UK equity market dispersion is at its highest levels since the TMT bubble, which has led to opportunities within "companies in the discarded bucket" for which the "fundamentals are better than the market thinks", according to portfolio manager of the ES R&M UK Dynamic Equity fund William Lough.
Lough, who took over from former colleague Philip Rodrigs in April 2018, identified furniture retailer DFS as a stock that the market has mispriced, with the capacity to "materially increase" market share in any downturn.
The £543m market-cap firm's share price ballooned nearly 40% in the month leading up to 25 December 2019, but has since fallen by around 11%, largely owing to the equity markets sell-off seen in recent weeks.
It remains 25% shy of its November 2015 share price peak of £3.47.
Lough said: "DFS and its brand suite are three times the size of the number two [competitor].
"People see DFS as a very operationally geared retailer, so very high fixed costs, therefore massive sensitivity to your like-for-like sales, which is true to a degree, but as with everything, there is a bit more nuance to it.
"They do not hold loads of stock; they have a build-to-order model, so their working capital is actually very efficient.
"All of this leads to a share price we think is more reflective of the challenging environment over the past couple of years, rather than the environment we think is likely to materialise over the next couple of years."
DFS is part of the ES R&M UK Dynamic Equity's 26.5% allocation to small-cap companies, compared to the benchmark's 6.9%, according to the fund's recent factsheet.
UK domestics have been prone to difficulty in recent years and Lough attributes the challenging UK environment to the "disappointing" performance of the fund in 2018.
He explained: "The biggest issue we had in the second half of 2018 was that we were too invested in UK domestics and that really hurt the fund's performance.
"UK assets were getting absolutely slammed at that point…that was a strategic error. In hindsight, being too overweight UK domestics clearly hurt us."
Lough described value traps as "a part of life within value investing" and said he was conscious that when looking for "opportunity in the rubbish tip" he has to be careful "because you might have picked something like a Debenhams a couple of years ago".
The ES R&M UK Dynamic Equity fund is up 3.8% over the past 12 months, compared to its MSCI United Kingdom Investable Market index benchmark, which is up 3.1% but has lagged the IA UK All Companies sector average, which is up 6.2% over the same period, according to data from FE fundinfo.