In the video series, "Fund Managers' Favourites", Morningstar speaks with UK-based fund managers to learn about their top investment picks. In this video, Morningstar journalist Alanna Petroff speaks with Richard Buxton from Schroders about some recent investment opportunities that have caught his eye, including Drax (DRX), 
Lloyds Banking Group (LLOY) and Ladbrokes (LAD).
Roughly a week after conducting this interview in early March, Buxton resigned from Schroders. Find out what this means for his Schroder UK Alpha Plus fund, by reading "Buxton Departure Raises Questions Over Future of Schroders Funds".
Video Transcript:
Alanna Petroff: If you are looking for equity ideas, it seems you can't go wrong with Richard Buxton. Richard runs one of the most popular, highly sought after funds in all of the country, the Schroder UK Alpha Plus Fund and our Morningstar OBSR analysts have said the fund is, “one of the best UK equity funds around.”
Richard joins me now to talk about his investment strategy, his investment ideas and his top picks. So, Richard, thanks very much for coming in.
Richard Buxton: Not at all. My pleasure.
Petroff: Now, you run billions of pounds and what are you looking at when you're looking to invest? There must be a bit of pressure there. What's your investment philosophy?
Buxton: Well, essentially, it is trying to make money for my clients for the investors. I am looking at companies on a very long-term view. I am not a trader. So I am investing for a three-, four-, five-year timeframe. I may spend months gradually building up a position in the portfolio. But what I and my team are trying to do is identify companies where we genuinely think that the market has underappreciated the growth potential, the turnaround opportunity. And I build a concentrated portfolio. It's not related to the index, so it's going to be a bit more volatile than the index in the shorter term. But in the long run, the evidence suggests that we can identify those companies that deliver a return.
Petroff: Okay. Now, let's talk about your top equity picks right now. We have Drax (DRX), Lloyds Banking Group (LLOY) and Ladbrokes (LAD). So let's start with Drax and why you like Drax?
Buxton: Drax is a coal-fired power station up in Yorkshire. It supplies about 7% of the country's electricity. Now the electricity market is actually tightening at the moment because a lot of old coal-fired plants and some gas-fired plants are coming to the end of their useful lives and these things are closing down. So there is actually a shrinkage of capacity.
In addition, Drax has been spending a lot of time and money in converting some of their stations to biomass fuel. Now, the government, they spent a lot of time working with, to get the right level of incentive to switch from dirty coal to clean and green biomass. And we think the efficiency of the plant doesn't drop by as such as people have expected. Actually there is a real win here for the country and a win for the company in terms of the level of profits that they are going to be able to generate from converting to biomass.
Petroff: So this is a bit of a sustainability play as well.
Buxton: It is a bit of a sustainability play as well.
Petroff: Okay. Now, let's move on to Lloyds Banking Group. I understand that you like most of the UK banks, but Lloyds Banking Group in particular, why do you like them? Not everybody likes the banks right now.
Buxton: They are very unpopular. Well, we bought a lot of banks during the financial crisis as they were falling very, very heavily. We fully accept that they’ve needed to rebuild capital and they've had to raise equity. We fully accept that they've got to take losses on a lot of legacy loans and this is a multi-year process. But if you are patient, they are making a lot of progress in terms of reducing the size of their balance sheets and the leverage in terms of taking the losses.
Actually, at the core – there is a business here with strong market shares capable of generating a good return on equity and ultimately the process of taking losses does come to an end. So, if you are patient and prepared to accept that it's going to be volatile, then underlying we think there is a really good business sort of waiting to come out.
Petroff: And Barclays (BARC) is another bank that you are also looking at.
Buxton: Barclays, we also like. It's different because it has still the investment banking arm, whereas Lloyds is a pure retail consumer bank. But again the new chief executive, we think, is doing absolutely the right things in terms of refocusing the business and changing the standards by which it operates and pulling out of areas that frankly it shouldn't necessarily have been in. So we're enthusiastic about all the UK banks, but there are slightly different stories in each one. Lloyds is my biggest bank position.
Petroff: Okay. Now let's move on to your last top pick: Ladbrokes. It seems a little bit odd to me that you'd be investing in gambling essentially, yeah. Okay, tell me more.
Buxton: Well, Ladbrokes is one of those situations in the portfolio, well there is always four or five stocks where you're backing a new management team that has gone into a poorly performing business. Ladbrokes was clearly underperforming its peers like William Hill and Paddy Power. So there was some basic stuff they needed to do to actually improve the level of profitability in the business and they are some way down the road to doing that.
But in addition, the market has worried that the traditional high street bookie is in structural decline. Its customer base is perhaps aging. There is less money being spent on gambling, maybe it's all going the way of the CD and the record player. Now our view is, ‘well no actually there is a whole new generation that is learning to bet in different ways’. It’s via the mobile phone, it's online, it's betting on football during the match, et cetera. It's not just greyhounds and horses. They've been investing a lot of money in the technology to actually enable them to capture this new audience. So we do think that there is scope for the sector itself to re-rate as people accept that it's not an industry that's in structural decline.
Petroff: There is a whole new generation of people willing to lose money too.
Buxton: Willing to lose money, which is fantastic for shareholders.
Petroff: Now let's talk about key risks. One key risk per company, Drax first.
Buxton: Well, Drax, if the government changes the incentive scheme for the biomass that would materially change the argument.
Petroff: What about Lloyds?
Buxton: Lloyds, it's either just if the economy deteriorates and the losses continue for longer, or probably if the regulator decides that they do need to raise more capital today. We think they can rebuild their capital ratios through retained earnings over time. But if the regulator was absolutely determined to say ‘no, you have got to go to this capital ratio today’, they would probably need to raise a little bit of additional equity.
Petroff: What about Ladbrokes? What do you think is the key risk there?
Buxton: Again, it's probably government. If they decided that they wanted to increase the tax take from bookies … it's quite popular if there are Daily Mail headlines about a new generation of addicted gamblers … it's quite an easy win for them to actually change the regulatory basis and the tax take.
Petroff: Okay. Thank you very much for coming in today and sharing your top picks.
Buxton: Not at all. My pleasure.
Petroff: That was Richard Buxton from Schroders. I'm Alanna Petroff. Thanks for watching Morningstar.
