The UK shares that will profit from Liz Truss’ tax reforms

R&M UK Recovery manager Hugh Sergeant breaks down the impact of government tax cuts and explains which types of British stocks are likely to perform best. He also talks though his PVT - potential, valuation and timing - investment strategy, and why it has worked well for the fund since launch 16 years ago.

R&M UK Recovery is a member of interactive investor's Super 60 list of recommended portfolios.

Sam Benstead, deputy collectives editor at interactive investor: Hello and welcome to the latest Insider Interview. I am here with Hugh Sergeant, manager of the Super 60 rated ES R&M UK Recovery fund. Hugh, thank you very much for coming into the studio.

Hugh Sergeant, manager of the R&M UK Recovery fund: Thanks for inviting me, Sam.

Sam Benstead: You've managed the fund since inception about 15 years ago. Can you tell me how you invest?

Hugh Sergeant: Yeah, definitely. I mean, our core philosophy, which we've had in place since we set out the business 16 years ago, is PVT, short for potential, valuation, and timing, and we follow that approach for all the funds we manage.

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Potential simply describes companies that can grow their shareholder value at above average pace over the medium term, so we're looking for companies that can grow. Value is looking to buy companies when they're cheap versus their intrinsic value. And then timing, we're thinking about when the right time to apply capital is, so we apply that to the recovery strategy, but clearly with recovery you're focused on the recovery potential and by that we mean companies that we like in terms of their franchises, but where profitability is temporarily impaired, temporarily depressed, and as profits recover, then you've got a lot of profits and cash flow growth. So that's the recovery potential of recovery PVT.

Sam Benstead: And what types of companies or sectors does this approach lead you to?

Hugh Sergeant:Just depends on, you know, the opportunity set where we are in the cycle. But the key make-ups of the portfolio I would describe as, first, value stocks so, you know, cheaper companies, recovery stocks where profitability's depressed and we expect a recovery. We are a multi-cap fund, so we're looking across a whole spectrum of size of companies from the largest down to the smallest [and we] would typically be overweight, small and mid-cap stocks. We've also got this additional element of being very comfortable investing in structural growers when they're out of favour, so it's kind of applying the recovery approach to those structural growers. But the key characteristics are value, recovery and multi-cap.

Sam Benstead: It’s a value fund, but that investment style has been out of favour for about a decade now, yet you've still managed to thoroughly beat the market. So, why have you been so successful with this investment strategy?

Hugh Sergeant: That's very kind, thank you for those kind words. It's never felt particularly easy, I must say. We've had lots of ups and downs; economies have over the last 15 years. I would say our key is in the philosophy PVT being a little bit more rounded than traditional deep value investing.

So, we're looking for companies with a potential, so companies that can grow, and we think more about the timing side of things. We don't like buying things just because they're cheap. We like the potential, and we like the timing aspect, and I think that's meant that we're a bit more rounded than some traditional deep value.

As you say, it's not been the ideal time, certainly since the global financial crisis for value investing. I don't think we've got time to go through that in detail today, but the key elements in terms of the background have been falling interest rates and falling bond yields, which has clearly supported the growth theme much more than value. But we do think now is the time for value. But we've managed to generate attractive returns by having that broader approach, also the small and mid-cap elements, so your typical small and mid-caps have performed better than large-cap value over the last 10 years. And then we try to think sensibly about the cycles. We do believe that everything in investment has a cycle, ups and downs, and we get more cautious when everything's going swimmingly, and then get aggressive where we think we're towards the bottom of the cycle, and I think we've added some performance by having that approach.

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Sam Benstead: So, where are we in the cycle now? How aggressive are you being, or defensive, and are there perhaps some stocks that can kind of sum up that investment approach?

Hugh Sergeant: Yeah, you know, it's a tough background for a lot of us now. You just have to follow the newspapers or the press and you get very depressed, but that uncertainty, it's a huge element of uncertainty. Uncertainty creates value, creates opportunities, and because the world is so uncertain now, it means the opportunity set is almost as large as I've seen it.

So, with respect to UK equities, I'm as bullish as I've ever been since the original Brexit vote, which obviously has acted as quite a headwind for UK equities over the last six years, but I am, you know, very bullish now, so I'm upping the ante in terms of risk. Always very gradualist in terms of, you know, buying individual stocks, that's why I have got a high stock count slowly in, and quite gradualist in terms of gearing up the portfolio. But I feel it's the right time to be doing that now for several reasons.

First, valuations are extremely low. So, if you look at UK equities trading on only nine times earnings and my hunting ground trades on less than that, so I've got some stocks in the portfolio that trade on two or three times earnings, the likes of EnQuest (LSE:ENQ), which produces oil and gas, or Reach (LSE:RCH), the newspaper hardcopy and digital platform, trades on about three times earnings.

I could go on. Lloyds Banking Group (LSE:LLOY) on five or six times earnings, and these huge, hugely discounted valuations, huge pessimism about the UK, which from my perspective has meant there's been lots of cash coming out of UK equities.

Can that carry on? I think we've seen the marginal sell-out being as aggressive as they're likely to be in UK equities. And then we have a bit of a regime change, which isn't really being talked about, but in terms of the governance of the country they are, the Conservative party under the new leadership, much more supportive of business, of finance and of growth, and I think that would be supportive of UK equities from a very modest valuation.

Sam Benstead: There's a lot going on at the moment in the UK. We've just got a new prime minister. How does this change the way you invest and are you finding opportunities because of this?

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Hugh Sergeant: I think that could be the catalyst. Clearly, we have this period of uncertainty and we've got significant difficulty with respect to the short-term economic background. One has to recognise that with the cost-of-living crisis. But we do know that the price of gas at the current level is unsustainable. It's going to be much lower in two years’ time.

So, we will come to an end and be able to see beyond this cost-of-living crisis, and it could coincide with a Conservative government that are more pro-business. So, the combination of us getting through the worst in terms of the economic background and a more supportive environment with respect to governance could be positive for UK equities, positive for our portfolio because its [about] recovery and value.

Sam Benstead: You said you have around 300 stocks in the fund, that is a lot, yet your performance has still been very different to the benchmark, so how have you avoided being a closet index tracker?

Yeah I know, it's a fair point, and I do get questioned about this aspect of portfolio construction quite a lot. What I say is that there actually isn't that much academic evidence that concentrated portfolios were better than diversified, and a lot of it's down to the individual investment approach, and then the DNA of the fund manager and their individual history.

I'm only doing this job 30 years on because I take a more diversified approach. For value and recovery, new value and recovery ideas are individually quite risky, and therefore it makes a lot of sense to be very gradualist and only put a small amount of capital of 10 to 20 basis points, 0.1 or 0.2 of the fund initially, into that stock and then to wait for the news flow to come through that supports your thesis. So, we're very gradualist and we're comfortable about having a more diversified approach. Not quite sure that really the value in recovery itself lends itself to really concentrated portfolios. But my investor DNA is to be more diversified, and to have lots of new ideas and to be very gradualist in terms of applying capital, and I think that's worked reasonably well over the years, but to accept it's not necessarily conventional wisdom in terms of how to construct portfolios.

Sam Benstead: Hugh, thanks very much for coming into the studio.

Hugh Sergeant: Thanks, Sam. Thanks for your time and all your great questions.

Sam Benstead: That's all we have time for. You can check out more fund manager interviews on our YouTube channel where you can like, comment and subscribe.