An audience with... Robert Churchlow

Legal and General Investment Management is one of the largest and most successful UK fund management organisations and that success has historically been built around the index business which has grown phenomenally in recent years. But perhaps people are less aware of the group's vibrant active business.

There are two issues here, one is the Growth Trust itself but the other is how this fund is representative of the active management side of L&G. Could you tell us a bit more about that?

Robert Churchlow (RC): In the UK, of the £71bn equity assets under management we have, around 10% of that is invested in active funds. The way we have structured the active business is to focus on high return products. The team we have put in place over the last three years has performed well and we are delivering some good performance for our clients. The Growth Trust is a great example of a fund where we have focused on a high return target and have achieved healthy returns for our clients.

The UK stock market is doing quite well having had a good run of two or three years, so how do you decide which stocks to pick in your fund?

(RC): The fund is a bottom-up stockpicking fund and we look for companies that create long-term value for their shareholders, assessing that by looking at underlying cashflow returns. We seek strong companies with a competitive advantage and a strong market position and look to invest in those companies when they are out of favour in the stock market for whatever reason.

We also look to invest in what we term turnaround situations - companies that are basically sound but have fallen on hard times, either because the management has not done a good job or due to an issue in their industry. We look for a catalyst for change, often a change of management, that leads to a change in fortunes of the company and an improvement in returns. So again we are not only focused on the long-term value creators but also of those turnaround situations.

Are there other key performance indicators you might look for when looking to select the stocks?

(RC): Cashflow returns in businesses are a key metric to understanding how successful a company is, but management is absolutely vital. One of the advantages we have is by virtue of our size. Being one of the biggest investors in the market, we have superb access to company management and that is important for us as bottom-up stockpickers. What we are about is really getting to understand companies well and building relationships with senior management. Because we are who we are, we have that access and can do that.

Looking at the example of two companies in the same industry, Tescos and Sainsburys, it is no surprise that in the long term one company has done a lot better than the other. It is down to superior management and nothing to do with the industry structure. Management can, and always does, make a difference.

You work with a limited number of holdings. Given the ability to select from the full All-Share index, how do you narrow this down? What are the benefits of such a focused approach?

We have deliberately restricted the number of holdings in the fund to 25 to make sure only our best ideas make it onto the portfolio. The UK stock market is very concentrated, so the largest 10 companies in the index represent 40% of the market cap of the whole of the UK. A lot of fund managers feel obliged to own shares in all of those companies by virtue of them being the largest.

We take a different approach on the Growth Trust and only want to own the companies we have a high degree of conviction in. The companies that are our best ideas and the way we structure the fund is to have 4% in each of those 25 companies. The focus means the hurdle for a company to get into the portfolio is very high. As a result, every position we hold in the portfolio has a high degree of conviction behind it.

When you say you have got a higher degree of conviction, is this about some quick wins though or are you really looking longer term?

(RC): Every time we invest in a company we look at the fundamentals of the business, we meet the management and get a strong understanding of the company. And what we also do is value that share and make our own assessment of what we think it is worth. In terms of time horizons, we are prepared to hold a share for the long term if that is how long it takes for the upside to be realised. At the same time, if we see short-term catalysts we think will be positive for the shares, that will be an added attraction for us. However we do not invest with a particular time horizon in mind, but more with an upside to the share price in mind.

Can you give some examples of the holdings you do have in the portfolio?

(RC): As I mentioned earlier, we are investing broadly in two types of companies - the long-term value creators and the turnaround situations. If we look at some of the long-term value creators, we have had a number of successes in the fund in recent times.

A good example is Man Group the hedge fund manager. For some time we felt this firm is a market leader in a growing industry. It has demonstrated very good fund performance for its clients and is in a strongly growing sector. We also felt the market has not fully appreciated the strengths of the company and its ability to generate superior returns. That has been a good long-term winner for us and it is a position we continue to own and have high degree of conviction in. The results recently led to analysts upgrading their expectations and that has been a familiar theme to the company.

In terms of turnaround situations, again we have had a number of successes. One good example is United Business Media where we invested in the company at an early stage as a new chief executive, David Levin, came into the company. We had a meeting with David before he actually took up his tenure, and this goes back to what I was saying earlier about our position as one of the biggest investors in the market allowing us access to senior management.

Our initial conversations with him confirmed the company could help itself to improve returns, selling off peripheral assets that were not generating a sufficiently high return and really focusing on its key strengths, particularly within the publishing area. We also felt the balance sheet had lots of potential to be restructured and subsequently the company has returned surplus capital to shareholders. We no longer hold United Business Media, simply because the share price has hit the price target we initially set for it and we have made a good return.

Another example of a turnaround situation is Compass Group and this goes back to what I was saying earlier about management making a difference. Compass is a basically sound company but has had issues historically. Most people have some negative anecdote about their experiences with Compass Group and Compass Catering, but we think a change of management is a catalyst for a potentially significant change in the group's fortunes.

Richard Cousins, who we believe has very strong credentials, came in earlier this year as the chief executive. He was previously chief executive of BPB where he did a fantastic job and the company was eventually taken over at a significant premium.

Our initial contact with Richard Cousins confirms our conviction that there is huge scope for returns to improve at Compass by addressing some very basic issues. The company has had a lax attutude towards cost control and management of working capital that can be attacked and also the top line revenue growth in the company can be improved.

Richard is speaking to the market at the end of November and will lay out his initial thoughts for the company and strategic plan for the future. We think that might be a catalyst for the market to reassess Compass as an investment and the potential improvement in returns that is possible.

Following the latest increase in the base rate to a new five-year high, will this have an impact on the UK stock market?

(RC): Clearly it will have some impact. The Monetary Policy Committee is concerned about inflation in the UK economy and the base rate rise is there to ensure inflation does not get out of control. But people with mortgages and the general consumer are going to have less money in their pockets. Also the cost of debt may go up for companies with borrowings and if they have short-term borrowings that may impact on returns.

Having said that, the outlook for the UK economy remains sound and, certainly for the companies we are investing in, the outlook is positive. We see good profit growth in the companies we are investing in and we do not feel the recent increase in base rates is going to have a material negative impact on that.

One of the other key factors driving the stock market is a high level of corporate activity. We have had a number of positions on the fund where we have benefited from that activity including John Laing. Legal and General are the largest shareholders in John Laing and we have a holding on the Growth Trust. The company has been subject to two bids of late and the share price has reacted in a very positive way to that.

A number of other companies on the portfolio have also seen third-party interest reflecting what we felt already, that these companies are attractive to other parties and potentially undervalued. We feel that is a continuing theme in the stock market and one we expect to continue to benefit from on the Growth Trust.

Is more of that investment coming from outside the UK now rather than it being a consolidation play just within the UK context?

There are a number of sources of that investment. John Laing is only one example of UK funds bidding for that company. But we have recently had a bid for Scottish Power from Iberdrola in Spain and the Spanish have already bought other UK assets, most obviously BAA. So there is definitely interest from overseas companies for UK-listed companies.

One of the big sources of capital for this interest has been the venture capitalist industry. That sector has raised lots of funds in recent years to invest in the corporate landscape and, by and large, they have been successful investors. With interest rates still low, they have been able to finance leveraged deals for UK companies and have earned a decent return, even after paying a premium to existing shareholders. That has been a very strong theme in the UK stock market really over the past few years, and we see no end to that activity. And again, the fund will benefit from that.