All but the gloomiest of bears are now agreed that the UK recovery is well under way, not least former Schroders star manager Richard Buxton, who joined Old Mutual last year. But an improving economy does not necessarily translate into easy and abundant returns for equity investors.
"Early-stage shares such as housebuilders and retailers have already been great performers and we have made a lot of money out of holdings such as Taylor Wimpey (TW.) and Next (NXT)," says Mr Buxton, who now manages the Old Mutual UK Alpha Fund (GB00B96MWT53). "There is an argument that you should buy later cycle companies - for example, those that benefit from corporate sector buying such as engineers and industrials. But I am happy to have these, and retailers and housebuilders which will still benefit from profit growth. There is a risk of selling too soon because certain stocks have gone up."
Taylor Wimpey's share price came down between February and April. "But Taylor Wimpey should deliver strong profit growth over the next two to three years - it has got pretty strong cash flow," says Mr Buxton. "If it falls from its peak prices I am likely to buy more."
Portfolio holdings also include International Consolidated Airlines Group (IAG) which owns British Airways and accounts for 3.79 per cent of assets. "This should benefit as it is much more driven by corporate sector spending, as should industrial and manufacturing company Melrose (MRO)," he says. "Whitbread (WTB), on a price-earnings ratio (PE) of 22.63 times, is also unlikely to re-rate more but should continue to deliver good profit growth and still make money, although it will not be like the last five years."
For some investors banks are a no go area but Mr Buxton is optimistic that they will be beneficiaries of both corporate and consumer spending. "Mortgage spreads are good and if small to medium enterprises become more confident they will borrow from banks," he explains.
Financials account for about a third of the fund's holdings, with around 11 per cent in banks and 14 per cent in insurance.
"We have added to Barclays (BARC)," says Mr Buxton. "As we expected, it has announced a more radical downsizing of the investment bank than many investors had anticipated. We believe there is material upside in the share price.
Although Lloyds (LLOY) is well off its recent lows this is the sector most people are reluctant to back significantly as they are concerned it will never make decent returns. But as banks return from deleveraging to volume growth they will benefit, and I think we will look back in years to come and say the banks were cheap."
Another area Mr Buxton invests in is pharmaceuticals. This sector is more normally associated with equity income funds than growth funds like Old Mutual UK Alpha, because while they can offer attractive dividends large pharmaceutical companies are not high growth.
"But dividends are an important measure of a company's values, and a management focused on growing dividends is a good thing," he explains. "It is part of our assessment of a company but any income we make is accidental - we don't target this. In pharmaceuticals, my key position is Shire (SHP) which is very much a growth company.
I hold GlaxoSmithKline (GSK) because I bought it at around £10 a share which I thought was ludicrously undervalued [the company now trades at around 1,622p a share]. It has taken longer to improve returns but it is getting there. However, I am not holding it for its income yields."
Pharmaceutical companies have hit the headlines recently because of merger and acquisitions (M&A) activity, most notably US company Pfizer's approach for UK-listed AstraZeneca (AZN).
"GlaxoSmithKline's recent asset swap with Novartis is sensible M&A," says Mr Buxton. "But I think you have to look at the merits of each individual company rather than whether it is involved in M&A. For example, I won't suddenly buy AstraZeneca because of the bid approach - I am not a speculator. I have held GlaxoSmithKline and Shire for a number of years.
Every stock has to be in the portfolio on its individual merits, but we do look at areas that are likely to positively surprise or have a tailwind of economic activity behind them. Individual company management, balance sheets and cash flow are among the company-specific attributes we consider important."
While an uptick in the UK economy and market is positive, it doesn't make things easy for value seekers.
"We have had five years of market recovery and it is not like in 2009 to 2010 when there were loads of cheap shares," says Mr Button. "But, for example, betting company Ladbrokes (LAD) and broker ICAP (IAP) are very cheap and could make a lot of money if things develop as I hope. And the cash flow that mining stocks will throw off in the next two to three years makes them pretty interesting investments."
Portfolio holdings in this area include Rio Tinto (RIO) which accounts for 4 per cent of assets.
"Aerospace and marine engineer Rolls-Royce (RR.) warned on profits earlier this year but I met its chief executive and am aware that because it has such a long cycle you have to be a long-term shareholder," adds Mr Buxton. "Its marine business will be helped by corporate spending and we should see cash flows in 2016 and 2017."
Having what Mr Buxton describes as a pro-cyclical, pro-financial portfolio means that the fund is likely to be affected by anything that would materially affect the economic outlook, such as a substantial downturn in steady economies such as the US and the UK. "But that is the right way to be," he says. "You just have to be patient, not swayed by short-term volatility and stick to your conviction."
