Mega-caps offer unexpected value

Ed Burke, manager of the Invesco Perpetual UK Growth fund, is not normally one to invest in the largest UK companies. But that is exactly where is his portfolio is heavily weighted at present.

It is odd to hear a manager at Invesco Perpetual get excited about the sort of mega-cap stocks that everyone else holds. But that is precisely where you will find Ed Burke, manager of the 1.2bn UK Growth fund. His top five holdings are a roll-call of FTSE blue chips: BP, Barclays, HSBC, BT and HBoS.

In previous meetings with the always highly engaging Burke, he has sketched out the typical portfolios of his rivals. He would run off a list of five stocks – basically the five biggest in the FTSE -tell me that is what all the others have, then explain why his approach and his portfolio is so different.

So what is going on when Burke’s portfolio starts looking suspiciously like the others?

In part it is down to a generally defensive position that Invesco Perpetual holds about the British consumer and the economy. That means you want to be in stocks like BP, where the UK consumer really is not that important. But the chief reason Burke holds these stocks is valuation anomalies.

The conventional wisdom is that you cannot find anomalies in stocks that are truly global and crawled all over by analysts and other investors. But Burke is confident that underlying valuations on the mega-caps are positive over the medium to long term, while over the short term there are some interesting technical factors.

He is intrigued by the impact of hedge funds and other more esoteric market operators, who are not restrained by indexing requirements. As the pension funds have shifted out of equities, the new holders of British equities no longer see their job as getting index-plus 1% or 2%, so they are not huddling in the mega caps. It means that right now some of the biggest British companies are relatively cheap.

BP is a good example. The casual observer of markets may conclude that soaring crude prices must have sent BP to record highs. Wrong. BP is trading at about 680p, but as Burke points out, back in 2000 it was at 650p and traded at about 550p-600p through much of 2000-2002. Only if you look it at from 2003, when it dropped to about 400p, does it look high today.

It is the same sort of story with Shell, another Burke holding, which was 2,200p in 2001 and is only 1,930p today.

One risk of being in the mega-caps is that you will miss out on the takeover party that has engulfed so many other FTSE stocks further down the list. But Burke is not so sure. “I would not be surprised to see corporate activity start to move up the market-cap scale,” he says.

He picks BT as an example. First, it is no longer that “mega”. Its market cap is 18bn, which makes it relatively small compared with BP’s 136bn market cap. It is not even half the size of Barclays or a quarter of HSBC. There has been market gossip of a private equity takeover and some sort of approach would not surprise Burke.

The fund has not exactly missed out on the takeover mania – it is a big holder of BAA and Burke does not rule out Ferrovial coming back with a higher offer.

Over the past year, the defensive stance has meant that Burke has found himself in the unusual position of only being second-quartile. Over one year, the fund is ranked 143rd out of 346 funds, with a gain of 29.4% compared with the sector average of 27.8%. Over three years, it is showing a 136% gain against 90% for the sector, underlining some good calls in 2003. So if performance temporarily goes down a gear, there is no reason for concern. It just goes to show how high one’s level of expectations is. Indeed, if you look at Burke’s far more concentrated UK Aggressive fund, it is up 39% over the past year and is ranked top-decile in the same sector.

But it is stock stories you want from Burke – the type of manager who is refreshingly willing to stick his neck out. His current favourites are industrials. He is particularly keen on ICI. “It has recently had a good run but I believe there is a fair bit more to go from here,” he says. “The management team is focused on the very good speciality chemicals business within ICI, as well as the paints business, which is a global business with a strong franchise. ICI is exposed to some strongly growing economies – for instance, it is the largest pan-Asian paint company and has a very good position in Latin America.”

ICI has gone into Burnett’s top 10 holdings in UK Aggressive and is also in UK Growth.

Another industrial that is in his top 10 in both portfolios is Rolls Royce. It has been another good performer but Burke has no intention of selling out.

“I feel there is still quite a lot more to go,” he says. “Rolls Royce has got itself through some tough management decisions over the past decade to emerge as a leader in the global aerospace market [along with General Electric]. It is the dominant engine supplier to all wide-bodied aircraft around the world and is starting to reap the benefits of that market position.”

Among Lloyd’s non-industrials, he is also a big fan of Hiscox. Yes, the Lloyds market reported some pretty flat figures last week but given an awful hurricane season, it is testimony to the underlying strength of the market. He likes Hiscox for its niche businesses – for example, it is the world leader in kidnap and ransom insurance – and likes it even more because it is currently on a price/earnings ratio of just 8x.

Now that it is the end of the Isa season, did the fund pick up much in the way of retail investment? The honest answer is that cashflows are still heading into the funds run by Burke’s colleagues. Investors remain risk averse and have been buying income and bond funds.

This is curious, given just how far the UK equity market has run over the past 12 months, but goes to show how long it takes to build up retail momentum.

It also shows what a superb UK offering Invesco Perpetual now has, with strength across income funds, corporate bond funds and UK growth funds.

This week it embarks on a new branding and marketing campaign, once again putting the Perpetual mountain peak – it is in Nepal – as the focus of its advertising. In the old days, this would have prompted a press trip to the Himalayas, but those days are gone. Boo hoo.