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Profits in unfashionable funds By Jeff Salway
We have all seen deeply unfashionable things become inexplicably popular again. From flares, flat caps and puffball skirts to ballroom dancing, many fashions seemingly consigned to the dustbin of history can suddenly get another The same applies to investments. This was an extreme example of the dangers of following investment fashions is the Dutch tulip frenzy of the 1630s. Tulips became so popular in Holland that speculators started trading them. Things reached a head and tulip prices crashed from around (the equivalent of) £40,000 to less than £1. But similar scenarios occur on a regular basis - most famously, the technology, media and telecoms sector bubble, which burst even quicker than it grew at the turn of the millennium. Popular sectors In the months to mid-2006, eight fund companies launched BRIC funds (Brazil, Russia, India and China), resulting in more money being invested in emerging markets in the first quarter of last year than the whole of 2005. Meanwhile, the launch of real-estate investment trusts (REITS) in January further fuelled investment in property vehicles - recent research from Fidelity found that 96% of IFAs are regularly recommending property funds to clients. There's a core of investment areas that, while never really fashionable as such, are always very popular, such as UK blue chips. Smaller companies sector However, when Moneywise celebrated its 200th issue back in February, the fund that had put in the best performance since we launched in 1991 - a period that takes in several bull and bear markets - was not a special situations, emerging markets or blue chip fund, as you might expect, but Schroders US Smaller Companies fund run by Jenny Jones. And this wasn't just a one-off. The US smaller companies sector overall generated better average growth, at 550%, than any other over that 16-year period. Industry figures reveal that the best-performing sector over the last one, five and 10 years has been European smaller companies, with the UK equivalent in second place over 10 years, third over five years and second again over the last year. If you'd invested a lump sum of £1,000 in the average European smaller companies fund in 1997, you'd now have a useful £2,705 to show for it. Given figures like this, you would assume that millions of investors would have ploughed their money into US smaller companies funds, hooked in by the potential for stratospheric returns. Yet since 2001, sales of both UK and European smaller companies funds have been in freefall, with the UK sector the worst seller of all in 2006. So why are people investing less and less in funds that are continuing to perform brilliantly? The key reason is fashion - most investors are swayed by hype. Which sectors to invest in? Another sector that frequently gets shunned by all but the most perceptive investors is biotechnology. There are admittedly less compelling reasons to invest, but again that doesn't mean there aren't profits to be made by brave investors. Elsewhere, Japan has had a shocking time and has become a decidedly unfashionable investment. One Japan fund that has survived tough times is the JO Hambro fund, run by the contrarian Scott McGlashan. Some sectors aren't out of favour because they've hit new lows, but simply because they don't offer the potential for stellar returns. Included in this category are tobacco and utilities. With governments around the Western world increasingly cracking down on smoking, the tobacco industry, in particular, doesn't seem a great bet for the future. While most fund managers are leaning to riskier sectors, Neil Woodford, one of the UK's most highly-regarded managers, has invested almost half his Invesco Perpetual Income fund in utilities and tobacco. Currently, three of his top six holdings are in tobacco firms, accounting for 15% of the fund. Contrarian styles Woodford's policy, like Scott McGlashan's at JO Hambro, is a typically contrarian one. But the best-known exponent of contrarian investing is American investment guru Warren Buffett, who has made billions out of swimming against the tide. His approach, at its most simple, is like that of a special situations fund manager - he buys profitable companies that are out of favour with the market and holds onto them indefinitely. Part of Buffett's success is down to the fact that out-of-favour stocks will outperform the favoured ones over time. So while the likes of Woodford, Buffett and the ex-Fidelity special situations manager, Anthony Bolton, are not investing in bad firms (they must at least have the potential to be good), they are focusing on the value they can get over the longer term as companies start to recover or to grow. And to date, this is a strategy that has paid off. In addition to Woodford, there are still a number of fund managers who thrive on going against the grain - Jeremy Lang, manager of the Liontrust First Growth and First Income funds, and Peter Webb, founder of Unicorn Asset Management, are other classic contrarians. There's also Patrick Evershed, who runs the New Star Select Opportunities fund. While at Rathbone, Evershed was one of the few managers - Woodford was among the others - to sell out of technology stocks before they crashed in 2000. Funds that thrive on going against the grain New Star European Growth, with high exposure to banks, this fund has grown 16.7%, 110% and 123% over one, three and five years respectively - all above the sector average. AXA Framlington Biotech has grown 11.6% and 28.7% over three and five years respectively. Over 80% of the fund is invested in US companies. Schroder US Smaller Companies has consistently outstripped its sector, returning 49.6% and 41.7% over three and five years. Threadneedle European Smaller Companies has risen by 214% over five years - well above the sector average - 166% over three years, and 22% in the last year to 31 March. How to spot a contrarian They often see negative sentiments about a company or market as a sign to invest in it. When something seems a little too comfortable, they get out. They are attracted to unloved, neglected stocks and sectors that most managers overlook. They are independent-minded and view opportunities clinically, without emotion. They have a high level of confidence and belief in their ability - as well as a big ego - because going against the herd can take real conviction. They are stubborn. When they avoid robust trends - such as the technology boom in the late nineties - their funds will lag behind their peer group until the bubble bursts. But, by sticking to their guns while they wait for cycles to peter out, they hope to avoid getting stuck in stocks or markets with unrealistic valuations that end up tumbling dramatically. Don't believe the hype? So, when you invest, you need to do your research to balance out the risk versus the potential reward to make sure it makes sense for you. Don't just invest in something because everyone else is. As the tech boom proved, the herd isn't always right.
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