Performance of Merrill Lynch UK Special Situations fund since Plackett took over the running of it in 2004 has more than vindicated what some felt to be a risky bias towards small and mid-cap stocks
When Richard Plackett assumed control of the renamed Merrill Lynch UK Special Situations fund in the summer of 2004, his principle aim was to construct a mainstream equity portfolio with a strong small and mid-cap flavour.
"I wanted to design a fund covering the entire UK equity market but which capitalised on our stock picking skills," he explains. "The vast majority of other such funds have most of their firepower in large caps but this has just 45% in the FTSE 100."
It was certainly a bold move, but even though some observers questioned the merits of completely restructuring the former Merrill Lynch UK Value fund in this way, the performance achieved since has totally vindicated the decision.
Over the past year the fund has delivered a bid to bid return of 32%, comfortably ahead of the 22.4% average achieved by the UK All-Companies sector, according to data compiled by Standard & Poor's to 23 January 2006. This puts it in sixth place out of over 280 rivals.
The £300m fund, benchmarked against the FTSE 250 index, has also achieved external recognition, having received AA-ratings from both S&P and Forsyth OBSR.
However, while the performance figures recorded have clearly been very impressive, they haven't come as a surprise to Plackett who has always been a keen advocate of the advantages that small and medium- sized companies can offer investors.
His other fund, Merrill Lynch UK Smaller Companies, has also delivered on its promises and is currently ranked fourth in its sector over the past three years to 23 January, after delivering a bid to bid return of almost 160%.
"Small and mid caps have consistently outperformed the market over the longer term," he says. "In fact, you would have made six times more money investing in them over the past 50 years than you would have done in the large caps."
In addition, you've got a much greater chance to add value by tapping into immature companies that are changing very quickly than you are buying the mature names with turnovers already running into billions of pounds.
The key is spotting the likely winners at an early stage.
"The fund is designed to only own shares that we think are going to go up, regardless of their size," explains Plackett. "We will never own a company simply because it's a large part of the index."
Central to the investment philosophy adopted by Plackett's four-strong team is visiting company managements. Over 700 meetings have been held over the past year and there's no sign of the pace slackening off over the coming months. The four fund managers have over 40 years investment experience of meeting and visiting companies between them.
"We are trying to find the best 60 companies out of an investment universe of up to 2,000 stocks which means we have to get out and meet as many as possible," he says. "Visiting them at their own offices gives you a much better feel for the organisation."
As well as attractive valuations, Plackett and his team are always on the look-out for five key characteristics which the most successful small and medium-sized firms seem to have in common. These are:
Good management and corporate culture. "We never invest in a company unless we've met the management face to face," says Plackett. "Senior people tend to shape the whole culture and attitudes within the firm. We aim to back management teams who own equity, exhibit salesmanship and control skills, and display strategic clarity. Businesses that diversify too far away from their core strengths will usually end up failing," he explains.
Barriers to entry. "Small companies which compete head on with large companies do not tend to succeed. It's important for them to have barriers to entry to ensure that they make premium returns on capital and that they grow within protected niches. These barriers to entry may involve ownership of a strong product, an important brand, exclusive contracts or of a skilled and unique workforce.
Cash generation. "If a company can generate cash then it can prove its earnings numbers are real," points out Plackett. "It can also help you avoid potentially disastrous investments and possible accounting scandals."
A performance track record. "We're always trying to buy companies that have good long-term track records, as well as good current trading figures," he says. "One of the reasons why markets have done so well is because of the huge earnings momentum across a wide range of stocks."
A strong balance sheet. "This gives companies significant strength," maintains Plackett. "If they spot a possible acquisition it also means they can make a move without having to raise any equity."
It's a tough set of criteria, but essential considering the concentrated nature of the portfolio. "Finding any one of these characteristics is demanding, but we like to see evidence of all five before we invest," adds Plackett.
Plenty of very successful companies have been identified through this tried and tested process. In fact, a number that Plackett first identified when their market caps were less than £100m, have gone on to establish themselves among the business élite.
"There's no better feeling that investing in small companies and watching them end up in the FTSE 100 as it gives you tremendous satisfaction," he says. "Capita, Sage and Shire Pharmaceuticals are examples of stocks I identified when they were small."
More recent examples of attractive stocks in the fund include Rotork, the designer and manufacturer of valve actuators which has enjoyed a 40% year on year rise in the number of orders, and Latchways which is increasingly selling its safety harness equipment on a global basis.
However, that's not to say that the multinational giants are ignored completely. "The great advantage of the ML UK Special Situations fund is that it isn't restricted wholly to small and mid-caps and it can still buy large companies when they offer good value," says Plackett. "For instance, there are some sectors like banking where small and mid-caps are not very well represented."
Currently, the largest holdings in the fund are oil giants BP and Royal Dutch Shell which each account for 4.9% of the overall portfolio. Other easily recognisable names in the top 10 include Tesco, Barclays, Rio Tinto and GlaxoSmithKline.
One of Plackett's guiding principles is that all stocks should contribute equally to a portfolio. Small and medium-sized companies will typically account for between 1.5% and 2% of the fund, with the less volatile large caps usually worth up to 4%.
"We set target weightings for stocks and stick to them," he adds. "When a stock goes up we'll sell some to keep it within the target weighting. However, we may maintain a holding in a company for some years as successful small and mid-cap companies can sustain premium growth rates for long periods of time.
"Perhaps more importantly, we will normally sell if a company issues an earnings downgrade because we haven't got any room in the portfolio for companies to disappoint."
Plackett clearly loves being involved in the day to day life of small and medium-sized companies. "We're really lucky to do a job where we can meet all these successful businesses and entrepreneurs from all walks of life and we love it," he says. "You can be meeting an IT firm in the morning, a leisure company at lunch and then a retailer in the afternoon."
And while he is understandably proud of what the ML UK Special Situations fund has achieved so far, he also acknowledges that the pressure will always be on to keep delivering similar returns over the coming years.
"The important message is that our success so far hasn't been built on two or three companies doing well - it's because over 50 of the 60 stocks we hold have been outperforming their business plans and targets," he says. "To date we have produced one of the best performing funds in the All Companies sector, but we're not complacent and are working extremely hard to maintain this performance. The companies we have invested in are talking confidently about their near-term prospects, which in turn must give us confidence in the future."
