The focus on UK mega-cap stocks by international investors is leaving a number of overlooked special situation-type opportunities further down the market-capitalisation scale, according to CRUX Asset Management’s Richard Penny.
Veteran fund manager Penny is to launch a new UK special situations fund after joining CRUX in June having left Legal & General Investment Management (LGIM) at the start of the year.
Between May 2005 and December 2017, Penny oversaw the L&G UK Alpha Trust during which time it delivered a total return of 319.20 per cent compared with a gain of 161.96 per cent for the average IA UK All Companies sector fund, as the below chart shows.
Performance of fund vs sector under Penny
Source: FE Analytics
The FP CRUX UK Special Situations fund will target long-term capital growth from a concentrated portfolio of around 40-60 ‘best ideas’ – UK companies where the manager sees good upside – and is due to launch on 17 September.
Penny said that his latest fund would not be dissimilar to his previous L&G Alpha Trust – which will make use of a bottom-up stockpicking approach – but will have greater leeway to invest in smaller companies.
As such, the manager will invest one-third of the portfolio in FTSE 100 companies, one-third in mid-sized stocks and one-third in smaller companies.
Within this, five or six names will derive from the FTSE 100, 10-12 will come from the mid-tier, and 15-20 companies will be located in the small-cap space, covering around 5 per cent of the total investable universe.
“We’ll only buy the smaller companies if they can add to the strategy and the reasons why they may do that is that it’s a really inefficient part of the UK market,” Penny explained.
In the large- and mid-cap parts of the market, Penny said there were a number of recovery situations, particularly in the oil & gas services sectors – as oil prices rise – and the embattled retail sectors.
The manager will consider stocks in distressed situations where confidence has been lost by the market but where he believes there has been an overreaction.
“Just because something’s gone wrong and may need money doesn’t mean we’re going to invest in it, we’re going to be very selective in recovery stocks,” he said.
Indeed, Penny said he would be putting his own money into the new fund, something that he also expects from the management teams of the businesses he invests in.
“The idea of alignment is a core principle of CRUX but it’s also something I look for within the businesses we invest in,” he said.
At the smaller end of the market capitalisation scale some interesting growth stocks can be found, particularly among burgeoning technology companies and areas of the market where management can add value through acquisitions.
Indeed, Penny said it is particularly prudent that UK investors look at smaller companies given the bias by some larger institutions to larger, more liquid mega-cap stocks in the FTSE 100.
“There are a lot of people looking at the area and it can be more difficult to find business that give you a lot of upside in the mega-cap stocks in the UK,” he explained.
“At the same time that people have been moving up and up the market capitalisation, there are more opportunities in under the under £200-500m space.
The Crux manager added: “It’s also true that fund buyers have been concentrating: as people are buying bigger funds that buy bigger businesses sometimes they become too big for whatever they were originally built to be.”
While investor concerns about valuations have increased in recent months as markets have marched higher, Penny said there was nothing to worry about in the UK market.
Indeed, since the EU referendum the UK market – as represented by the FTSE All Share index below – has lagged behind its global peers, returning just 25.56 per cent compared with a gain of 49.93 per cent for the broader MSCI AC World index.
Performance of indices since EU referendum
Source: FE Analytics
“I don’t think valuations are at the top of the market,” he said. “The UK stock market isn’t the UK economy. If we look at global markets, the growth momentum is certainly way out there.
“But if I look at portfolio construction obviously we’re launching a fund that is built for this market.”
Indeed, among the characteristics of the high-quality businesses that the manager aims to invest in – along with low debt, strong management teams, and an economic advantage – are those that have a strong geographic exposure limiting the impact of Brexit somewhat.
Despite the continued growth of markets since the global financial crisis, Penny said active management can deliver and outperform indices, particularly when managers are also co-investors.
“If you take funds where the manager is invested meaningfully there is 2 per cent per annum outperformance,” he said.
“So, while it might be very convenient for [passive] investment houses to say that active managers underperform, it’s also very inconvenient for them when those funds where managers put their own money into the fund outperform on average.”
“To some extent I’ve done this before: I started a fund that was £5-10m and run a concentrated best ideas fund,” he added.
Another positive for the fund, according to Penny, is its high-conviction approach to asset management which should also help it outperform the broader market.
He added: “If you look at the UK fund space, of 250 funds there are actually quite a different selection.
“A lot of the other funds are closet index trackers maybe where funds have been going for 20-30 years and lost their mojo.
“Then you’ve got a lot of very small funds that never make it and lost their way, and there are some funds that may well be concentrated best ideas funds in a manner similar to ours that have got to a size of several billion pounds and can’t buy into the stocks they need to make performance.”
Penny concluded: “The proposition of the CRUX fund: this is the same I’ve done before, I’ve started small and so you’re buying a fund that has the capability to deliver outperformance.”