Old Mutual Global Investors’ UK Mid-cap fund is the most viewed factsheet across FE Trustnet over the past month – and there is a good reason why. The fund is a giant in the sector at £2.1bn and also the third best performer out of 252 funds over three years. It is on virtually every platform’s recommended list. What its many investors want to know is how a fund so exposed to the UK economy is going to perform in the new world of Brexit.
Manager Richard Watts doesn’t pretend to know what the final shape of Brexit will be. None of us do. But he’s not especially alarmed. “My personal view is that the economic impact is being overstated,” he says.
But he’s by no means an optimist; he believes the current economic cycle is in its mature stage and that the outlook for economic growth is at best muted.
“It feels to me that the underlying fundamentals for economic growth is that it is not going to be more than 2 per cent in the US or eurozone. Emerging markets could do better, pushing up the overall global figure to 2.5 per cent to 3 per cent, which is fine, but modest. That’s consistent with mid single-digit profit growth. So you can expect to see 4 per cent to 5 per cent profit growth and 3 per cent on dividends. People should accept that’s about as good as it’s going to get.
The risks, going forward, are around inflation. If sterling remains low, or falls further, and inflation spikes towards 4 to 5 per cent, then that’s very bad news, says Watts. But he reckons it could also come in at 2.5 per cent to 3 per cent, which will be far more manageable.
His thoughts on Brexit and inflation are shaping the portfolio directly. Marmite wars are going to break out everywhere, as producers try to push up prices but distributors try to hold them back. The result? Retailers are likely to see profit margins pared back as they do their best not to pass on price rises. Good for consumers, but not so good for the shareholders of retailers.
As a result, he has reduced holdings in stocks such as Greggs and Dixons Carphone. He’s also out of Howdens.
But while Watts is low on high-street retail, he’s a fan of some online retailers, such as Boohoo.com, who cannot only fight on price but also have overseas earnings.
To many investors, Boohoo is the next Asos. The cheap and cheerful online retailer has seen its share price roar back after a rocky start. Watts bought it at IPO in March 2014, when it was priced at 50p. A profits warning nine months later sent the stock down to 22p. But today it is trading at around 115p.
“Its growth potential is enormous, and to have double-digit profit margins at this stage of its development [it began in 2006] is impressive. About one-third of its sales are outside of the UK, and are growing faster than in the UK.
“But the UK business is also enjoying 40 per cent year on year growth. People look at it and see it as similar to Asos, although it has a market cap of £1.2bn compared to £4.5bn at Asos,” says Watts.
Boohoo is the fund’s fourth largest holding, at 4.9 per cent of the total portfolio. Another online stock, Just Eat, is his second largest, at 5.6 per cent. Like Boohoo, he bought at IPO in 2014, when it was priced at 260p. Now it’s 550p.
Watts takes punchy positions. Traditionally, small and mid-cap funds have tended to have large portfolios, reflecting the riskier and more volatile nature of the sector. But Watts runs a portfolio of no more than 50 stocks, and within that his top 10 makes up 40 per cent, and his top 30 accounts for 80 per cent. For him, portfolio management is about picking good stock ideas and holding them for the long term, with turnover usually below 20 per cent a year.
“I don’t think risk is any greater [with a concentrated portfolio] so long as you structure it carefully. So I don’t want positions that are 7 per cent to 8 per cent of the portfolio. If you get them wrong, you don’t have anything else. You need to be able to back yourself to be right six or seven times out of 10,” he says.
He believes that earnings expectations across the market are too high, and that consequently you need to hold stocks that really will maintain earnings growth.
But he also sees opportunities that have emerged since Brexit following the remarkable divergence in valuations since the June 23 vote.
“Overall, the mid-cap sector is on 14 times earnings,” he says. “But since June 23 it has become a polarised market, with UK domestic cyclicals marked down. Around 25 per cent to 30 per cent of the index is on very cheap multiples, reflecting fears of a UK economic downturn in 2018/2019. The other 70 per cent to 75 per cent of the market is a bit expensive. The multiples there are relatively full.”
So what are the stocks that are now looking underpriced? Watts is cautious, as he reckons some will remain cheap (such as high street retailers).
Indeed, he has reduced his overall exposure to the UK economy. But if you believe Brexit is not going to be a total disaster, then he says the housebuilders, the challenger banks (such as Aldermore and Virgin Money) and real estate stocks are all looking like value.
The good news is that if you believe the mid-cap sector represents a good bet, this fund remains open for business. In the past some funds have soft-closed once they became £1bn or £2bn in size. Not Old Mutual UK Midcap.
“If you look at the total market it is £340bn in size. There is no reason why this fund can’t be £1bn bigger.”
Biography: After studying maths at Oxford University, Richard Watts’ first job was at PriceWaterhouseCoopers’ investment management division. He joined Old Mutual in 2002 as an analyst, becoming deputy manager of the UK Select Mid Cap fund in July 2006. Over three, five and seven years he has consistently outperformed his peer group, according to FE analytics. Looked at on a year-by-year basis, he has outperformed every year since 2009 except in 2011, when he lagged competitors by a small amount. He enjoyed an exceptional 2015, recording gains of 25 per cent when his peer group average was around 5 per cent, according to FE. He says most of his outperformance is attributable to stock-specific gains rather than macro-based decisions.
£2.1bn Old Mutual UK Midcap fund’s total assets
40% Proportion allocated to the fund’s top 10 holdings
3rd Fund’s sector ranking over a three-year period
50 Upper limit for number of stocks held in the portfolio
£340bn Size of UK mid-cap market
KEY TAKEAWAY: While not completely optimistic on the outlook for the UK economy, fund manager Richard Watts is seeking opportunities in the polarisation of the mid cap market following Brexit. Housebuilders, challenger banks and real estate are areas of the market Watts sees value. Punchy positions in a portfolio that does not exceed 50 stocks has paid off in the past, with the fund on nearly every platform’s recommended list.