big multinationals, especially those boasting relatively defensive recession-proof business activities (such as pharmaceuticals, tobacco companies, food manufacturers) appear expensive, when compared to their longer term earnings multiple or rating. However, a number of medium or smaller sized company businesses (which this blog has commented on previously but, incidentally, are not owned by the writer) merit a mention, as they enjoy significant non-sterling revenue and have continued to see earnings upgrades from analysts within the broking community. Amongst those whose share ratings remain below the market average – and often offer attractive dividend income – are the following:

Bank of Georgia – a £1.1bn market capitalised business, set to deliver earnings per share (EPS) growth of 47% in the current year and a further 13% in 2017. This puts the shares of Georgia’s leading bank on a price to earnings (PE) ratio of 8.1x next year’s earnings, with a forecast dividend yield of 3.6%. Of 10 brokers currently publishing a view, 4 say Buy and 6 say Hold.              

Empressaria – a £53m market capitalised business, set to deliver EPS growth of 9% in the current year and a further 29% in 2017. This puts the shares of this international recruitment group on a PE ratio of 7.6x next year’s earnings, with a forecast dividend yield of 1.2%. Brokers with an independent view are scarce, with only 1 being found, recommending a Buy. 

GVC – a £2.2bn market capitalised online gaming business, set to deliver a decline of 28% in EPS in the current year but an 88% rise in 2017. This would put the shares on a PE ratio of 15.4x next year’s earnings, with a forecast dividend yield of 3.1%. Of the 7 brokers currently proffering a view, 6 say Buy and 1 says Hold.                          

OPG Power – a £213m market capitalised business, set to deliver EPS growth of 53% in the year to 31 March 2017 and a further 26% in the following year. This puts the shares on a PE ratio of 5.9x next year’s earnings, with a forecast dividend yield of 2.5%. Of the 4 brokers currently providing research on this Indian power generation firm, all say Buy.             

Paysafe – a £2.1bn market capitalised digital financial payments business, set to deliver EPS growth of 1800% in the current year and a further 14% in 2017. This puts the shares on a PE ratio of 12.9x next year’s earnings, but no dividend payment is forecast. Of the 9 brokers currently offering a recommendation, all say Buy.             

Plus500 – a £728m market capitalised international mobile retail financial derivative firm, set to deliver EPS growth of 9% in the current year and a further 8% in 2017. This puts the shares on a PE ratio of 8x next year’s earnings, with a forecast dividend yield of 7.6%. Independent broker opinion is scarce, with only 1 being found, recommending a Buy.                  

Playtech – a £3bn market capitalised gaming business, which is set to deliver a 4% decline in EPS in the current year but growth of 21% in 2017. This puts the shares on a PE ratio of 13.5x next year’s earnings, with a forecast dividend yield of 3.4%. Of 11 brokers currently proffering a view, all say Buy.             

XL Media – a £201 market capitalised business, set to deliver earnings per share (EPS) growth of 24% in the current year and a further 7% in 2017. This puts the shares on a price to earnings (PE) ratio of 9.4x next year’s earnings, with a forecast dividend yield of 5.7%. Of 3 brokers currently proffering a view on this digital marketer, all say Buy.             

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.