Finding an edge in the stock market

Each week, a professional investor tells MoneyWeek where he’d put his money now. This week: Matthew Tillett, fund manager, Allianz UK Unconstrained Fund.

What is the purpose of active fund management? To outperform the market, obviously. So why do the majority of active funds underperform over the long run? The answer is that most are simply not active enough.

They own too many stocks, often without much conviction, and they end up looking a lot like the indices they are supposed to outperform. Over the long term, by investing in a fairly small number of stocks, and believing in them strongly, you’re more likely to succeed.

But you can only do this successfully if you have a genuine investment edge. This means you have to understand why a stock is mispriced.

My investment edge can have behavioural or analytical roots. A behavioural edge accounts for the psychological aspect of investing. The herd mentality of the stock market – with lots of investors following the latest fashion – can lead to situations where share prices don’t reflect underlying value.

An analytical edge comes from examining the fundamentals and coming to a conclusion that is materially different to the consensus view.

Here are three examples where I believe I have an edge. Firstly, Mothercare (LSE: MTC), the UK’s leading baby clothes and toys retailer. The company has been having a tough time in its home UK market. A mixture of underinvestment, a weak consumer environment and fierce online competition has pushed the UK business into loss.

Because of this, most of the media commentary and analyst recommendations are negative. Yet, most of Mothercare’s value is in its international franchise business, which has been growing strongly for years.

The market’s focus on the UK negatives at the expense of the quality and growth characteristics of the international business has left the stock undervalued. Confirming my view that there is value here, Mothercare has recently rejected two takeover approaches from a US retailer.

My second example is Sirius Real Estate (LSE: SRE), which owns and operates mixed-use business parks in Germany. After getting into serious trouble during the financial crisis, the new management team has beenworking to turn the business around.

Costs have been brought under control, the sales process improved and, importantly, the balance sheet has been successfully refinanced. The share price is 30% below the net asset value (NAV), which means the company is substantially undervalued. What’s more, the true value of the assets may be higher than the NAV.

The management team has several initiatives in place to drive improved occupancy and rental growth, and the stock still isn’t widely followed by analysts or investors.

Centrica (LSE: CNA) has been hit by a number of unfortunate events. First, Labour leader Ed Miliband targeted energy suppliers with a proposed price freeze. Then profits were dented by a spell of unusual weather events across the UK and America.

Most recently, a number of senior executives have left or are about to leave. As a result, the share price is down by nearly 25% from its 2013 high. The stock is undervalued today, because these negatives are mainly short-term in nature, yet are being heavily discounted in the current share price.

Centrica’s scale gives it an advantage in its downstream UK supply business, which should allow it to earn industry-leading profit margins over the long term. The shares can be bought on a free cash-flow yield approaching 10%, an attractive price for a relatively defensive business.

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