The bombed-out cyclical shares the pros are buying

Which unloved shares are fund managers backing to recover and ride out recession risks?

These are strange and challenging times, with no shortage of headwinds keeping investors on their toes, including high levels of inflation, interest rate rises, the war in Ukraine, and the growing likelihood of a global recession.

Where does that leave fund managers trying to make allocation decisions?

Many have been leaning towards the safety of defensive holdings such as utilities and consumer staples in the volatile markets of recent months.

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At the same time, they have sold off not only growth stocks on high valuations but also stocks in some cyclical sectors such as consumer discretionary and materials, where they fear business will be hard hit if recession does bite this winter.

Economically sensitive stocks under the cosh

Carl Stick, manager of the Rathbone Income fund, describes the current situation as “an unusual paradox”. As he explains: “Rising interest rates have punished highly valued, longer-duration stocks (promising earnings in the future, not today), while recession fears have hit more economically sensitive, cyclical stocks.”

Both trends are very evident in the data: year-to-date (14 October), the MSCI UK Value index has fallen 0.4%, while its sister UK Growth index is down 20%.

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But although the threat of recession has by no means gone away, have the sell-offs been overdone?

Ian Lance, co-manager of the value-focused Temple Bar (LSE:TMPL) investment trust, points out that investors have been selling out of funds exposed to “cyclical value”, even after many of the stocks held by those funds had halved in value in 2022. “As a wise investor said to me many years ago: ‘If you are going to panic, panic early’,” he added. “Selling cyclicals now feels too late to us.”

Lance makes the point that it’s extremely difficult to invest tactically on the basis of trying to second-guess what’s going to happen in the economy, for better or worse. Instead, he said, investors are likely to be more successful following investing guru Warren Buffett’s advice and “exploiting the over-reaction of others to the swings of the economic cycle”. In other words, buying into unloved sectors rather than selling out of them.

Stick neatly sums up the current position for value-driven investors keen to exploit such swings. “Great uncertainties still prevail, but our focus remains on valuation – [how much recession] is priced in? And what if the gloomiest prognosis does not come to pass? The areas worth attention right now seem to be split into two categories: cheap 'growth' and cheap ‘cyclicals’.”

Time to start a watchlist of cheap shares

But Joachim Klement, investment strategist at investment bank Liberum, cautions that these are early days and the cyclicals’ story could come more strongly into its own in the coming months.

“We don’t think cyclical stocks will do well in the immediate future, because markets are in the process of pricing in a recession,” he says. “However, in September our early warning indicators for cyclical stocks stabilised for the first time in 2022. If this continues for three months or so, we could have a strong signal to buy at the turn of the year.”

He recommends starting a watchlist of interesting cyclicals now and beginning to buy them towards the end of the year as prices decline further.

Stuart Grey, who runs the multi-manager Alliance Trust (LSE:ATST) portfolio, is much more focused on time in the market than on short-term market entry points. He stresses that an investor’s time horizon is really important, and that if you’re buying stock with a 10-year perspective, you’ve priced in the various rotations that are a natural consequence of an economic cycle.

“We want to take a long-term view on businesses we own, so we put up with some market volatility to capture those long-term opportunities, he says. “But we also rely on reducing that volatility through the natural diversification provided by using various different styles of fund manager.”

Therefore, while the sub-managers may tweak their portfolios in response to emerging risks and opportunities, they are usually making marginal adjustments rather than “big heroic calls”.

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Indeed, that’s true of most fund managers’ reactions to these rotations, says Andrew McHattie, publisher of the Investment Trust Newsletter. He comments that that while some value-oriented managers have been picking up cheap cyclical stocks, “few will swing meaningfully from one investment style to another as market conditions dictate”.

He adds: “Investors usually want to back a particular style and are not seeking too much deviation from the manager.”

Opportunity knocks for bargain hunters

Bearing in mind those caveats, what kind of opportunities are value-focused managers favouring among these unloved sectors? As far as cyclicals are concerned, there’s considerable diversity in the sectors and stocks being picked up.

Stick has added a mix of businesses including packaging company Smurfit Kappa Group (LSE:SKG), Ashtead Group (LSE:AHT), the equipment hire business focused predominantly on the US market, and ceramics maker Vesuvius (LSE:VSVS), whose products are used in steel production.

Vesuvius provides “mission-critical technology that is crucial in managing the flow of molten metal”, says Stick. “This is heavy industry, and very capital-intensive, so it’s at risk in the face of economic slowdown. However, Vesuvius has continued to operate very well in its particular niche this year, and, in our opinion, market expectations around the broader industry are so negative that there’s plenty of room for upside surprise.”

Alex Wright, the contrarian manager of Fidelity Special Situations fund and Fidelity Special Values (LSE:FSV) investment trust, picks out banks as an interesting opportunity. “Banks are traditionally viewed as very cyclical and have de-rated in anticipation of a recession,” he says. Yet the current higher interest rate environment is a big advantage for the sector, and bank profits are now materially larger than they were in 2019.

Wright gives the example of NatWest Group (LSE:NWG), a top 10 holding in the funds. “Its earnings estimates for 2023 have more than doubled in the last two years and are still being upgraded, which is a compelling story in an environment where markets are seeing earnings downgrades and fears of more,” he comments.

Other similar holdings include Irish market leading bank AIB Group (LSE:AIBG), which is completing a three-year cost-cutting plan to improve returns, as well as Barclays (LSE:BARC) and Close Brothers Group (LSE:CBG). “Both stocks also benefit from some counter-cyclicality (where revenues are strongest when there is high volatility), Barclays through its investment banking business and Close Brothers through its retail brokerage arm,” he says.

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Against that, however, the Fidelity team has trimmed other more vulnerable cyclical stocks in light of the deteriorating near-term economic outlook, reducing exposure to areas such as housebuilders, advertising and big-ticket consumer items.

“Overall, we are now only slightly overweight consumer discretionary stocks, with a preference for less economically sensitive areas, smaller ticket items and self-help stories,” says Wright. “We are also underweight mining and energy, where we think many stocks are factoring in unsustainably high metals and oil prices.”

Temple Bar’s Lance points to stocks such as Marks & Spencer Group (LSE:MKS), ITV (LSE:ITV) and Currys (LSE:CURY). “We can go into the market today and buy such stocks on mid-single digit price-to-earnings ratios and generous dividend yields, yet it seems most people would rather sell these stocks than buy them.”

Liberum is looking ahead into 2023, but says that once inflation starts to decline (which it expects to happen after the October adjustment to the energy price cap), cost pressures should start to ease and cyclical companies with revenues in sterling should start to outperform. It highlights car advertiser Auto Trader Group (LSE:AUTO), facilities management business MITIE Group (LSE:MTO) and bowling alley group Hollywood Bowl Group (LSE:BOWL)as examples on the buy list.

Even historically more growth-oriented managers such as the Monks Ord (LSE:MNKS) team at Baillie Gifford are recognising that the threat of recession is throwing up opportunities among certain high-quality businesses viewed as cyclical by the market.

Jon Henry, an investment specialist on the Monks team, highlights prospects for companies with “well-capitalised balance sheets and good capital allocation abilities”. “Monks already owns several such businesses and is selectively adding others such as the purchase of Royalty Pharma (NASDAQ:RPRX) this year.”

Pharmaceutical companies are perhaps not the most obvious examples of cyclical holdings, but Monks views the opportunities to deploy capital and the expiry of patents as both naturally lumpy. The manager has also added some more conventional cyclical holdings to the portfolio, including online broker Charles Schwab Corp (NYSE:SCHW) and building supply merchant CRH (LSE:CRH).

The key message for canny investors is that on a long time frame, cyclical stocks are looking remarkably cheap – but you may have to wait a while to reap the rewards of your bravery. In the meantime, hold on to your defensives for shorter-term ballast.