Fund Managers’ Favourites: FTSE 250 Opportunities

Fund manager Richard Watts from Old Mutual discusses 3 UK mid-caps on the FTSE 250 that have plenty of growth potential

Alanna Petroff 25 September, 2012 | 1:25PM
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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 fund manager Richard Watts from Old Mutual about three of his favourite UK mid-cap companies. These are companies that he’s been buying into his Silver-rated Old Mutual UK Select Mid Cap Fund.

Funds and Securities Mentioned in this Video:

Old Mutual UK Select Mid Cap Fund (Rating: Silver)
Analyst Research (Premium members can see why this fund received a Silver rating)
Persimmon (PSN)
UNITE Group (UTG)
Ashtead Group (AHT)

Video Transcript:

Alanna Petroff: The largest companies listed in London are traded on the FTSE 100 Index. These are the companies that grab the headlines and move the markets. However, there are the mid-cap companies on the FTSE 250 that are a little bit ignored sometimes, but offer a lot of growth potential. So joining me now to discuss mid-cap opportunities on the London Stock Exchange is Richard Watts. He runs the Silver-rated Old Mutual UK Select Mid Cap Fund. So Richard, why mid-caps? Why do you like mid-caps?

Richard Watts: Well, the mid-cap part of the UK market is extremely dynamic. So lot of fast-growing companies and it's that fast-earnings growth that really, in my view, is the source of the substantial outperformance of the mid-cap index versus the large-cap [index] over the last 10 years or so.

Petroff: So if you can stomach a bit of volatility, then mid-caps might be for you?

Watts: I think absolutely. I think, really, I mean, what drives valuation ultimately over a longer timeframe is earnings growth and the mid-cap index historically has delivered far superior rates of earnings growth over time.

Petroff: Okay. Now, let’s go over your top three picks on the FTSE 250 right now. We have three companies: Persimmon, UNITE, and Ashtead. Let’s talk about Persimmon first. They are in the home building sector. Why Persimmon?

Watts: We really like the house building sector at the moment. Persimmon is one of the largest house builders in the UK, and quite simply, what's happening here in the sector is that these house builders bought lot of land post the credit crunch at very attractive prices. They are now building houses on that land today at very substantial profit margins. 

So this is really a profit recovery story. Balance sheet is also very strong. So Persimmon has got net cash in its balance sheets. It's got a great balance sheet. It’s actually committed to returning a substantial amount of its capital in the next nine years, almost equal to its market cap. So what you have here is a strong dividend or income story and you end up with a house builder that's actually going to grow through time as well. So it should be worth more at the end of it as well.

Petroff: Okay. We have UNITE, that's in the housing and, well, residential sector. Tell me a little bit about UNITE. They are a bit of a different company.

Watts: Yeah, slightly different. UNITE is a real estate company. UNITE owns and operates student accommodations. So you think when students go to university, the typical accommodation here would be provided by someone like UNITE. UNITE builds the accommodation and rents the rooms out. I mean it’s that simple. 

The story here is that UNITE trades at a substantial discount to its net asset value. So this is the book value of the company. It’s roundabout 30% discount today. Now, looking at the company and looking at the prospects, we think net asset value will grow at roundabout 15% per annum. So what you have here is a re-rating story as the discount-to-book value unwinds through time and the fact that that book value should grow at roundabout 15% per annum. So in our view, this is actually very attractive.

Petroff: Why was everyone ignoring this stock? I mean trading at a discount that seems remarkable.

Watts: Yeah. I mean, when we bought into the share, it was trading at roundabout a 50% discount. So 30% today but really substantial discount when we first bought in. There was a lot of fear around basically. Looking at the student market in the UK with the tuition fee increase from £3,000 to £9,000, and many people out there thought that would put a lot of students going off to university. Clearly, obviously, if your business is renting rooms out, the fear was ithat actually your occupancy levels would fall. And it’s not proven to be the case. Actually there has been a little bit of an impact on student numbers but for UNITE, occupancy levels are currently 98% to 99%. So, not really much of an impact at all.

Petroff: And no discounting their rooms for rent, or anything like that?

Watts: No. Rental growth has been pretty good. We think rental growth will be something in the range of 3% to 4% this year. When you actually sort of compare that with other real estate stocks, 3% rental growth is pretty attractive at the current point in time. So, it really does stack up on a number of measures for this company.

Petroff: Now let's talk about Ashtead, your last top pick. You've been loading up on this company for a while now. Tell me why?

Watts: Ashtead is one of the biggest possessions in our portfolio. It's been a great performer for us over the last 18 months, two years or so. Ashtead is a US rental equipment company, basically. It's got a small operation in the UK, but this is really about a story on the US market. 

This is not about end-market recovery. This is about a structural change in its marketplace and what do I mean by structural change? Well, lots of its competitors in recent years have gone out of business, so a difficult environment, very difficult to access financing, so replenishing their fleet was very, very difficult. Ashtead's got a really good balance sheet, so not a problem for them. 

And there has also been a structural change with its customer base as well, so customers choosing to rent rather than buy. Obviously, not buying because of the constraints in terms of availability of credit. So, there is a structural change in the marketplace that is driving very, very fast top-line growth, so revenue growth is very, very strong. And by the very nature of being a rental equipment company, rental companies are highly operationally geared, and what I mean by that, fast turnover growth drops through and delivers even stronger rates of profit growth, so fast top-line growth is really driving profits quite significantly at the current point in time.

Petroff: And you are going to continue buying and holding for the long-term for this one?

Watts: Absolutely. We had a trading statement two weeks or so ago. Very, very strong update. So, the company continues to trade very strongly. I think what's probably changed, in a positive way in recent months, there are signs that the US house building market and the US light construction markets are actually showing signs of gently improving, which will be absolutely fantastic.

Petroff: 
Definitely. Now let's go over one key risk for each company. So what's the key risk for Persimmon?

Watts: The key risk for Persimmon, as it is for all house builders, is really if house prices start to fall from here. So, our investment is predicated on flat house prices. So we are not expecting house prices to grow, we just don't expect them to decline. So that would be the key risk there.

Petroff: And UNITE, I feel like the key risk is kind of past us now with the rise in tuition rates. What's the current key risk you think?

Watts: I think you are absolutely right. I think the key risk is behind us. Obviously we are about to start the new student year. So, that key risk I think we've actually moved through it. It's part of the reason why the shares re-rated so strongly in recent months.

Petroff: Okay. Let's go over Ashtead, the key risk. Well, I mean, most of the revenue is from the US market.

Watts: That's right, yes.

Petroff: So, macro level risk, I suppose?

Watts: I think you've identified it. This would be the concern or the key risk there would be if the US economy starts to go backwards then obviously that wouldn't be great news for construction markets in America. So, macro really is the key risks there.

Petroff: Okay. Thank you very much for joining me today.

Watts: Thank you.

Petroff: That was Richard Watts from Old Mutual and I am Alanna Petroff. Thanks for watching Morningstar.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Alanna Petroff

Alanna Petroff  is a financial journalist with Morningstar UK.