The pros relying on the micro as macro storm rages

First and foremost fund managers pick stocks, but at times the macro proves to be too much of a headwind. 

In fund management lingo, ‘top-down’ and ‘bottom-up’ are used by fund managers in everyday conversation to explain how they pick shares when building a portfolio.

Those who describe themselves as top-down investors factor in the big picture, examining wider economic trends, while a bottom-up investor ignores the so-called macro and focuses specifically on the fundamentals of a business.

In reality, most fund managers pick stocks first and foremost, but consider the wider economic backdrop. After all, it seems hard to ignore how interest rate rises impact companies. Interest rates influence the “risk-free” rate, which is important for the way a stock is valued. 

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Those who focus on the micro rather than the macro point out that over the long term it is the former that is the biggest driver of returns. 

However, over shorter time periods, macro headwinds can prove to be a painful and sobering experience, as the past 18 months has shown as interest rates increased from 0.1% to 5%. 

Two examples of the many investment trusts that construct portfolios on a bottom-up basis are Monks (LSE:MNKS) and Montanaro UK Smaller Companies (LSE:MTU). When issuing financial results this week, both trusts referenced rising interest rates as a dominate theme impacting stock markets.  

Monks, one of many investment trusts in Baillie Gifford’s stable investing in quality growth stocks, said in response to its disappointing performance that it has taken action to reposition its portfolio by reducing exposure to its highest-risk stocks, which it labels ‘rapid growth’. 

The fund managers, Spencer Adair and Malcolm MacColl, acknowledged that they have “made mistakes”, which led to the changes. Over its financial year, which runs to the end of April 2023, Monks’ share price declined by 7% versus a rise of 3.2% for its FTSE World Index. 

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However, the fund managers are upbeat on the long-term prospects for the way they invest. 

They said: “The operating environment for companies has undeniably changed. We have reflected on where we may have done better and adjusted the portfolio. We are confident that the companies we own for Monks are well-placed to adapt and thrive. 

“Monks’ proposition is clear, namely, to grow savers’ capital over the long term. The most certain way to do this is to invest in companies that grow their earnings over long periods - this is the hard currency of returns. We are fortunate to be able to look across the growth spectrum and around the world for ideas.” 

Charles Montanaro, the veteran stock picker who manages Montanaro UK Smaller Companies, apologised to shareholders for the worst three-year underperformance since it launched in 1995. Over the year, to the end of March 2023, its share price declined by 12.4% versus a loss of 7.9% for its composite benchmark. Over three years, its share price has gained 18.1% compared to 50.8% for the benchmark. 

Montanaro explained that the macroeconomic backdrop has negatively impacted sentiment towards UK smaller companies as a whole. 

He said: “The negative performance of UK SmallCap as an asset class can be attributed to the combined effect of rising interest rates coupled with investor concerns over a possible recession in the UK. 

“According to the Investment Association, investors redeemed a record £1.3 billion from open-ended UK SmallCap funds in the 12 months to 31 March 2023. In addition, MUSCIT suffered from its exclusive focus on quality and growth companies, which as a whole underperformed.” 

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However, Montanaro stressed the important of investing for the long term. He points out that over the very long term – since January 1955, UK SmallCap has outperformed in 78% of the 70 ten-year rolling periods since then and in 99% of the 30-year rolling periods. 

He also says that the macroeconomic picture may improve, although he claims “no expertise in forecasting macro-economic developments and waste[s] little time in trying to do so”.

Instead, Montanaro says he is reassured by the operational performance of the smaller companies he invests in. 

“Many (not all) have posted good numbers in the latest reporting season, giving us the confidence that in our quest for good companies with outstanding management, we have identified those that are not only growing, but are doing so from a position of strength. 

“History has shown us that it pays to invest in and back high-quality companies with good pricing power, strong competitive positions in markets with high barriers to entry, robust balance sheets and highly motivated, entrepreneurial management with exemplary standards of corporate governance.”