How to make money in a flat market

Lacklustre performance from many UK equity funds this year is prompting a rash of hurried explanations from flustered fund managers. Uncertainty due to US elections, higher energy prices, corporate activity or even subdued customer interest are among the reasons offered in the latest quarterly roundups.

Even hedge funds, which pride themselves as being able to make money whether the market is rising or falling, have produced an excuse for current unimpressive returns: the market is flat. How are investors supposed to make money while the market is sitting comfortably in a narrow range and showing no sign of breakouts either way?

One fund manager not blaming or complaining is Mark Lyttleton, who runs the UK Dynamic fund at Merrill Lynch Investment Managers (MLIM). Lyttleton has been at MLIM for 12 years and running UK equity portfolios for 10, including the group's UK Dynamic fund.

UK Dynamic was launched three and a half years ago - not the most auspicious timing, some would say. For the first 18 months after launch, the UK market was weak but the fund did quite well. For the next year, the market was strong and the fund still did well. And for the past nine months, the market has done little but Lyttleton's fund continues to outperform.

UK Dynamic is a £290m long-only UK equity unit trust, using no leverage, so there are none of the usual levers for short-term success. The secret ingredient, according to Lyttleton, is a stockpicking strategy founded on relentless research and a rigid discipline about what is held and shed.

"We spend a lot of our time trying to identify the catalysts that will move the share price," says Lyttleton. "What is perhaps different from other funds is that the criteria required to make it into the portfolio are very strict. With usually only 40-50 stocks in the fund, each one really has to justify its position and continue to do so.

"If a company has its results, or a series of price rises, and the shares don't react as I expect them to, or do react but I can't see what will make them move from there, I am rigorous about selling and moving on to the next interesting thing. That means the portfolio is always fresh and avoids legacy holdings. The money in the fund is being used as efficiently as possible."

Lyttleton looks for shares to hold from three to 18 months. "Buying and selling does add to costs a bit but we certainly don't turn over the fund five times a year or anything like that," he says. "Sometimes I buy something because I think it will go up in the next three months, while other times I take a longer-term view. It can happen that the longer-term view goes up the next week because other people think the same way, feel the shares are wrongly valued, or believe the company has a product launch that will lead to an earnings upgrade. If I can't see any reason for the shares to rise further, I'll sell."

Lyttleton does not buy the story about flat markets depressing performance. "There are always things going on, even if the overall level of the market is flat," he says. "One of our holdings, Cairn Energy, is up some 300% this year, despite the direction of the market. Other holdings such as British Aerospace, which is up 25% this year, or Xstrata, up 35%, have also performed well. You need to delve about to find interesting shares. That's what being an active fund manager is all about."

He also laughs slightly ruefully at descriptions of the current 'low volatility' stock market. "The overall volatility of the equity market may be quite low but woe betide any company that disappoints," Lyttleton says. "MFI had a profit warning and the shares fell 15% but 25% of the share capital was traded in one day. Market volatility may be low but, on individual stocks, it can be very high."

Such reaction provides Lyttleton with the opportunities for which he is looking. Apart from the two obvious price catalysts each stock has every year, interim and final results, he is alert for changes in each sector, for pricing power coming into the market, consolidation, new entrants putting pressure on prices or competitors getting into difficulty.

Acquisitions or disposals can change companies' competitive or balance sheet situations. Those making big disposals might offer buybacks, like BP, which benefited from higher oil prices and embarked on new investments in its business but also a quite aggressive share buyback.

The fund can invest across the UK equity market but tends to be concentrated in FTSE 350 stocks. Lyttleton will buy small caps but demands a hefty 50%-100% annual return for the extra risk he takes. Apart from picking winners, a good strategy is to avoid losers, he notes.

"We haven't had Shell or M&S, which was a loser until it was a winner, Sainsburys, Unilever or Cuthberts, which have had warnings," Lyttleton says. "Our investment process helps us screen weaknesses but, generally, avoiding losers is an unappreciated skill. With a portfolio of 40 to 50 shares, we can't afford to carry anything but winners."

Despite AA ratings and other independent assessments of the quality of his team and process, Lyttleton keeps his feet on the ground. "Last year was a momentum-driven market," he says. "It didn't matter what you held as long as it was in the right sector. Logica, Sage or Misys - they all doubled. By the end of December, when Misys had had a profit warning and fallen 30%, it made a big difference."

This year has been much more of a stock-picking environment. Commodity prices have had a strong run recently but investors needed to hold the right stock. Rio Tinto, one of the largest shares in its sector, underperformed the market while Xstrata, which is also a FTSE company, outperformed by 75%.

UK Dynamic is now overweight sectors such as real estate, oil and gas and mining, as well as banks, where valuations are low, but underweight pharmaceuticals.

Lyttleton thinks the UK market is a good place to be right now. In a global context, its valuation is quite attractive, partly because life funds have been strong sellers recently. Yet the equity risk premium for the UK, at 4% or 5%, is considerably higher than that for the US, at around 2%. "There seems to be little reason for that," Lyttleton notes.

With the high degree of internationalisation in the UK market, there is a lot of flexibility and freedom to find themes. "You can get Asian exposure through Standard Chartered or HSBC, US exposure through big dollar earners like BP but some parts of the market are very UK-centric, like the pub chain Enterprise Inns," Lyttleton says.

This is part of the UK's attraction to international investors, giving extra depth to the market.

Lyttleton also likes the innovation across the UK market, particularly the mid and small-cap sectors. "There are plenty of interesting companies around, and a lot of good cashflow generation," he notes. "I like the fact a lot of UK companies generate a significant amount of free cashflow and are getting a lot more disciplined about what they do with it, whether reinvesting in their businesses or returning cash to shareholders."

IPO activity has also picked up, although some offerings are better than others, he adds. "There was a bit of exuberance around earlier in the year, for perhaps a month or two, when there were companies that came to market too early or at too high valuations, or with what I would consider flimsy business models," Lyttleton says. "But it didn't last long."

Investors are now demanding better structured deals at keener prices. If sellers are happy to take the lower valuations, UK investors will buy them. "Some of the companies you wouldn't start with if you had a blank sheet of paper but the market is quite clever and when the company wants to be priced at 'X' the market says, 'No thanks, X minus 20%'," Lyttleton says.

Similarly, the market seems to be dealing with the impact of the growing number of hedge funds. "It is always interesting to see what hedge funds and the private equity guys are doing," he adds. "They have increased the volatility, and sometimes you get some funny share prices: a company has a profit warning, and the share price doesn't go down because the hedge funds have already shorted it. But the market gets it right in the end. The extra volatility can provide opportunities as much as threats."

Lyttleton's confidence in what many other managers consider tricky conditions, and his fund's solid track record, are attracting attention, much to the manager's delight. "I suppose it is what people want," he says. "Not too much stodge and something that really makes their money work. We're happy. We believe we could double the size of the fund and still continue to do what we are doing."

Some people think these are dull times for equities but Lyttleton is excited. "We've got lots of ideas and we're doing the work, with all the resources of Merrill Lynch behind us," he says.