The five pillars of long-term value

published 31 August 2006

A professional investor tells MoneyWeek where he'd put his money now. This week: Clive Beagles, senior fund manager, JOHCM UK Equity Income Fund

In an environment of low interest rates and low inflation, it is important to keep stockmarket returns in perspective. Equities have given up ground recently, but at the end of July the UK market was still up about 8% in the year to date. In the rallying market of the last three years or so, hopes may have got a bit ahead of themselves, but unless there is a serious recession, which seems unlikely, stockmarkets remain attractive relative to both government and corporate bonds. I believe what we saw in May and June this year was mainly a stockmarket, rather than an economic, event, as some investors unwound over-leveraged positions.

When I look at companies, I try to identify pillars of value over and above the dividend yield; in particular I am looking for under-utilised balance sheets. Some stocks that we own could be described as steady, but others are recovery situations where investors generally dislike the sector. Unilever (ULVR) is a good example. It is unloved and perceived as having little new product innovation, but nearly 40% of its revenue is in emerging markets. But a cultural change is happening: organic sales figures are improving and it is modestly valued against its peers. Most investors are bored with the stock and cannot bring themselves to believe fundamentals may improve and therein lies the opportunity.

I also think the consumer electronics cycle has a long way to run. Retailers such as Dixons owner DSG International (DSGI) and Comet owner Kesa Electricals (KESA) should continue to benefit well beyond the World Cup. On the TV side there should be a much longer duration to this demand cycle as high-definition TV is only just being introduced, and the Government plans to turn off the analogue signal in a few years' time. We see some real potential here, particularly with Dixons. Its decision to buy DSG Russia could add 40% to the group's market cap and will boost business in Eastern Europe.

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Umbro (UMB) was another short-term beneficiary of the World Cup, but again we are taking a longer view. The firm's England football shirt sales were important, but it has a well-balanced branded goods portfolio. It also has net cash on the balance sheet, while emerging market sales account for about 30% of turnover. Overseas franchisees take the stock business risk, and yet it is only rated on ten to 11 times earnings.

The capped capacity of our fund enables us to invest in small- and mid-cap stocks, as well as FTSE 100 names. Inspired Gaming (INGG) is one such stock. Just because it is Aim-listed does not mean it is small and speculative. The company floated in May 2006, during the market sell-off, at a time when most investors weren't interested in new ideas. It is the leading operator of gaming machines in the UK, with clients such as William Hill and Gala. More interestingly, it leads the way in the server-based gaming sector where content resides on a central server and is downloaded onto machines via a broadband network. Machine incomes tend to be far higher from these digital terminals because the content is refreshed frequently and maintenance costs are reduced as the machines do not need to be moved. If the firm can cut these costs by £15m, which it is very confident it can achieve, its operating profit would increase by 50%.

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