By Kira Nickerson When the Merrill Lynch UK Dynamic fund launched onto the UK retail market last ...
By Kira Nickerson
When the Merrill Lynch UK Dynamic fund launched onto the UK retail market last year it inherited a AAA rating from Standard & Poor's based on the performance of its offshore predecessor.
The rating was also due to the longevity and strength of its investment team, which had built up an impressive track record.
The Mercury Offshore Sterling Trust UK fund, on which UK Dynamic is based, had been managed by Peter Davies, a member of the group's specialist team of eight that is used for high performance mandates, since 1997. Davies left the group earlier this year to join a hedge fund but before concern could develop about the fund's future, Merrill Lynch appointed Stephen Thompson, the head of the specialist team, as the lead manager of the fund.
According to Standard & Poor's report on the Most UK fund last year, when it received its AAA rating, the specialist team liaised extensively with colleagues in other teams, although it is not bound by the overall house view on sectors or stocks.
Despite the recent volatility, the fund has kept ahead of the market via choice investments in retailers and construction and house builders, including stocks such as Marks & Spencer, which for the year to the 16 March was the best performing stock in the FTSE.
For the three months to 13 March, the fund is ranked 17 out of 302 funds in the UK All Companies sector based on bid to bid returns of 0.6% compared with the sector average returns of -6.1% over that time period.
How defensively positioned is the portfolio at present?
We correctly anticipated the current market conditions a year ago and positioned ourselves defensively. We have been reducing the defensive position to a less aggressive position more recently. However, we retain a defensive 'tilt'.
Investor sentiment has remained volatile as markets contemplate the likelihood of a recession in the US. Our flexible style and focus on stock selection (within a concentrated portfolio of 40-60 shares) has enabled us to outperform.
We expect the Government to increase public spending, so we emphasised firms that are well placed to benefit from subsidies. Firms such as Amec and Balfour Beatty are likely beneficiaries. The strong demand experienced by these companies makes them attractive protection against an economic shock. Amec is also in the advantageous position of having the option to acquire the remainder of its strongly-performing French subsidiary Spie, which should enhance the combined group's earnings by some 15%. Other firms in transport-related areas should also benefit, such as National Express and Firstgroup, which are both bidders for rail franchises. There are also opportunities in the building and construction sector. Many firms in this industry are relatively small, which means that corporate activity is likely to release significant economies.
We remain underweight in the information technology hardware and software sectors, which aided relative performance. We expected strong investment to lead to overcapacity. This, combined with the prospect of slowing earnings growth due to cyclical factors, was likely to result in pressure on margins. For similar reasons, we are underweight in telecoms.
I am head of the specialist team and lead manager of the UK Dynamic fund, but while I may lead the investment debate at team meetings, all managers actively contribute. The team decide the 'team themes', which make up 30% of portfolio, and core stocks, which make up 50% of portfolio. As fund manager I introduce my own ideas for the final 20%, including more smaller and mid cap companies.
Our style is one of bottom-up stock selection, sector strategy is a secondary tool. We have controls on active positions on stocks (FTSE 100 at 5%, Mid 250 at 4%, FT Small Cap at 3%). In addition, we monitor the active risk of the overall portfolio using Barra. All the teams' portfolios have to be in a range of 3% to 5.5%. Sector restrictions are not used, although extreme weightings would lead to the active risk of the portfolio rising above the range. The portfolio generally holds 40-60 stocks.
This depends on market conditions. It could range from 100% over six months (such as fourth quarter 1999 to the first quarter 2000), to 100% over 18 months.
We are slightly overweight small/ mid cap relative to the FT All-Share.
We don't restrict ourselves to one particular approach. We try to identify things in a company that the market has not seen, such as growth rates, that have not been recognised. Whereas market analysts look at earnings growth for one to two years, we would look further out, make our own assumptions and often have forecasts significantly greater or less than consensus three years out. This often provides an investment opportunity.
We also look at changes in the external environment that could affect a firm. For example, Thames Water before the last election was suffering due to concerns about windfall taxes and the possible change in Government but we saw that as a buying opportunity as there was nothing in the company itself that had changed before, during or after the election. We try and look at companies in a different way to the market. Another example is Centrica. Originally it was followed by utilities analysts and compared with companies in that sector but we didn't see it as a utility and sure enough this eventually came through to the market.
Royal Bank of Scotland is a good one. Before its purchase of NatWest, the market gave it very little credit for potential cost savings due to the merger. We held a big position in the company and benefited when its earnings grew significantly greater than that forecast by the market. Particularly the way the market is at the moment, companies that can generate earnings growth internally are attractive.
We have also been keen on construction and house builders and we have made a lot of money there so far. We remain optimistic about the sector as we believe there is value still there. We are seeing an uplift in Government spending and so firms that play on that theme will obviously experience a more benign environment and good demand.
No, but I can see that companies involved in merger and acquisition are attractive at this stage in the market cycle. There is not a lot of earnings growth out there and so firms involved in integration are creating extra value.
It is difficult to call the bottom of a market. In the UK I can still see a lot of value, although not in technology, where I still see some downside. The concern is the US. The excesses of the past 18 months still have to be worked through the system so we may still see a further 5-10% fall in the markets. There was bubble and this is a correction of that bubble. Not long ago you could take a piece of wire, stick it in the ground and call yourself a telecom company and be valued at eight times what you spent. The new economy is real and there is a change in the markets, but we have moved too quickly. The internet is not the death of high street retailers overnight but over years it will change the way we buy. It's not the technology, but the speed of change we have to question. Looking ahead, overall, we are seeing some select buying opportunities. We see infrastructure as a theme and we are also looking for beneficiaries of lower interest rates such as retailers. Companies such as Next and Boots are on attractive ratings.
The outlook for the UK economy is relatively attractive, because it should be supported by stronger consumer demand. The UK is also much less exposed (than the US) to the downturn in technology spending.
Inflation has now been below the Government's 2.5% target for 21 months, which should give the Bank of England plenty of room to reduce interest rates in the event that domestic growth shows signs of slowing more sharply.
We favour sectors where capacity is shrinking while demand remains relatively robust.
We expect consolidation to result in cost savings, while under-investment has the effect of reducing supply.
We believe that earnings in the building and construction sector and sub-sectors within leisure (such as hotels) should be relatively robust, while general retailers may also benefit from the redistribution of capital.
The fund is underweight in technology and telecoms, where the capacity situation is the reverse (because of years of strong capital expenditure).
Our central view is that the US economy will achieve a soft landing, although the risk of a recession in the US remains.
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