While many investors have fled to defensive holdings so far in 2016, Rachel Reutter and Michael Ulrich, deputy managers on the JOHCM UK Opportunities fund, say there are still a number of under-loved companies worth owning. 
The five FE Crown-rated fund, which buys predominantly out of favour companies, has performed well this year, matching the returns of the FTSE All Share despite a lack of exposure to the so-called ‘expensive defensives’.
Run by FE Alpha Manager John Wood, the £1.8bn fund focuses on management strategy and balance sheet strength before making an investment, as well as paying particular attention to a company’s share price.
Performance of fund vs sector and benchmark in 2016
Source: FE Analytics
The fund has returned 13.54 per cent to investors so far this year, 72 basis points behind the FTSE All Share but 5.26 percentage points ahead of the average return in the IA UK All Companies sector.
Ulrich said: “What we want managements to do is what is right for the company in the long term but what they are being told to do is what is best for shareholders in the short term.”
This year has been difficult to gauge, with many investors focusing on the top end of the market, but below Reutter and Ulrich outline an example of a company that has successfully turned around, one that has failed to do so and one they are currently working to improve.
The success story
One company’s transformation that has been well documented throughout 2016 has been supermarket chain Morrison’s, following the arrival of new chief executive David Potts.
Ulrich says he has the “not really that extraordinary view” that rather than coming from an accounting perspective and therefore focusing on push the margin higher, he is looking to improve the product.
“He has the idea that if he makes the prices more competitive, the staff more trained and have a few more of them, make the stores a bit nicer and increase the availability of the products you will have more people coming into your shop – and it’s working,” Ulrich said.
“So that is an example of management coming in and doing the right things.”
Reutter added that the finance director is known for wanting a strong balance sheet, not necessarily an efficient one, which she says is “music to our ears”.
This change in strategy has been reflected in the share price this year, with Morrison’s gaining 58.70 per cent, as the below graph shows.
Performance of Morrison’s share price in 2016
Source: FE Analytics
While this has provided a good investment for the fund, Ulrich notes that this outperformance has meant the price is now above their target and so the fund has had to sell it off.
“We do have some good management stories, but as soon as it starts to come through the market jumps on it and starts to reflect the good news,” he said.
The tough turnaround
For every Morrison’s however, there are likely to be companies that do not pan out or that take longer than expected to see the changes come to fruition.
For Ulrich this is Capita, where he remains concerned that the management needs to do more to manage its debt.
“There have been catalysts that we have been worried about for a while and have been engaging with management about,” he said.
“And to be fair to them they have taken the message on board, we’ve had discussions about how their debt issues can’t increase and they’re focused on doing that.
“But it just goes to show that just because you think everything is going well and you are managing that high level of debt at the moment, as soon as you have a bump in the road – and all companies do – the balance sheet becomes amplified.
“We’re in discussions and the important thing for us is we need to believe they get what we are talking about improving the balance sheet.
“We cannot tolerate stretched balance sheets especially in what is likely to be a changing and uncertain environment we are facing.”
Reutter added that “Capita has been a mistake and we are definitely learning from this”.
The work in progress
While Ulrich and Reutter remain concerned about Capita, the fund still has a 3.38 per cent holding in the company, putting at the bottom of its top 10 holdings.
Also among the current holdings is Centrica, which the fund has a 4.15 per cent holding in and has been on a downward spiral since the middle of 2013 following a series of profit warnings.
Performance of Centrica’s share price over 5yrs
Source: FE Analytics
Over the last five years the company is down 9.24 per cent and has been on a downward trajectory since 2013, but Reutter sees an opportunity at the firm.
“We’d already been through the process with Centrica where we’d had a change of management and we didn’t like the strategy of the previous management team of buying EMP assets and gearing up the balance sheet at the top of the oil price,” she said.
“We were very encouraged when [chief executive] Iain Conn came in and actually talked about growing sustainable cash flows. When he came in he actually cut the dividend so that already had happened.
“The placing that happened they got caught out – some of the ratings agencies changed some of their metrics and Centrica is a company that has to have a strong credit rating, it can’t operate in too much debt because it’s got an enormous hedging book.
“So unfortunately they were in a position where they had to raise that money in order to function as a business and it also gave them the capacity to make some small acquisitions which are going to help transform the strategy into more retail focused, cash-generative, sustainable strategy in our opinion.”