There is little doubt that periods of market turmoil, such as those we are currently experiencing, will also create opportunities. There are companies currently sitting at market valuations which will prove to have been ridiculously cheap in a couple of years’ time. The difficulty, of course, is deciding now which shares fall into that category.

One man looking forward to this challenge is John Wood, manager of the J O Hambro Capital Management (JOHCM) UK Opportunities Fund.

Wood has nearly 20 years’ investment experience, first as an analyst and then as a fund manager at Newton Investment Management, where he also ran a UK Opportunities portfolio. He moved to JOHCM in October 2005, to launch this similar fund. Stock-specific calls And there are certainly opportunities in the UK stock market at the moment.

Wood feels that ‘2009 and beyond is going to be about bottomup analysis of industries and companies, whereas 2008 was all about big top-down calls and avoiding the carry trade. In 2009, investors will need to focus more on medium-term, sectorspecific competitive dynamics in an environment of severe capital rationing.We are moving into a genuine stock picker’s market so now we are about identifying winners as we move into the distressed phase.’

He explains that ‘The objective of the fund is to produce above-average risk-adjusted returns through the investment cycle and the way we do that is to concentrate on return on equity. In essence, we are buying companies with very high returns and relying on the compounding effect.’

Wood points out that ‘There are two main characteristics to my approach. I don’t use indices to build the portfolio and I use absolute valuation metrics rather than relative valuation metrics. Essentially, what we are doing is investing in the cash flow of the business and relying on the intrinsic value of the business to grow as the business itself grows. We don’t hold unattractive investments.We hold stocks because we want to hold them. There is nothing worse than holding something you don’t like in order to manage tracking error.’

He adds, ‘The fund usually has between 30 and 40 holdings, currently we have 34. All new investments receive 1.5 per cent of the portfolio. We feel we are making a commitment to a stock, but we don’t automatically rebalance the portfolio. Everything starts off at 1.5 per cent and the target is to get it to three per cent.’

Large-cap focus
This means that the portfolio favours the strongest franchises among the larger UK-listed stocks. Wood explains that ‘The initial screen is return on equity and our universe is mainly the FTSE 350 stocks.We look for sustainability of that return, which itself reduces the list down to 60 to 70 stocks, roughly half in the portfolio.’

And he insists that ‘Capital rationing will be crucial going forward.What you want to own are companies with access to capital, be that debt or equity, and they tend to be the largercaps. But what we are expressly not doing is hiding in big-caps simply because they are big.’

Wood adds,‘Because we have had a bubble in financials, in banks in particular, when it burst, it caused a global economic recession, which means that everything is going to slow down. There will be a raft of rights issues coming and the bankers will say that you have to come first in your sector to get funding. That is capital rationing, but those companies that do manage it will be in a position of strength. So, for example, there are some companies not in the portfolio at the moment that need rights issues and if they have them we will reappraise them.’

Patience is a virtue
Wood also insists that, in order to receive the full benefit of this strategy, you have to be prepared to wait. ‘The key factor is time. If a company is maintaining a return of 20 per cent a year then that will amount to a very significant figure over time. You need patience. The dominant factor in the market at the moment is speculation, focusing on where share prices are moving. But there is a difference between the fair value of a business, which is discounted cash flow, and market valuation, which is driven by speculation.’

He asserts,‘It is easy to identify companies with a high return on capital.The hard part is to manage the noise that emanates out of the market.At the moment, we have a lot of distress and when you have a lot of forced selling, that is a good time to buy on a three-to-five-year view.’

Wood is also very clear about the importance of knowing when to get out of an investment that isn’t living up to expectations. ‘The assumption is that we are going to hold an investment for some time, but when we get this wrong, when there is something wrong with the cash flow, we sell to zero.’

He adds,‘In the last 12 months, turnover has been 68 per cent.We have a higher turnover than a lot of conventional funds because when we get it wrong, we sell. Because of the uncertain times we now find ourselves in, nobody wants to take any risk at the moment. We want to do the opposite and that means the failure rate will go up and we will continue to sell when we get it wrong.’

Concentrating on cash
Wood explains, ‘The fundamental strengths of a business are top line sales growth, with volume growth as a key element underpinning that. For example, Capita and Serco are two of the biggest holdings in the fund. They are outsourcers, but they are contract based, so they don’t start the year with nothing and you are looking for a further 10 to 15 per cent growth.’

He adds,‘Cash is the ultimate measure. The golden rule is that if cash flow is broken, then you sell it. When we look at a set of results, we should be able to see what is relevant in 20 minutes. You start with the top line growth and see how that links to cash conversion.You find these characteristics more in some sectors than others.They tend to push you towards sectors with high barriers to entry, so we tend not to like retailing concepts, for example, but barriers to entry actually create a high return.’

Focused research
Wood says that ‘We do a lot of due diligence before we buy a stock, and that means looking its competitors as well as its own numbers, because we appreciate that what we are doing is investing via a share price in a management that will manage our capital.’

He argues that ‘The skill in fund management is to leave the winners alone and get rid of the poor performers as quickly as possible.You can use up a lot of emotional time dealing with that.The key skill is to invest capital, sell out and then take that capital and invest it somewhere else.’

And Wood concludes,‘It has become fashionable for fund managers to think they know how to run a business better than the business managers. Short-term gain has dominated as a philosophy, rather than the long-term development of a business, and that is why there are so many problems in some sectors. It has encouraged financial engineering, sale and lease back deals, and so on and the consequences of these approaches are now coming home to roost.’