Fund Managers’ Favourites: No-Limits Investing

Video Transcript:

Alanna Petroff: Enough of this focus on just small-cap, or just large-cap, or just value, or just growth. 

Old Mutual's Simon Murphy looks at all of the companies traded in London and tries to cherry-pick the very best of the best. He runs the Old Mutual UK Select Equity Fund, which is rated Bronze by our Morningstar analysts, and he joins me now to talk about his investment strategy and his top picks listed in London right now.

So, Simon, let's go over your investment strategy a little bit. If you look at the whole market, what's the strategy that you have when you're cherry-picking these companies?

Simon Murphy: Sure. Well, our process is designed basically to construct portfolios that consist of stocks that come from three particular investment themes that we have found over time consistently make us money, but importantly, really complement each other when you put them together in a portfolio.

Those three things are:

- undervalued quality: companies that we think actually the market is not giving an appropriate rating to, given the strength of the underlying franchise of the business.

- Internal change: companies which are undergoing self-help measures to improve future performance. These companies are often associated with management change.

- Finally, external change: companies that are in an industry which is undergoing some sort of structural change and they are benefiting, as are the whole industry, from that particular changed dynamic.

Petroff: So your favourite three companies right now are Signet Jewelers, Wolseley and Capita, all traded in London, and they each fall under one of those three categories. So Signet would be undervalued quality, Wolseley is internal change and Capita is external change. So let's start with Signet and why you like that. And what exactly do they do? Not everyone would know.

Murphy: Sure. Well, Signet is actually the largest jewellery retailer in the world and it’s the number one retailer in the US, with its Jared and Kays brands. It gets about 80% of its earnings from the US, so it is by far the most important area for them.

What we like about Signet particularly is not only it is a play on recovering US consumer confidence, which is looking like it’s starting to pick up, but because it is the number one player, it has some scale advantages in terms of new products, in terms of ability to do national advertising, and to grow the store chain.

What that means is they are continuing to take share from weaker competitors. So we think that the company is capable of doing solid double-digit growth over the next few years, given those brand and franchise strengths. We don’t think that’s reflected in the valuation of the company. It’s currently on approximately 10 times forward price-to-earnings multiple, generates a lot of cash that it’s returning to shareholders, and we are really quite excited about the outlook for the business.

Petroff: Let’s go over now: Wolseley. That fits into the internal change category that you have. So why Wolseley, and what’s so great about their internal change strategy right now?

Murphy: Sure. Wolseley is the world's largest plumbing and heating distributor to the trade builders. It again is a very US-centric business. Approximately, 60% of the business is in the US. It had great difficulties post the credit crisis and the downturn in US housing; and we brought in new management in the summer of 2009, led by Ian Meakins, the CEO. He has really set about reinvigorating the business. He has basically sorted out the balance sheet and taken the extreme debt position down to almost net cash now. He sold off a lot of non-core, low quality businesses. The efficiency in the businesses that are left has really been improving.

So the operating margins of the company have gone from 1% in 2010 to over 5% now. We think there is a lot more to go here and also – we also think they will be a key beneficiary of any recovery in the US housing and construction industries, which look again like they are starting to turn up.

So it is not as cheap as Signet. It is on about 13 times forward earnings, but we think there is still a lot of internal change with a bit of help from the US construction markets and we think the company again will do solid double-digit growth for the next few years.

Petroff: Okay. Moving on to the external change category, you have Capita as your company there, as your top pick in this area. What is it about Capita that you like?

Murphy: It's a fairly recent purchase for us in the portfolio and it's the UK's leading business process outsourcing company. Basically, it does back office administration and customer contact for both the public and the private sectors.

The big external change here we like is simply the state of the UK government’s finances. Given the pressure on budgets and the desire to save money by the government, there is an increasing desire to outsource to the private sector for efficiency benefits. Capita, being the market leader there, is in a prime position to take on a lot of new contracts and win a lot of business.

The contracts it takes on are typically long-term contracts with good visibility on revenue and earnings. So we see again with this business the capability of doing double-digit earnings growth over the next two to three years off a rating of approximately 13 times earnings, which again for us looks good value given that change is going on the back of the government's finances.

Petroff: So now let’s go over the key risks, because there are always risks for, obviously, any investment. So for Signet Jewelers, what would you say the key risk is there? 

Murphy: The principal risk there is the US economy and, in particular, unemployment, because people lose their jobs, clearly they won't be spending so much on diamond jewelry and so forth. So it's principally a macro risk around the US economy and unemployment.

Petroff: And Wolseley, what about Wolseley?

Murphy: Not dissimilar. It's again a US-centric business, so it's a US macro-economic risk, though in this case it's more about housing market and construction markets in general, rather than necessarily unemployment per se.

Petroff: Okay. Capita?

Murphy: Well, Capita is really – the big risk there is reputational risk. It's taking on a big high-profile public sector contract and making a mess of it; that's the big risk. We’ve seen a few of those from companies, historically. Capita have a great track record, but...

Petroff: Of not messing up?

Murphy: ...of not messing up, but you never know.

Petroff: All right. Okay. Thanks very much for coming in, Simon.

Murphy: Thank you.

Petroff: That was Simon Murphy from Old Mutual. Thanks for watching Morningstar.