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The growing season

James Smith assesses the strategies of some of the top performers in the UK all companies sector

UK all companies funds have had a difficult 2010 in sales terms, with the sector the least popular with retail investors in February, March and April.

This reflects general risk aversion to some extent but other equity sectors have overtaken as a default option – with absolute return, cautious managed and UK equity income all eroding UK all companies’ market share.

This trend fails to reflect improving performance from the sector, with its average 13.2 per cent over 12 months to October 4, outperforming UK equity income as well as all the other developed world markets.

Over the last one and three years, the sector’s best overall performer is Slater growth, run by Mark Slater, almost 50 percentage points ahead of the average for three years. He recently refined the process, introducing a purer focus on favoured low price to earnings’ growth ratio stocks with good earnings’ growth and a strong outlook.

He says: “Our holdings will typically be in either fast-growing or niche areas as companies able to show consistently dynamic earnings growth will be re-rated upwards, particularly in more difficult markets.”

Slater highlights niche stocks such as Aim-listed Hutchinson China MediTech, with strong turnover and profits and no debt. “This company is exposed to the China theme but a healthcare stock is not dependent on whether GDP grows 6 per cent or 9 per cent whereas commodity plays are.”

He says as a general rule he prefers to invest in companies not dependent on the economic background and capable of growing in all conditions. “Within the fund, we have been careful to avoid problem areas, in particular, stocks and sectors that are consumer facing (with the exception of SuperGroup) or exposed to government cuts.”

Mid caps have generally struggled in recent years, particularly during the flight to blue-chip safety in 2008, but they have also rallied hard since the low of March 2009 – and two of the top six funds over three years focus on this part of the market.

Fourth ranked is Derek Mitchell’s Royal London UK mid-cap growth, with the manager highlighting a supportive spell of merger and acquisition activity.
Mitchell says: “Mid and small-cap stocks have merited their inclusion in portfolios this year and I expect outperformance to continue given that most bid activity will take place in this part of the market. Companies are currently flush with cash following their cost-cutting efforts during 2008 and 2009. According to research from Morgan Stanley, UK plc is now sitting on £140bn of cash, which is equivalent to 11 per cent of market cap or 8 per cent of total assets.”

Mitchell says the most likely candidates for future merger and acquisition activity are likely to come from three main areas – commodities, industrials and technology.

Another consistently sector-topping mid-cap manager is Rensburg Fund Management’s Paul Spencer and he highlights the FTSE 250’s diversity as a key advantage over the FTSE 100. In the latter, for example, oil and gas producers account for 21 per cent of the market capitalisation, compared with just 4 per cent in the 250.

Spencer says: “Mid-cap funds therefore have the capability to add genuine balance by providing exposure to often much more attractive industry sectors.”

In recent months, Spencer has been moving his UK mid-cap growth portfolio back towards a balanced operating-profit split between UK and overseas. Two months ago, the split was 65/35 in favour of overseas and the manager has sold down Dana Petroleum and Weir and bought Britvic and Persimmon to change the skew.

Spencer says: “The rationale for this is growing concern that a very crowded trade has developed in companies with overseas exposure, at the same time as genuine valuation anomalies emerge in domestic companies. Some might raise an eyebrow at increasing our investment in UK-facing stocks at a time when the outlook remains bleak but we believe the market is now taking this fact into valuations.”

Other key themes on the fund include an emphasis on companies with strong balance sheets and positive cash generation. He says: “Net cash and surplus capital allow management to consider whether such resources should be used to make acquisitions, increase capital investment, build up working capital, initiate share buyback programmes or pay special dividends.”
Another top performer over three years is Liontrust special situations, previous known as First opportunities, run by Anthony Cross and Julian Fosh based on their economic advantage process. This focuses on buying high quality growth companies with intangible strengths, as these create defendable barriers to entry that competitors struggle to reproduce.

Economic advantage has three main strands, intellectual property, distribution and recurring contracted revenue and Cross says much of the fund’s success has been down to the focus on well financed businesses during 2008 and early 2009, with many that were forced to seek new capital downgraded.

Like most managers, he wants to buy underappreciated companies and highlights cyclically cheap opportunities to buy stocks like Michael Page and Carpetright last year.

Overall, the process tends to keep Cross consistently overweight in some sectors, while being consistently underweight in others. The fund currently has little in housebuilders, mining companies and retail banking, for example.

In contrast, he is usually overweight in areas where intellectual capital is key, namely manufacturing, pharma-ceuticals and technology. He says: “We remain heartened by the continued strong profit performance of nearly all of our businesses. This is particularly the case with our international engin-eering and service companies and UK stocks with good recurring revenue streams, notably in software. We are more nervous about UK-centric cons-umer companies and those exposed to public sector spending but the fund has little exposure to these areas.”

Two of the sector’s up and coming stars also feature in the top performers, with Standard Life Investments UK equity unconstrained and Legal & General UK alpha both passing their five-year anniversary this year.

Ed Legget’s SLI fund has benefited from a large stake in mid-cap stocks, with a considerable overweight position in industrials, and the manager’s early move into cyclical stocks was also rewarded strongly last year.

As for the L&G offering, manager Richard Penny uses a barbell approach to hold strong growth and deep-value positions from across the UK market.

Penny says: “One deep-value play we made last year was with so-called fallen angels. 2009 saw a number of mid caps drop into the smaller-cap indices. These were fundamentally good businesses with strong management and we took a view they were underpriced. We capitalised on these before most investors could take a position and some were also prevented from doing so by their mandates.”

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