Andrew Holt discusses the legacy of the financial crisis, the ongoing threat of risk and the overlooked benefits of small caps with Miton fund manager Gervais Williams
For many, analyzing the current market outlook means looking at US President Donald Trump and a potential trade war or another variation on the geopolitical scene. For Gervais Williams, the award-winning fund manager at London-based Miton Group, it begins with quantitative easing (QE).
‘The advantage of QE when it was first initiated was that it distorted market prices,’ Williams tells IR Magazine. On this insightful narrative, he notes that after the global financial crisis, QE encouraged investors to allocate capital away from government bonds into more volatile asset classes, such as property and equities.
‘Our collective problem is that the political cost of using QE was perceived to be so low that the policy has been overused,’ Williams notes. ‘Hence, after a decade of market price distortions, we find the wrong market signals have led to a long-term change in behavior. Generally, it has been more advantageous for corporates to maximize current cash payments to shareholders, rather than invest in long-term productive assets. As a result, global productivity and wage growth have stagnated.’
The phasing out of QE leaves an adverse legacy from the recent past. ‘Generally, corporates have underinvested in the future, so their underlying cashflow is not growing as fast as it has in the past,’ observes Williams. ‘In addition, we have an ageing business cycle, which tends to be reflected in a lower sensitivity to collective risk.
‘When the downside cost of too much debt is a recent memory, there is a natural caution to gearing up corporate balance sheets. Ten years after the last recession, however, the recent memories are dominated by those who have generated substantial returns on growth stocks, including many businesses that are running at sizable losses.’
QE: Curtailing the cull
Williams draws the analogy of stock market investing being equated to a forest of trees, where the occasional challenges of a recession cull the weak or overextended. ‘But the introduction of QE curtailed the usual cull in 2008,’ he points out.
So now – a decade later, as the current business cycle matures, ‘we have a forest with fewer hardy specimens than usual. Come the next setback, we will be entering the downturn with a greater degree of vulnerability than might be appreciated.’ This is a stark warning from Williams: ‘When large trees fall, they tend to crash into others – so come the next downturn, it won’t just be the tallest that are vulnerable.
‘The current setback within the retail sector demonstrates the nature of this risk. With some of the most indebted retailers that have failed, the bad debts they have created have been damaging for some of their suppliers. Furthermore, the drop-out of anchor tenants in some shopping centers has greatly reduced the footfall for others that have remained open, so quite a few property companies have also suffered.’
Generally, the overriding issue when market liquidity reduces is that marginal borrowers tend to find it harder to access credit. ‘During 2018, these challenges have been magnified by US corporate tax cuts and tax reductions on cash balances, which have boosted the capital repatriated to the US away from other territories, and thus worsened the effect of the liquidity shortfall,’ Williams explains.
Risk and share prices
He therefore believes it is appropriate for fund managers to be ‘unusually’ attentive to minimizing financial risk. ‘We worry that companies that have previously managed to roll over debt might find it more difficult to refinance these balances in future,’ he says. ‘Ultimately, a number may fail to raise the necessary funds and end up in receivership. In summary, we worry that excessive debt may be particularly toxic in the near future.’
This risk is now being factored into share prices, with heavily geared stocks such as Interserve declining to such a degree that any restructuring of their debt will effectively leave the debtholders with almost all of the equity. ‘Valuations of many growth stocks have been marked down quite a bit recently, especially those that are currently loss-making and hence may run out of cash because their cash balances are finite,’ Williams says.
In this context, he notes that many of the largest growth stocks are listed on the FTSE AIM index, and during Q4 several of them suffered a severe share price setback. ‘This explains why the FTSE AIM All-Share Index fell 21.5 percent over the quarter, but the FTSE AIM 100 Index fell 25 percent. Note that the FTSE All-Share Index was down just 10.3 percent over the same period.’
Small caps: Coming into their own
In the future, UK investors face two headwinds. ‘First, there is growing economic evidence that world growth is slowing,’ says Williams. ‘Second, uncertainty may persist for some months over the terms of the UK’s exit from the EU. There are worries these factors could dilute market returns, especially for those listed in the UK.’
Given this, Williams emphasizes that Miton’s UK funds have not been set up on the basis of the UK economy being superior to others. ‘Rather, they were set up in anticipation of quoted small-cap stocks entering a longer-term period when they would outperform the mainstream indices, especially overlooked small caps, because they have a history of performing better than similarly sized growth stocks over the longer term,’ he expands.
At times of substantive change, he says small caps as a group tend to come into their own: ‘Specifically, their corporate agility is a great advantage in times of economic uncertainty – especially for quoted small caps given their scope to access external capital at times when it is scarce.’
Importantly in this context, following globalization, the UK is one of the few remaining markets that still retains a diverse universe of listed small caps. ‘While UK growth may be subnormal over the coming years, the advantages of quoted small caps are not easy to access elsewhere,’ Williams concludes. ‘Overall, we believe a small-cap strategy investing in overlooked stocks has real advantages in the current investment climate, as it did prior to the period of globalization.’
