RICHARD WATTS has been deputy manager of the Old Mutual UK Select Mid Cap fund since July 2006 and will become lead manager from January 1, 2009.
Q: Can you explain your investment style?A: My style is pragmatic, as it is across the desk. We blend top-down with bottom-up analysis. We have a firm and clear idea of the top-down view over the next six to 12 months, involving growth rates and interest rates and any other factors of merit, for example commodity prices. That sets the overall positioning. Once we have the top-down views we look at setting the overweights and underweights.
Turning to the bottom-up [research], we do a lot of detailed forecast numbers work. We go through spreadsheets looking at sales growth and margin structure. We put this all together and focus on three criteria. The first is identifying stocks that can beat market expectation.
The second is identifying stocks that offer the potential for a re-rating. The third is identifying stocks where earnings growth will be at least as much as the earnings average. Ideally a stock will meet all criteria, but it has to have at least one for us to consider buying. The idea behind our approach is that it allows us to change the position of the fund depending on the market conditions. It gives us flexibility.
Q: The largest weighting is industrials, at 36.2% followed by consumer services. Can you explain why?A: Industrials is a broad category. It includes energy stocks and support services stocks for example. The characteristics of these sectors are different. We are overweight in areas that have defensive growth characteristics and have been positioned in these areas for some time. We are overweight the support services sector. The revenue is highly visible and is contract-based, with three-to-five year contracts in place. They are outsource-driven opportunities and have growing earnings streams.
Q: Can you give an example of a stock you hold in the support services sector?A: Sirco is a company that provides a range of services and activities to a whole list of clients, such as local housing authorities and regional government departments. For example, they monitor prisoners on tag release and [provide] refuse collection [services]. The key reason we like Sirco is you have visibility of revenue on a 12-month view. Contracts can be anything from three-to-five years.
Another stock example is Babcock. It provides operational and maintenance support to a range of key infrastructure assets, for example, naval dock yards. Some 50% of its profits are in those kinds of areas, operating and managing naval bases. They also operate in the power distribution sector and provide power lines in the UK and South Africa. They have a range of contracts with the MoD [Ministry of Defence]. These are key services they provide. This plays on the defensive growth attributes we’re looking for.
Q: What sectors are you underweight within the portfolio?A: We are underweight in areas linked to the consumer, for example the general retail sector. We think the UK consumer is under a lot of pressure and that will continue. That’s a function of inflation running ahead of wage growth, income has been declining.
Secondly, the availability of credit has been significantly scaled back this year, and the cost of that credit has been increased, so debt has become more expensive. Thirdly, the unemployment rate is rising and will continue to rise, and that will put extra pressure on consumer spending. The trading environment in these areas will remain difficult. We expect a number of profit warnings coming through in this area [and] we’ll continue to see more.
Q: Have you made any changes to asset allocation within the past few months?A: Late-cycle and economically sensitive areas such as oil service stocks, industrial engineers and oil producers are areas that have performed very strongly up until May/June this year. [Since then] there has been a dramatic sell-off. We’ve been taking money off these areas over the last few months and buying the early cycle consumer areas. For example, we bought Mothercare and we increased our exposure to WH Smith and the pub company, Green King.
Structurally, we still remain underweight consumer discretionary. The key call probably needs to be made next year. That will structurally change the portfolio.
We’d like to see the magnitude of earnings declines coming through. Different components of the market move at different times. Commodities did well at the end of the cycle. Interest rate sensitive companies, such as retailers, restaurant companies, providers of finance and banks, tend to perform well when you see aggressive cuts in interest rates. As the economic cycle starts to mature, we will increase our exposure to areas that respond favourably to economic growth. We are moving into a new phase of the economy. Where we are now is there is a global recession [but] these areas will lead us out. It’s the key call and the true determinant of generating outperformance for the fund in 2009.
Q: How has your outlook altered in light of the credit crunch and banking crisis?A: This has been ongoing for over 12 months now. It became prominent in July/August last year. The banking crisis has been worse than people had imagined. It’s our view the government and central authorities are intent on solving the issues in the banking sector. Providing liquidity to the banking system demonstrates there is a powerful movement there. It is our view a solution will be found.
The banking crisis has become apparent and damage has been done to the economy over the past few months. The economic data has been poor across the UK, US and Europe, but also emerging markets. There will be a global slowdown over the next 12 months. The market is grappling with the issue of how pronounced that will be.
Q: How much of the UK Select Mid Cap fund is held in cash?A: Just over 10% at the moment. That’s in line with our defensive view of the market.
Q: There are 80 holdings in the portfolio. Will this change when you are lead manager?A: I will run the fund with a slightly tighter list of holdings, about 65 to 75 stocks. It plays to my strengths. I like to back conviction on stocks and I tend to be more analytical. The smaller positions in the portfolio will be sold or made into slightly bigger units. I don’t envisage any other changes being made. It’s a team-based approach.
There is no change in the process and there is a lot of continuity on the desk. There will be three fund managers including myself, and three research analysts.
We will be looking for another analyst to replace Ashton [Bradbury]. He will not be running money but he will continue to provide top down input and be in charge of the monthly strategy as head of equities.