ISA ideas: where should contrarians look for opportunities?

At a time when we have become accustomed to the Nasdaq almost single-handedly fuelling our portfolio returns, it can be hard to volte-face and look for the next great investment opportunity.

The herding of investors into US tech giants over the past couple of years of solid gains has created a concoction of concentration risk and valuation risk. Now more than ever, investors need to be diversifying away from the “Magnificent Seven” and into other sectors.

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Today, US equities comprise nearly 70% of the global market, up from less than 45% in 2010, and some 75% of the S&P 500 market capitalisation is accounted for by just 50 stocks, says David Aujla, multi-asset strategies fund manager at Invesco.

What this means is that 70% of a global portfolio depends on the performance of a single country’s market, and 70% on the performance of just one currency. “Consequently, if US equities fall out of favour, or if the UK pound appreciates against the dollar, it could significantly impact portfolio outcomes for UK based investors.”

How to slim down US tech giant weightings

One way to reduce exposure to Big Tech is to switch some of your portfolio into a passive position in the S&P 500 Equal Weight index via an ETF, which assigns equal weight to all companies, regardless of market capitalisation. This will improve your diversification across market segments.

Examples on interactive investor include the Invesco S&P 500 Equal Weight ETF Acc GBP (LSE:SPEX) and Xtrackers S&P 500 EW ETF 1C GBP (LSE:XDWE). Both rebalance the stocks quarterly, taking profits from winners that have increased above the 0.2% weighting, and topping up those that have fallen below the 0.2% weighting. The yearly charges for the ETFs are the same at 0.2%.

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However, it is dangerous to rely too heavily on even the broader US market for continued growth as Trump policies such as tariff hikes and a squeeze on labour supply growth are stoking inflation, which rose to 3% in January, its highest rate for six months, encouraging the central bank to hold interest rates unchanged.  

“There’s little question that thebig consensus view right now is US exceptionalism - markets are essentially implying that the US economy will continue to chug along at a 3% rate, the dollar is the only game in town, and as a result, Treasury yields will continue rising both outright and relative to other bond markets,” says Mike Riddell, portfolio manager of the Fidelity Strategic Bond W Acc fund. 

However, he believes “this theme has run its course. In a similar vein to 2017 with Trump 1.0, the big trades this year may well be to fade the US dominance narrative. US growth will likely weaken anyway, which I’d expect to push the dollar and Treasury yields (US government bonds) weaker.”

Smaller company comeback?

Fortunately for contrarian investors, smaller companies the world over are sitting at steep discounts versus their larger peers, representing an unusual buying opportunity.

“Over the long term, small-cap companies have tended to outperform their larger-cap cousins, once referred to as the small-cap effect, which has been forgotten in this period of mega-cap dominance,” says David Lewis, investment manager in the Independent Funds/Merlin team at Jupiter. “The small-cap space has the benefits of being extremely diversified, thinly covered by sell-side analysts and full of nimble companies looking to innovate their way to success.”

This is particularly true of the UK market. Fund managers say there are plenty of resilient UK businesses, particularly as you delve down the market-cap spectrum.

“With the drive to global allocations, we have seen an increasing concentration in the US, which has meant lesser markets have become sidelined,” says Ian Rees, head of multi-manager funds at Premier Miton. “This lack of demand for UK equities has resulted in the UK market looking very cheap relative to its own history, and unfairly cheap compared to its developed market peers. Private equity and overseas buyers will likely seek to take advantage of these cheap prices.”

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The UK’s healthy dividend culture is also often overlooked, and is sustainable given the strong cash-flow generation and dividend cover. “The underwhelming capital performance creates the opportunity for improved performance from here,” says Rees. “And in the interim, you could be paid a very healthy yield to sit and wait.”

Abby Glennie, co-manager of abrdn UK Smaller Companies and abrdn UK Smaller Companies Growth Ord (LSE:AUSC) trust, points out that “being positive on the UK as a whole is quite contrarian now”.

She adds: “The overall earnings growth forecasts for 2025 for the UK small-cap universe is 10%, which isn’t to be sniffed at…if achieved. Your valuation entry point on UK markets is pretty appealing, so delivery could drive strong returns.

“Many sectors are struggling such as industrials, consumer, and housebuilding, but there are resilient businesses across a range of sectors which are consistently delivering and have taken the inflation and growth challenges in their stride.”

She names food producers such as Cranswick (LSE:CWK), Hilton Food Group (LSE:HFG), and Premier Foods (LSE:PFD), global shipbroker Clarkson (LSE:CKN), review platform Trustpilot Group (LSE:TRST), financial solutions company Alpha Group International (LSE:ALPH), subsea equipment rental firm Ashtead Technology Holdings Ordinary Shares (LSE:AT.), ME Group International (LSE:MEGP), with its big European presence in laundry and photo facilities, and Cairn Homes (LSE:CRN), the Irish housebuilder experiencing quite different conditions to its UK peers.

Martin Currie, abrdn, Artemis and Liontrust offer respected UK smaller company funds, while the £39 million Unicorn UK Smaller Companies fund is worth a mention because it's tiny and can move nimbly to buy tiddler stocks. Long-standing investment trust Henderson Smaller Companies Ord (LSE:HSL) is favoured by interactive investor analysts due to its inclusion in its Super 60 list of investment ideas.

Claudia Sheinbaum, president of Mexico. Photo by ALFREDO ESTRELLA/AFP via Getty Images

Overseas opportunities

For something a bit different, Kirsty Desson, manager of abrdn Global Smaller Companies I Acc fund, also a member of the Super 60, says Mexico is a standout, as President Claudia Sheinbaum is proving more pragmatic than feared. She has laid out her economic vision, focusing on alleviating reliance on Chinese imports, helping domestic steel producers, and strengthening North American trade - measures aligning Mexico to the US and addressing Trump’s allegations of Mexico acting as a back door for Chinese imports.

“After a phone call with Sheinbaum on 3 February, Trump agreed to pause proposed tariff implementation by one month,” says Deeson. “Despite this uncertain backdrop, much of the bad news appears to be priced in.”

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Latin American countries are also hotly tipped in the bond market. Emerging market bonds have been totally out of favour for almost a decade, with local currency debt at rock-bottom levels.

Ridell notes that local currency emerging market bonds “could deliver outstanding returns”. He adds: “Brazil in particular is very unloved. The Brazilian real is now around the cheapest level in over 20 years on a trade-weighted basis, and its local currency bonds are yielding just shy of 15%.  It’s easy to see how a bout of dollar weakness and a Federal Reserve easing cycle  - which is now barely priced in - could be the catalyst for a substantial emerging-market local bond rally.”

Commodities: a hedge against inflation and geopolitical risk

For further diversification, commodities are always a good hedge against inflation and geopolitical risk, particularly in the light of Trump’s inflationary policies. “The longer-term outlook for commodities seems encouraging as major central banks continue easy monetary policy,” says Dzmitry Lipski, head of funds research at interactive investor.

He adds: “Furthermore, heightened uncertainty driven by a wave of Trump’s policy announcements and the prospect of additional fiscal stimulus from China should support commodity prices, particularly for precious metals and energy transition metals (eg copper). Meanwhile, external factors, such as extreme weather events, have caused surges in prices of certain soft commodities such as coffee and cocoa. Some experts are even speaking of the early stages of a new commodities supercycle, led by copper.”

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Lipski highlights WisdomTree Enhanced Commodity ETF - USD Acc GBP (LSE:WCOB), which tracks the technical Optimised Roll Commodity index, which should outperform the widely followed Bloomberg Commodity Index over the long term. “The fund’s effective cost management and lower-risk profile gives the strategy a competitive advantage against other funds in the sector,” Lipski says.