Fair value offers a good investment approach

Matthew Cox, manager of the UBS UK Select fund, answers questions from Adam Lewis

Q: This week marks the end of your first year in charge of the fund. What changes have you made to the portfolio in that time?

A: I took the fund over from Paul Fairbrother, who made an internal move within UBS to manage core European money. I made the main change right away in August; this was to up the portfolio’s weighting in small and mid caps from 18% to just short of 50%. Prior to taking over, some 85% invested in large caps. When the change was completed in September 2006, it moved the fund to being closer in line with the peer group (IMA UK All Companies) and plays more to my strengths.

Previously, I was a small and mid cap manager in UBS’s UK and continental European team. None of it was retail money, it was institutional money and money run on a team basis. I worked closely with Frank Manduca on the UBS UK Smaller Companies fund.

Q: Why did you reduce the large cap exposure so drastically?

A: I do still think that the mega caps are cheap, but I wanted to get more ideas into the fund. With hindsight, the previous manager played the large cap story too early and such a large exposure had led the fund to underperform. By upping the mid and mall cap exposure, I was able to spread the risk of the fund more around the FTSE All-Share [the fund’s benchmark].

Q: Has this exposure altered much over the past 12 months?

A: Not a great deal. At the end of June, 38.5% of the portfolio was held in mega caps; that is, the top 10 companies in the FTSE 100, which is in line with the benchmark weighting of 39%. But in terms of the other 90 firms in the FTSE 100, I only hold 10.2% compared with the benchmark weighting of 43.8%.

Elsewhere, I hold a combined 18.9% in small and mid caps, and 27.2% in what I call “other”. This “other” equals Aim [Alternative Investment Market]-listed companies and companies that are listed on the stockmarket, but that aren’t included on any benchmarks. The reason for this is that the fund looks for things the competition has not yet found. You cannot outperform your peers by doing the same things they are. Several of our success stories in the past year have been companies that graduated from being on Aim.

Q: What type of companies are you looking at that your peers are missing?

A: At present we like resilient/defensive growth companies. Given the current uncertainty in stockmarkets, we like companies whose prospects for earnings growth are not highly correlated with that of markets over the next two years. One example is an Aim company called Mecom. It’s a media publishing company and is currently one of our top 10 holdings.

Q: What did you do to the number of holdings in the fund?

A: Since taking over, I have upped the number of holdings in the portfolio from 64 to just over 70. The reason for this was mostly because of the decision taken to reduce the weightings in the fund’s top 10 positions.

Historically, the largest positions each made up between 7-9% of the overall portfolio, but by scaling this back to 5% money was freed up to be reinvested right across the All-Share. Today, the top 10 holdings in the fund equate to 40% of the fund’s overall assets under management; when I took over they made up closer to 50%.

Typically, the number of holdings in the fund reflects where we are in the market cycle. If we were at the bottom of a bull market, the number of holdings would fall because there would be more opportunities to make money. Conversely, if we were at the top of the market cycle, the number of holdings in the portfolio would expand, as it would be a time of profit-taking and also the number of opportunities in the market would decrease.

Q: Has anything else changed in the way you managed the fund?

A: The fund is now more actively managed. I run the fund using a core/satellite approach. Typically, three-quarters is invested in the core, solid ideas where we think companies will outperform on a twoto three-year time horizon. The remaining quarter is held in firms we expect to outperform on a short-term basis. This side of the portfolio is much more dynamic, in that turnover is higher than on the core holdings to the tune of about 200% a year versus 50% on the core stocks. This is because there will always be times when the core holdings outperform; having the satellite holdings allows the fund to stay ahead of the peer group during these times.

Q: How has the fund grown since you took it over?

A: When I took over 12 months ago, the fund was about £120m in size and it is now £132m. We have seen asset flows from various distributors, but I think many people have been watching to see how I do in my first year before making any decisions.

Q: How would you describe your investment approach?

A: We use a price-to-fair value process on the fund. This means we spend a lot of time focusing on a firm’s fair value, then ignore any stockmarket noise to the contrary. We wait for a company’s share price to fall far enough below its fair value before buying, then sell when it goes too far beyond its fair value. The aim is to work what is fair value across the market cycle; in large caps particularly, we look five years ahead.

Often, stocks can stay below their fair value for a long time, and being conscious of the fact of the pressures on performance, I do look for catalysts that would bring this fair value out of the company early.

Q: Given the fact you currently like resilient growth companies, what is your view on the direction of the British stockmarket going forward?

A: I think we are in the final leg of the bull market. At the moment there are three possible scenarios as to which way the market could go. The first is that the bull market ends later this year, the second is that there is one to two years left of the bull market, and the third would be a situation similar to the 1990s, whereby we have all misjudged the market and the bull market lasts another five years.

The possibility of the third scenario is low, while the pros and cons for scenarios one and two are even. My focus is not to second-guess which way things will go; I am just building a list of stocks that will do well in either situation.

MATTHEW COX joined UBS Global Asset Management and took over management of the UBS UK Select fund in August 2006. He was formerly a portfolio manager and analyst on the pan-European small and mid cap team. Before joining UBS he was an accountant at PricewaterhouseCoopers.