by Jake Moeller.
Jake Moeller reviews highlights of a meeting with Roland Arnold and Luke Chappell, Fund Managers of Blackrock U.K. Special Situations Fund, on September 14, 2015.
You would be hard-pressed to meet a more modest and engaging fund manager than Richard Plackett, and the oft-used “superstar fund manager” is probably not a title that would sit easily with him. However, his stature in the industry cannot be ignored, and his imminent retirement will likely be felt not only by BlackRock. Key-person risk is one of the vagaries of active fund management, and following a raft of high-profile movements in the U.K. over the last two years, a risk fund houses have been keen to mitigate–or at least be seen to mitigate.
BlackRock in this instance may appear to have been inoculated through having to deal with Mr. Plackett’s sabbatical in 2013, but Messrs. Arnold and Chappell are quick to point out that there were more significant restructures at BlackRock in 2012. A move away at that time from institutional silos has bred a more collegial environment, resulting in stronger cross-support structure within specialities. The notion of co-managing isn’t anathema either. The duo has been working together for 15 years, and clearly they are very comfortable in each other’s company.
“Actually,” Mr. Arnold jokes, “Richard was the ‘new boy’ joining BlackRock after us.” There appears then to be little disruption to this fund. Mr. Plackett remains until year-end to assist the transition (although the portfolio is already in the likeness of the new co-managers), the process remains unchanged, and there is a strong and pre-existing rapport among the team.
BlackRock Special Situations Fund has a long pedigree, having been launched in 1981. It is a concentrated portfolio of 60-80 stocks with an overall bias toward mid- and small-cap stocks. This poses some unique challenges to the fund managers, who must juggle the potential additional volatility this might bring to the portfolio. However, they use their large-cap allocation and a long-term holding period (stock turnover was only 31% in 2014) judiciously to take some risk off the table when required. “In the second quarter of 2014,” states Mr. Chappell, “we saw the mid-cap reversal, and at that point we reduced our mid-cap weight and maxed our FTSE 100 holdings to 50%, where we’ve felt comfortable remaining.” The portfolio also currently holds only about 10% exposure to riskier small-cap shares.
Table 1. Historical Market Cap Split of BlackRock U.K. Special Situations Fund
The fund uses a five-step bottom-up process that considers management, market position, cash generation, balance sheet, and prior track record. It is largely growth-based, considering “merits of future strategy” and using metrics such as EV/Sales and Price/FCF but without being excessively quantitatively driven. Considerable work is undertaken to understand businesses, and manager meetings are crucial with some 700 manager visits a year taking place.
Earnings growth is a major focus in this fund. The managers believe this to be the most important driver of share price return over longer periods. “In the last few years big themes have been driving buying patterns,” Mr. Arnold explains. “We’ve seen valuation of higher-yielding, lower-P/E shares expand, but you’ve had compression of valuations with a myopic market. More recently, companies performing in an earnings basis have been performing on a share price basis.” This is an environment that has resulted in a recent improvement in relative performance via stocks such as Ted Baker (see Table 2, below).
Table 2. One Year Historical Share Price of Ted Baker (to October 30, 2015)
One of the criticisms of the co-manager structure is that it can dilute accountability and cause vacillation on decision making. Messrs. Arnold and Chappell strongly refute this in their case. They argue that the structure actually encourages swift action and adds robustness to the sell discipline. They cite a recent example of Fidessa, which had been a long-term holding. In August 2015 a poor set of numbers led to a discussion between the two, and a quick consensus was reached to sell the holding. “We sold at 8% down, and it finished the day at 18% down.” states Mr Arnold. They, like many fund selectors, also recognise the pressure that marketing responsibilities place on fund managers. “When we need to see a client, one of us will always be watching the portfolio,” says Mr. Chappell.
The performance history of this fund is generally strong (see Table 3, below), with 2014 being an exception (largely because of a holding in Aveva and the sudden collapse of the oil price). A rotation away from industrials toward consumer and banks such as BAT and HSBC reflects a view based on the “lower for longer” interest rate cycle. Most recently, they have started to dabble again in some oil and gas stocks, but they still remain relatively underweighted and the fund has returned second quartile returns year-to-date.
Table 3. Ten Year Performance of BlackRock U.K. Special Situations Fund within IA UK All Companies Sector Quartiles (to September 30, 2015 in GBP)
Messrs. Arnold and Chappell, while not being overly bullish, have a favorable outlook for equities. They see some froth on valuations but emphasize that earnings growth is still being overlooked because of general liquidity-led momentum. They are expecting a pickup in U.K. M&A activity, which although they do not specifically seek it, they see as a potential tailwind. They share a positive view on the U.K. consumer but warn that wage inflation could affect companies that are unable to pass on costs to consumers.
BlackRock U.K. Special Situations Fund has been through some transitions, and the loss of Mr. Plackett’s expertise will certainly be felt. However, BlackRock has set a good example of how to deal with the key-person risk associated with the “star manager.” There has been a well-managed handover with plenty of transition time. The co-managers have a strong pedigree and history of working with each other, and importantly for fund selectors, the portfolio style biases remain the same. The fund appears to be in excellent stewardship.