Contrarian approach to finding british equities

Glen Pratt, manager of Melchior UK Opportunities, responds to this week’s questions from Will Jackson.

Q: Your new fund, Melchior UK Opportunities, is the first in the Dalton range to focus on British equities. Why has it been launched now?

A: We have a lot of clients, high net worth individuals in particular, who have expressed an interest in British equities. We can also use the fund for our balanced accounts, which invest money around the world.

Something like 200bn worth of UK equities is held in unit trusts, so if the fund performs well, we should be able to take a small percentage of that. We believe the UK market is very attractively valued at the moment and there are a lot of good stockpicking opportunities.

As to why we have not developed a UK product before, Dalton is a small organisation and you cannot launch 10 products on day one. You have to expand in a considered manner. We now have more than $4bn [2.1bn] in assets and can start to take on new people and develop new products.

Q: In what types of company does the fund invest?

A: There are three broad categories of stocks I like, all contrarian special situations. First, I look for undervalued firms – BT, for example. If you look at the stock on a free cashflow or price-to-earnings basis, it is much cheaper than other telecommunications companies.

The market thinks profits and cashflows will decline in perpetuity but I think they will grow. BT has an exciting information technology service business, which seems to have been missed. The market thinks the business is going backwards but I think the stock should be worth between 270p and 280p [BT Group closed at 224.5p on May 22].

Second, I invest in turnaround situations, normally where a firm’s profit margin or return on capital employed is less than its peer group. Sainsbury’s has a profit margin of 2.5%, compared with Tesco on 6%. The firm’s margin has historically been between 5% and 6% and there is no other reason for it than it has not been properly managed. The team was changed 18 months ago and I think it will be the next Marks & Spencer.

If Sainsbury’s can increase its profit margin from 2.5% to 5%, the share price could go up by 30%. Of the 25 analysts who cover the firm, 18 are saying “sell” and just two are saying “buy”. I like the fact that most people are saying “sell”. Tesco is covered by 30 analysts, 25 of whom are saying “buy”. It is a great company, but everyone knows it.

The third category is unrecognised growth situations. These are small and medium-sized companies that are growing quickly, especially in terms of cashflow, but have not been picked up. Datacash, for example, processes credit and debit card transactions made over the internet and has a market capitalisation of less than 100m. The firm receives 10p for every transaction it processes and its earnings are a function of how many people shop online. The market is growing exponentially, at about 50% a year.

Overall, our decisions are based on fundamental analysis. We are looking for valuations based on absolute, intrinsic measures. I learned how to pick stocks at Fidelity and at Newton it was all about risk and minimising downside. I am hoping to marry the best aspects of both approaches to produce a fund with good returns but less volatility.

Q: The fund was launched on May 11 with $20m in seed capital. Is it fully invested?

A: Yes, as of yesterday [May 22]. There was a bit of a market bloodbath but some stocks were very attractive.

Q: The launch coincided with the start of the recent downturn in world markets. Has it helped or hindered the investment process?

A: We were probably 80% invested after day one and, on balance, it is probably easier when the markets are going down. That said, our long-term objective is to provide absolute returns for our clients, and the current conditions are not conducive to beating cash.

We are down 5% since inception but the caveat is that the market is down 7%. This has largely been down to our cash position and three stocks that have done particularly well. BT is up 10% since we bought it and BA has recently posted good results. Retail Decisions also had a takeover approach last week.

Q: What is the fund’s performance target ?

A: Over the medium term, and as an investor myself, I want to beat cash. There is no explicit target but if I can get 4.5% in an ING Direct account, I should be looking to beat that by a decent amount. We believe the stocks in the fund today offer a total return of about 30% over the next two years.

On this basis, we should be looking at north of 10% a year. But for an accurate measurement, you will have to view returns over a three-to-five-year time horizon.

Q: What types of investor are buying the fund ?

A: A lot of Dalton employees have invested and the seed money came internally, from our balanced accounts. We are not going to sell the fund aggressively. We want a good 12 months and perhaps to talk to funds of funds. It is all about getting a good track record and seeing if people find it interesting.

Q: You have previously managed the Fidelity UK Aggressive, Newton Growth and Newton Income funds. What are the advantages of running a smaller portfolio ?

A: The simple one is that it is much more nimble. You can move in and out of stocks very quickly. More importantly, you are working in a small team. With bigger houses you may have a good idea but you need to convince other people. With a smaller group, you can put the idea in there and then. Rapid decision-making contributes to additional performance.

Also, if you are dealing with $10bn worth of UK equities, not $25m, other organisations will want to buy the stocks as well and you can get crowded out of the optimum position. You have to wear many hats in a larger company and my only role here is to manage the fund. I could not be more incentivised.

I have equity in the firm and a significant shareholding in the fund – I have transferred my own pension fund into it. It is also a lot more fun and it feels almost liberating. Before, I was often tied to the benchmark and what analysts were saying. But now, instead of looking at Vodafone, I can look at companies like Datacash.

We had a call this morning, with a company I cannot name, that was very exciting. It is a stock we can see growing by five to 10 times over the next five years. It is a lot of fun to find those situations. In many respects, it is a return to my stockpicking roots. We are a small firm growing very quickly and there is a tremendous vibrancy.

Glen Pratt joined Dalton Strategic Partnership at the start of May. He previously worked at Fidelity Investments, where he managed the firm’s UK Aggressive portfolio. This was followed by almost three years at Newton, where he ran the Growth and Income funds. He graduated from the University of Nottingham with a degree in economics and econometrics. His new fund, Melchior UK Opportunities, was launched on May 11.