Over the last few months, UK equities have gained popularity as a result of their attractive yields compared to traditional fixed income assets such as government bonds. 
Blue-chips in the oil & gas and healthcare sectors such as GlaxoSmithKline, Royal Dutch Shell and BP are currently offering dividend yields that are well in excess of 5 per cent, helping to draw some investors from the small- and mid-caps and into the larger-cap part of the market.
Performance of indices in 2015
Source: FE Analytics
Alan Custis, the UK equity manager at Lazard, told FE Trustnet last week that he no longer sees the appeal of most smaller stocks, compared with well-known large-caps and what they now have to offer.
“What is interesting is that we had this post-Greece bounce [in the FTSE 100] so we’ve seen that macro concern come off large-caps and have therefore seen some of the valuation characteristics start to come back to the fore. Therefore the value as we see at the moment remains in large-cap relative to small,” he said.
As such, he has increased his exposure oil giants like BP, Rio Tinto and BG Group in his Lazard UK Omega fund, which he co-manages with Lloyd Whitworth.
Amid the blue-chips that are renowned for their reliability, however, are slightly more contrarian stocks that Custis sees as offering substantial growth potential over the coming years.
These stocks are selected via three categories: restructured, mis-priced and compounders. In the below article, Custis tells FE Trustnet his favourite stock in each category that he believes will significantly improve in performance over time.
Restructured: Tesco
Tesco divides opinion among investors, following a series of headwinds that caused the stock’s price to fall by more than 37 per cent in the second half of 2014.
These included the departure of chief executive Philip Clarke in July, an announcement that dividends would be cut by 75 per cent in August and the revelation the following month that the supermarket’s half-year profits had been erroneously reported.
However, the stock’s performance has since improved following the appointment of former Pets at Home and Halfords chief executive Matt Davies.
Performance of stock vs index over 1yr
Source: FE Analytics
“Tesco is a Marmite stock – half the market can’t stand it and half the market is prepared to give it the benefit of the doubt and we’re definitely in the ‘benefit of the doubt’ camp,” Custis said.
“The new management team are, to our mind, doing all the right things, engaging with their suppliers and not making it a combative relationship, which clearly existed before and didn’t do anybody any good.”
“I think that engagement is important and I think they’ve had some initial success in that engagement, particularly in growth. Also, they clearly want to make sure their pricing is competitive versus the hard discount supermarkets such as Aldi and Lidl. I think the management are approaching the restructuring of the business in the right way.”
Tesco’s preliminary results for 2014/15 also revealed a £1.4bn group trading profit, which was in line with the company’s expectations. Custis believes that this positive momentum is set to continue throughout the year as the supermarket’s ‘comps’, or comparable same-store sales, make performance improvement easy.
“This time last year the company did two quarters at minus 5 per cent like-for-like. We think the momentum on a relative basis will continue to be evidenced in the market,” he added.
Since the appointment of Davies as chief executive, Tesco has drastically restructured its portfolio, which Custis says is another reason the disgraced stock now seems appealing.
Over the last five years, Tesco has abandoned the development of 62 stores across the UK and shut 43 existing stores earlier this year in a bid to save money.
“I think this pruning of the portfolio is positive,” Custis said. “Our sense is that it’s a very interesting restructuring opportunity. It will take many years to play out and it’s not going to happen overnight, but we continue to find this kind of valuation quite compelling.”
Mispriced: Synthomer
Despite the fund manager’s preference for blue chips, Custis sees a value opportunity in Synthomer, a FTSE 250 stock that supplies speciality emulsion polymers and pharma chemicals.
“Synthomer has been around in various guises for generations. It used to be called Yule Catto and before then it even pre dates me, but it’s been in the public market for a long, long time,” he said.
“What sparked our interest is the fact that they’ve got an entirely new senior manager on board and all the members of senior management have come from a company called Ineos, which is a private chemicals company and is actually the largest private chemicals company in the UK and one of the largest in Europe.”
Former Ineos chief executive Calum MacLean left the company at the end of 2014 and replaced Alan Whitfield of Synthomer in January this year.
However, MacLean became embroiled in a bitter legal battle in April this year with his former business partner Jim Ratcliffe, after Ratcliffe claimed he had poached one of his finance directors, Steve Bennett, in an unfair manner.
Despite Ratcliffe warning that the hire would damage Synthomer’s reputation, this stock has continued its success and has grown in value by 34.23 per cent year-to-date.
Performance of stock vs index in 2015
Source: FE Analytics
“What we like about this business is we think the management expertise that allowed [MacLean] to build up Ineos is now going to be applied in the public domain for the benefit of shareholders, and we think there is the potential for the company to execute their strategy in the public domain because of the number of larger chemical companies in Europe because of player consolidation,” Custis explained.
“We call it a ‘roll-up strategy’ and our analysis suggests that, if they’re successful in executing that, there will be an upside in the share price for its shareholders.”
Compounder: Associated British Foods
Custis admits that he often struggles to find value in compounding companies due to their ability to generate earnings from previous earnings alone.
However, AB Foods, which owns sugar, agriculture, grocery and clothing brands such as Primark, The Silver Spoon Company and Ovaltine, presented an opportunity to the team at Lazard UK Omega earlier this year as a result of poor performance in its sugar operation.
Performance of stock vs index in 2015
Source: FE Analytics
“The company’s sugar profits have fallen £500m since 2012, which is huge – it has fallen broadly to zero. I think that clearly has dampened the underlying earnings growth of the business significantly, for instance Primark which is now at 50 per cent of profits.”
Another factor that made AB Food’s valuations more appealing was the slowdown in Primark’s earnings, which was primarily caused by the strong dollar against the sterling as the company was sourcing in dollars.
Rather than increasing product prices, AB Foods decided to take a margin hit in order to maintain the brand’s reputation for being affordable.
“Obviously currencies have now weakened since then, and actually trading at Primark has been more robust than a lot of commentators were giving it credit for,” Custis pointed out.
“I think the attraction for us was, as we move forward, that they’re opening their first store in Boston, US, which is obviously potentially a massive market for them. They’re then opening eight additional stores in the US in 2016, which is part of a Sears deal. They’ve also communicated to the market recently that they’re opening three stores in Italy as a new geography.”
“We think that Primark has re-established its value credentials and has reinforced its credentials in the high street. They’re opening up what could be a massive market for them - it will be interesting to see how the Americans take to the Primark offering.”
