It’s important to strike a fine balance between buying value stocks with strong brands and balance sheets and buying cheap companies enduring a crisis, according to Alex Savvides. 
Investors have had a tough few months in the UK thanks to various macro headwinds such as the threat of China’s ‘hard-landing’, the Greek debt negotiations and uncertainty over the future of interest rates.
The FTSE All Share, for example, is down some 5 per cent over the past month but following the recent falls and as the US has decided to hold of raising interest rates, many experts are anticipating a rally in equities which should suit investors in higher risk areas of the market.
However, the FE Alpha Manager – who runs the five FE Crown-rated JOHCM UK Dynamic fund – says that investing in recovery stocks involves focusing on yield, management, cash generation and a demonstrable ability to improve returns on capital.
As such, he steers clear of any companies under £100m in value, and will usually choose to invest in companies that are more than £200m in size.
“I try and avoid the very small, very illiquid companies that haven’t really got a long trading history,” he explained.
“I don’t back fly-by-night companies or companies that are very new to the world of stock market investing. I don’t typically back IPOs, they’re not really a fertile hunting ground for a recovery special situations strategy, which this is.”
“I do look for a longer trading history from the company that I invest in and a better market position. Where does this company sit within a market – does it have a good position? Does it have a brand, either for its goods or services? What is it known for? Is there customer loyalty? Is there an ability for the business to recover itself very quickly because it has a well-known brand? Market position is important.”
UK small-caps have increased in popularity this year following the election of a pro-business majority government in May and a strong domestic economy, while the more international facing large-cap index has been hit by the macroeconomic headwinds which have caused a rout in global equity markets.
UK mid-caps, however, have delivered the strongest performance in 2015 and have returned 8.15 per cent, outperforming the FTSE Small Cap index 1.19 percentage points and the FTSE 100 by 10.38 percentage points.
Performance of indices in 2015
Source: FE Analytics
This is also an area of the market that Savvides has been reducing his exposure to over the last year, as he says it is difficult to find the blend of cheap valuation and corporate change that he looks for when allocating capital to new ideas.
Instead, he has bought into large- and mega-caps in the recovery space for their attractive dividend yields and their well-established business models, despite many investors’ fears that such dividend-paying blue-chips are high-risk ‘bond proxies’.
Currently, JOHCM UK Dynamic has Royal Dutch Shell, HSBC, BP, AstraZeneca and Barclays as its top five holdings, with more than 5 per cent of the portfolio weighted in each of the top two.
“There are two things that are going to happen when a company like Shell or any other company hits a yield of around 7 per cent as it is today. Either they’re going to cut their dividend or they’re going to keep paying their dividend and the share price is going to revert to a price that brings that yield down.”
“I firmly believe that, with Shell, they will pay their dividend, they will continue to pay a dividend and, as a result of that, either shareholders will get their minimum 7 per cent yield if they choose to take it or they will grow their profits.”
“At the current valuation of the company I can’t see you losing too much on your capital at the same time because the valuation is low – they’re nearing at or around book value which is traditionally very low for companies such as this.”
As a result, the manager believes that these high-yielding stocks can offer very attractive opportunities and should be taken seriously, especially as share prices have decreased and yields have increased.
However, he warns that these stocks must be selected carefully because, if the businesses are being mismanaged in some way, the capital will be destroyed beneath the investor and will counteract the high yields.
“In the case of these companies, Royal Dutch Shell, HSBC and BP among others, all of these mega-cap companies that the market doesn’t like at the moment, they are all being managed in a way underneath the surface that is much more attractive to an investor like me that focuses on change investing, that focuses on trying to improve returns on capital,” he continued.
These weightings are a far cry from how Savvides’ portfolio looked 18 months ago. Back then, he was very much underweight oil and saw no appeal in holding banks due to issues surrounding prior misconduct charges, which meant a lot of their capital generation went to paying fines.
As the graph below shows, the FTSE 350 Banks index has been hurt by the increasingly negative sentiment and has been underperforming the wider UK equity market for a number of years now.
Performance of indices over 5yrs
Source: FE Analytics
“Actually, as we look at the sector today within the broader financial space, we do find the sector looks a bit more interesting,” the manager said.
“Going back to basics, we back companies that are going through corporate change and when I look at the bank space I see a set of management teams that have been pushed very hard by the stock market to change their behaviour.”
“That’s as a result of the financial crisis of course, but it’s also as a result of regulatory changes that have stemmed from the financial crisis. So we see a set of businesses that are being forced, because of a scarcity of capital, to be more efficient and to think about what businesses they are in and the returns those businesses generate.”
In terms of oil stocks, many investors are bearish on the sector huge falls in the oil price over the past 18 months which means brent crude sits at just $49 a barrel.
Savvides says that the appeal of holding firms such as Shell and BP is a combination of strong business management, good valuations and capital return prospects.
“We talked about the yield, that’s fine, what about the capital return? There’s no doubt that over a longer period of time, for us to generate a substantial capital return from our investments in BP and Royal Dutch Shell we would have to expect that the oil price would recover somewhat,” he explained.
“It doesn’t need to get back towards previous highs at all but, currently, the incentive price for new production is somewhere around $70 and maybe a bit higher – it’s very difficult to get oil out of the ground, it’s found in deep water and unfavourable environments in parts of the world with strange tax structures, so it’s costly to get this stuff out the ground.”
“Although it’s not happening today, there will be a mismatch of demand and supply over time at the current rates of production. This would inevitably lead to a stabilising oil price because you’d need to get the oil price up as an incentive for new production to come on stream to meet demand.”
“We are expecting a recovery at some point. Am I expecting it tomorrow? Next week? Next month? Next year? No, I’m not. But I do believe in the rational economics that would support, over time, some improvement in the oil price.”
Over Savvides’ tenure, JOHCM UK Dynamic, which is £343m in size, has returned 111.2 per cent, more than doubling the performance of its FTSE All Share benchmark and outperforming its IA UK All Companies sector by 53.52 percentage points.
Performance of fund vs sector and benchmark over management tenure
Source: FE Analytics
The fund has a clean ongoing charges figure of 0.74 per cent and yields 3.42 per cent.
