A desperate hunt for ideas amid underperformance of Switzerland’s four mega-cap stocks has led to surging valuations in several mid and small-cap companies, with many nearing bubble-like levels.
In 2016, large caps have enjoyed great success in domestic markets such as the UK. However, it has been the reverse in Switzerland. The SPI Small and Mid-Cap Index (SPISMC) has outperformed the Swiss Market Index (SMI) (consisting of the country’s 20 largest stocks) by 12% since the start of the year and by 20% over 12 months to end of September.
This has nothing to do with company fundamentals, instead it reflects the severe underperformance of just two sectors and four stocks; Novartis and Roche in the pharmaceutical sector, and UBS and Credit Suisse in the banking sector.
Given their weightings, if these four stocks struggle then the whole index suffers, making mid and small-caps look more attractive.
The resulting problem is that, in only a handful of stocks, the demand for shares is pushing prices up to nonsensical levels in classic ‘bubble’ territory.
There are typically two types of fund in Switzerland – those with very low tracking errors to the index, meaning they have higher exposure to large-caps, and the more actively-managed funds where the manager’s focus is more on mid- and small-caps.
Our offering is somewhat unique, adopting an all-cap approach with a high tracking error and an 80% active share. We have opportunities in both large, mid and small caps, opposed to just one or the other.
To back this up with numbers, the 50 largest Swiss equity funds do not go above a tracking error of 4, with a typical level being 2. Our tracking error is 7.5. This all-cap structure gives us the chance to move away from the extremes we are seeing in the market at present, while others might be restricted.
For example, we were heavily exposed to small-caps during their period of outperformance, but right now we think valuations look more attractive in large-caps and we have substantially bought back into them.
This year, our weighting to large-caps has risen from 30% to 40%, a historically high level. Of the four names which have held large cap back this year, Credit Suisse is one we have heavily bought back into as we felt it had dropped too much.
Both Credit Suisse and UBS started the year at very unattractive valuation levels, so we held neither. However, following the large drops in their share prices, both became more compelling to us. Investors tend to forget that Credit Suisse is one of the world’s largest wealth managers, with a pretty stable business model, which can be picked up at chf13, with we believe a tangible book value of chf20, which represents good value to us. This is value as it is defined.
In terms of pharmaceuticals, our focus remains on Roche. We think it has more potential upside than Novartis, which faces more company specific issues.
In bubble environments such as this you need to have clear valuation targets for every stock. For example, we recently sold out of Interroll, an industrial firm that produces rollers and conveyors, a position held in the Fund since launch. Today, its set up is close to perfect, but so is its valuation. While its multiples have doubled in four years, there is little surprise potential left now. We became concerned when its share price rose 20% in one week, leaving all fundamentals behind, putting it firmly in bubble territory.
However, there are small and mid-caps where the story keeps improving. One example is Temenos, the number one vendor worldwide for third-party core banking software. It is the most expensive stock we hold but it is one we are happy to stick with as its growth case keeps getting stronger as the banking sector realises it must move to standardised software.
We can switch into much cheaper small- caps that are sitting on attractive valuations. One such is Metall Zug, one of the lowest valued Swiss industrial stocks. Having previously held its competitor Komax, whose multiples have doubled in two years, Metall Zug was trading on nearly half of its multiple, so we saw it as a good time to switch.
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