RLAM UK Special Sits manager’s top-down high conviction approach gives top-quartile outperformance as portfolio celebrates third anniversary
Derek Mitchell’s Royal London UK Special Situations fund celebrated its third anniversary last month by delivering top-quartile returns, driven by the manager’s top-down high conviction approach.
According to Morningstar, the £363m vehicle is ranked fifth out of 281 vehicles in the IMA UK All Companies sector over three years to 23 July, up 8% compared to a sector average decline of 13.1%. Over one year it is up 34.4%, compared to a sector average of 23.3%.
The fund is a concentrated ‘best ideas’ portfolio, which takes high conviction stock and sector positions based on Mitchell’s top-down market view. He identifies a series of key drivers for the UK economy and backs these views with high conviction sector positions in his portfolio.
Stock selection is driven by seeking companies where he believes current market value is below their long-term worth, identifying potential catalysts to drive forward the earnings growth of the company.
“It is the way I have always run money over the 25 years I have been involved in investment,” Mitchell says.
“Without the macro view effectively there is no micro view.
“I cannot pick the right stocks or get involved in the right sectors without sorting out that macro view first. For me, this is the starting point of the investment process.”
Mitchell believes performance has been driven by his ability to call the top-down view correctly.
“We launched at the peak of the market in 2007 but stayed overweight the mining and oil sectors because we felt the China growth dynamic at that point was still very powerful,” he says.
During the downturn in 2008 he reduced exposure to oil & gas and miners, switching instead to defensives, which proved to be another correct call.
Towards the end of 2008, he took the view that the virtual zero interest-rate policy, combined with quantitative easing, meant there had to be a positive economic outcome.
The manager explains: “While a lot of other investors believed this was the end of capitalism and we should sell every equity we had, I was quite happy to start buying cyclicals again at the end of 2008 and at the start of 2009.”
In recent months, in response to market jitters, he has reduced the size of the cyclical exposure in the fund.
He says: “The market seems to have gone straight from recovery at the start of the year to double-dip.
“Obviously, we had the sell-off in April and May as the market effectively took some profits, and now it is confused.
“The market does not know if it is going to double-dip, or whether some of the comments which have come out of companies of late are simply alluding to a slowing of growth.”
Mitchell has switched out of domestically-focused cyclicals, and is now looking to invest in international growth.
He says: “There are no retailers or housebuilders in the fund, for example. This is a part of the market I think is going to struggle next year.
“In future, as rates start going up and the well documented tax increases take place, that is going to keep a lid on anything related to the consumers.”
Mitchell adds: “I think you have got to look at the growth differentials between the developing and the emerging economies and those of the developed world. There is something like a 400 basis point differential, according to the IMF statistics.”
He plans to stay invested in some of the international growth names that sit in the portfolio, identifying two of the fund’s top 10 holdings, Compass Group and Aggreko.
Another growth stock he favours is the oil services company Petrofac.
“It has a focus on the Middle East – it is not involved in the US at all – and that is very much still a growing market,” Mitchell says.
The manager believes investors are attracted to special situations funds because of their flexibility.
He explains: “This fund has a remit to go anywhere. For example, at the moment I have got one small AIM-listed company called Rockhopper Exploration which has recently struck oil in the Falklands.
“The share price is already up five- or six-fold this year, and we certainly believe it can do this again. There are large-, mid- and small-cap companies within the fund.
“At the moment, I am roughly 75% in the FTSE 100 and 25% outside, mainly mid cap,” he says.
“But if you look back to late 2008 and 2009, the mid-cap weighting was up to 40%. So I am quite happy to move it about where I believe I am going to generate the best performance.
“Mid caps have done very well this year, so you are fighting against the investment houses, which have got mid-cap funds as well.”
Mitchell notes there has been a surge of M&A activity in recent weeks, pointing to bid activity around SSL, International Power, and Tomkins, all of which he holds in the fund.
“I think the M&A outlook, and therefore for special situation funds, means there is going to be a lot more activity in which to get involved,” he says.
“Managements have raised a lot of cash, trimmed their budgets, and moved manufacturing from high-cost economies to low-cost economies.
“As a result of doing this, they have found themselves with cash at the highest levels they have been at for the past 25 years.”
He believes cash is going to underpin the market as M&A starts to happen.
“It did not happen in the first half of this year, and I was slightly surprised, especially given the weakness of sterling.
“I thought that was going to be open season for UK companies from overseas buyers, but I think we are now beginning to see this.”
Mitchell says the good thing about all these business deals is they are conducted with cash.
He says: “Debt financing is no longer an option in the market. So the businesses are for cash, the cash comes into the institutions, we recycle it and that helps underpin the market and drive it higher.
“I think M&A and higher dividends are going to be a feature. Buybacks will once again be on the agenda of many companies. I think we can still see some good earnings growth from a lot of these actions, and therefore the market looks fairly well underpinned at these levels.”
