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Fund focus: Hermes US SMID Equity

Paloma Kubiak
Written By:
Paloma Kubiak

With the world’s attention on the US, investors will no doubt be looking for opportunities. We talk to Hermes US SMID Equity fund lead manager Mark Sherlock to find out why his strategy enables him to pick stocks from a diverse universe which provide long-term asset price increases.

The US market is notoriously difficult for fund managers to outperform in due to its efficiency and maturity and as such, passives or trackers are seen as a cost-efficient way for investors to make money.

However, Mark Sherlock, lead manager of the Hermes US SMID Equity fund says that the Russell 2500, an index of the smallest 2,500 companies in the United States which is “much less covered” provides him with a greater opportunity to outperform.

He explains that much like the UK’s FTSE 250 home-weighting, the States’ Russell 2500 index has more exposure to its domestic market and therefore sources most of its earnings internally from the US rather than from overseas.

Sherlock says: “The small and medium cap companies have larger exposure to the US market, in the region of 70-80% while the large caps have around 50-55%. If the US economy is improving, we want exposure to that economy.”

The Hermes US SMID Equity fund invests primarily in US equities which are considered the riskiest asset class but his low-risk approach seeks to provide investors with long-term capital appreciation from small and mid-cap sized companies.

With 2,500 stocks to choose from, Sherlock whittled his holdings to just over 50 with his strategy of finding “dull” companies and industries with high, as opposed to low, barriers of entry. His time horizon is around the four-to-five-year mark, while the New York listed stocks only have a horizon of four months.

‘Look for dull companies, not the next shining star’

Amazon, Apple, and Google are big and successful names from the States but for Sherlock, he says he’s not looking for the next big thing.

“We look for dull businesses while a lot of the market is looking for the hare, we’re looking for the tortoise,” he says.

He gives the example of Ellie Mae, a disruptive tech business which automates residential mortgages helping to speed up the process and cut costs.

“Every single process of buying or selling a house is automated and in the states, the mortgage market is quite labour intensive and prone to mistakes. Ellie Mae does this all electronically. We came across it five years ago and it’s up five to six times. Now it’s an expensive stock so we’ve taken profits from it,” Sherlock says.

He says that in the last 12 months the fund has been tilting more towards cyclical stocks such as industrials, energy, materials and banks. He’s topped up his bank holdings as he believes interest rates are likely to go up, so it should help them as margins have been squeezed in the last few years.

High barriers to entry

While other fund managers may look for easy or low barriers to entry, Sherlock explains why he looks for high barriers such as competition and costs. “We thought hotels were difficult to disrupt but look at Airbnb. We also thought taxis were difficult but now we have Uber.”

Sherlock includes FLIR Systems – infrared cameras and thermal imaging in his portfolio of stocks. “The barrier was that it was the least cost-productive company, with equipment costing £10,000 which was used for border control. Now the price is less than £100 as the heat map technology is used in high-end cars and boats, in maintenance equipment to source heat escape and for vets to spot infections in animals,” he says.

A hybrid of the “dull” and “high barrier to entry” company is Martin Marietta Materials, an infrastructure materials aggregate. Sherlock says: “Rock quarries have great barriers as it’s difficult to get a new quarry opened so per tonne, it’s very cheap and it’s also uneconomic to transport the material more than 50 miles. But it now has a higher level of profitability than at the peak of 2006 and it’s producing more volume so the margins should be much higher.”

‘Trump to turbo-charge the economy’

But with Donald Trump’s unexpected win to become the 45th president of the United States, with his rhetoric and policy implementations already gaining ground, Sherlock say that the Trump economy he inherited is in a “pretty good state” and he expects it to be “turbo-charged” by the new president.

“This is an exciting place to be. Away from the headline grabbing Trump, the real story is about the economy and in economic terms, there are four main pillars all of which will be positive, including for small and medium caps.”

Corporate taxation: This is currently 35% in the US but Trump’s looking to reduce it to 20-25% which is good news for companies.
Repatriation of the US dollar:
Around $2trn are overseas and not being repatriated because of the 35% corporation tax. The proposed 10% repatriation tax means that billions of dollars will be brought back to Fed coffers to build roads, plus the money can be added to corporate balance sheets allowing them to invest in capital equipment as well as to buy back stock or complete mergers and acquisitions (M&A).
Deregulation allows an economy to do business cheaper and faster which will be a good thing. Sherlock says: “It won’t particularly benefit SMID but sectors to benefit are financials and energy.”
Road ways are in a pretty poor state and major transport is in fairly poor repair, requiring significant infrastructure spending. Trump is pro-growth though he will need support from the fiscally conservative democrats who may oppose his policies to get some infrastructure spending through.

“His personality and timing is an issue. It will take years but the market is impatient so there will be periods of market volatility but when there’s higher volatility, it will allow us to go shopping. Volatility creates great entry points and it’s a great opportunity to get involved; that’s why we have a long-term perspective to smooth it out. In the short-term, this is helpful for SMID companies as it makes imported goods cheaper. Our long-term, low-risk strategy will work over a multiple year period,” Sherlock says.

‘Fund has consistently outperformed’

An independent fund researcher, Darius McDermott, managing director of Chelsea Financial Services, gives his view on the Hermes US SMID Equity fund and its lead manager:

“Mark was original co-manager on the fund and was made lead manager in 2013. He looks for quality small and medium sized businesses with minimal debt, in industries with barriers to entry, or that provide products or services that cannot be easily replicated.

“From an original universe of the Russell 2500 he narrows it down to a ‘watch list’, and will then look at the quality and consistency of earnings before assessing valuations. This is done with an in-house tool that tests investment rationale for companies, even in difficult environments. He wants to see the potential for at least a 20% increase to the current share price. Both before and after investment, he and his team will regularly travel to the US to ensure they meet and engage with company management.

“Against a market notoriously difficult to beat, Mark has built an enviable track record, outperforming the average US equity fund and the index consistently over the years. The team’s lower risk approach to an otherwise higher risk investment area is grounded by a solid and understandable process with sensible constraints, but enough flexibility to give the fund a great opportunity to excel.”