Running a fund that concentrates on a particular sector, or group of companies, brings its own set of rewards and problems. When it is in favour, outperforming the market should be relatively easy. It is when the market is shunning your chosen sector that the ability of the manager to discover hidden value is put to the test.

This is the task facing Simon Shaw of investment boutique EEA Fund Management as manager of the CF EPIC Insurance & General Fund. Despite the fund’s name, he is keen to point out that it covers the full spectrum of financial sector stocks: ‘The fund invests in companies whose activities are predominantly, or partly, deemed to be within the financial services industry. So it is actually a general financials fund.

‘If you look at the largest holdings in our portfolio, you find companies like Domestic General, which is in the insurance sector but is more of a service company. We can potentially include everything that is in the financial sector, and that gives us a lot of scope.’

He adds, ‘The fund’s portfolio is predominantly invested in UK companies, with one US holding and a couple of European ones.

There is also a bias towards holding small and medium-sized quoted companies.’

Looking for value

Shaw explains that, although he adopts a clear investment style, it would be a mistake to take too rigid an approach, especially in a sector that can be volatile, as recent events have proved. He sums it up by saying, ‘We take less risk than our competitors. Our investors want us to build a track record over time, without taking too much risk. We construct a portfolio from companies that fall into three categories â“ value, growth and momentum. The mix will depend upon the available opportunities and can, therefore, move from a growth bias to a value bias and vice versa.’

He adds, ‘Our proposition is that, by not being rigid in the selection of investments, the portfolio can persistently outperform. We are biased towards value, but I have been doing this since 1981 and there are definitely years when you need to follow growth themes rather than value. Over time, we would favour the value approach, but we also believe that growth companies are good things to own.’

He adds, ‘The most important thing is that companies grow, but they must grow in a capital-sustainable and cash-generative fashion. Our perfect investment is a deep-value investment which then produces the earnings that the market was worried it wouldn’t deliver. For example, you invest in a company with a price to earnings (p/e) ratio of seven that then goes to nine and ends up at 20 or more, and throughout the process profits are growing at 20 per cent.

‘Back in 2003, there were a lot of companies, such as DTZ, that were doing very well, but investors didn’t believe they were because of the problems of the market as a whole. We feel that there might be a lot of opportunities like that in the financial sector over the next few months.’

Of course, finding such paragons of virtue is easier said than done, but Shaw argues that the specialist focus of his fund means there is a strong chance of identifying them when they do come along. And the diverse nature of the financials sector means that there is also scope for asset allocation, even within a sector specialist fund.

He points out that ‘The fund had a heavy insurance weighting last year, which stood us in good stead, and we have been underweight banks for a while. However, if we do get a down cycle in banks, then we would likely look to buy the probable winners in the sector â“ companies with a strong banking business that could look to expand their margins in the future.’

Avoiding the banks

Explaining why his fund has been wary of the banking sector, even before the recent credit problems, Shaw reports, ‘We felt that the nature of banks’ earnings was changing as a result of the growth of venture capital. What you have seen with the private equity boom is banks putting some, often quite substantial, one-off equity profits through their P&Ls, which, by definition, aren’t going to be repeated.’

He adds, ‘As a result, you are seeing profits going up at the same time that the banks’ ratings are going down. The paper held by the banks is generally pretty good quality, but the current credit squeeze means that they are going to have difficulty financing the short end of their books.

‘This, in turn, means that they will have to hold more cash, which will clog up their balance sheets. In addition, short-term funding costs are very high at the moment, which means that the banks’ margins are being squeezed. In some extreme cases, they may even be making no money at all.

‘The market has been most concerned about problems in the credit markets, and especially problems in the US sub-prime mortgage market. Investors don’t know who exactly is most exposed to these problems, and many financial stocks are getting hit even though their businesses may have no exposure to this area. A lot depends on how the money market reacts, but it looks pretty certain that the value of the banks’ assets and the fees they get from this business will fall, while the costs of holding these assets will increase.

‘We would be more bearish than most on the US economy as we would be worried that the seizing up of the credit process would start to squeeze the US housing market.’

An ill wind

However, this itself creates opportunities for his fund. ‘Our insurance company exposure has mainly been to the US, particularly windstorm cover,’ he says. ‘Again, if you look at our top ten holdings, Beazley is writing US liability business and Heritage Underwriting is an arbitrageur of windstorm cover. The high impact of windstorms in the States a couple of years ago means that this type of insurance contract is now very attractively priced, assuming that you get two major hurricanes a year.’

He adds, ‘The current level of rates for windstorm cover means that if you do get two hurricanes a year, you will make money, and if there are less than two a year, you will make a lot of money. So far this year, there has been comparatively little storm activity. We still think that this type of cover is well priced, but if we have another benign year, those rates will start to fall.’

And he draws a stark contrast with the UK insurance sector: ‘Conversely, I wouldn’t want any exposure to the UK insurance market. It is very competitive, probably too competitive. We don’t feel that the rates on UK business are high enough, and in some areas they are dangerously low.’

Shaw admits that ‘Given this level of US business exposure, we have suffered badly at the hands of the currency. Most of the companies we hold make their profits in US dollars, and the effect of dollar weakness has been to reduce the fund’s profits by 15 to 20 per cent.’

But he explains, ‘We don’t get involved in any hedging, as that is not our field of expertise, so investors are buying a lot of US exposure with this fund. Having said that, a lot of UK-invested funds have a significant amount of US dollar exposure as an increasing proportion of their earnings will also be received in dollars. The currency is the most difficult thing that we think about, but the more we think about it, the more we conclude that we can’t really make a call over it.’

Lloyd’s exposure

Another key aspect of the insurance element of the fund’s portfolio is its exposure to underwriters, both in the London-based Lloyd’s market and overseas. ‘We hold a number of investments in the Lloyd’s and Bermuda-based insurance companies, which have performed well,’ says Shaw. ‘They tend to be on low p/e multiples and pay very good dividends, which is useful in a time of volatility.’

He adds, ‘There should be some consolidation in the Lloyd’s market, but I am not convinced that it is going to happen. You should look at Lloyd’s brokers as part of the wider insurance market, and there are very compelling reasons why Lloyd’s companies should change their structures.

‘At the moment, there is a massive arbitrage between Bermuda and the Lloyd’s market. Lloyd’s offers a much more efficient capital base than Bermuda, but Bermuda is tax free. So, logically, you would have a Bermudan company taking over a Lloyd’s broker to get access to a wider range of capital, but then reinsuring back into Bermuda to get the tax breaks, and we have seen a few recent examples of this.

‘We were largely out of mergers and acquisitions (M&A) last year. Our premise is that, if we buy good companies on low valuations, that is historically where M&A takes place. There has been a lot of M&A and potential M&A in our sector, but there has also been a lack of definition.’

This article is from the October 2007 issue of What Investment.