Expectations push shares too low…
With the UK economy in the doldrums many investors have focused their attention on UK companies with a high proportion of international sales.  The F&C UK Mid-Cap Fund has benefitted over the last two years from a significant exposure to developing economies particularly in the Far East.  Building such a position was the result not only of a view on Asian growth but the conclusion that the strong growth not factored into share prices.

More recently I find that the share prices of UK companies with a high proportion of domestic sales factor in a very low level of expectations.  In fact many share prices imply a slow perpetual decline.  So whilst I too see the weak economic data and tough outlook for the UK, there has been increasing opportunity for stock pickers to find a clutch of “diamonds in the rough”.

…providing opportunities for selective investors
This focus has paid real dividends with a number of our holdings impressively delivering the goods thus far in 2011.  With expectations low any sign of stabilisation – let alone good news - is greeted warmly by investors and can result in a meaningful uplift in the share price. 

One theme is the emerging market wealth that is spilling over into the UK economy via the London property market.  Whilst the overall UK housing market remains fragile, demand in London has been robust.  The London focused Berkeley Homes has just announced sales reservations 30% higher than last year and a plan to return a significant of cash to shareholders.  West end property specialist Shaftesbury recently reported that “visitor numbers and spending have remained buoyant” and their property continues to “experience healthy demand” whilst “vacant space remains at a historically low level”.

With the overall economy struggling, much has been made of the UK government outsourcing opportunity.  The key here has been to find those businesses with the skill sets that are in short supply and that can deliver savings for the public sector.  The Ministry of Defence in particular needs to find ways to save costs whilst maintaining its operational capability.  Defence engineering company Babcock is in the right place reporting a bid pipeline up from £5bn last November to £6bn in January and £8.5bn now.

Homeserve is a company that derives the overwhelming bulk of its profit by selling plumbing and drainage and electrical insurance to UK households.  The market had been concerned that a weak consumer would stop renewing these policies.  In fact by developing innovative new products and utilising a well incentivised sales force, Homeserve saw 10% growth from is UK business in the year to March 2011.

We have been selectively and carefully increasing our exposure to domestically orientated investments throughout 2011 with a corresponding reduction in our overweight towards the industrials. 

F&C UK Mid-Cap Fund is placed in the top decile of the IMA UK All Companies sector over 1, 2, 3, 4, 5 years and since launch.* 

*Source: Lipper Hindsight to 31 May 2011.  Launch date 31 December 2005.

I am reminded of the well quoted corollary that the best way to make money in the gold rush was by selling picks and shovels. Fast forward 150 years, replace gold with shale gas and the F&C UK Mid-Cap Fund is finding the old adage still to be true.

The startling pace of shale gas production growth has seen output of this unconventional gas account for 20% of US gas production in 2009 - some 2.4 trillion cubic feet - up from 1% in 2000. The US Energy Information Administration forecast a rise in US shale gas production to around 5.5 tcf by 2030, an increase of some 130%, with growth likely to be quickest over the next ten years.

Further areas for exploration have been identified in Poland, Hungary, Romania, Turkey, UK, China, Argentina and Chile.

Once a shale gas play has been identified there is a relatively high drilling success rate.  They also tend to be spread over a wider area than conventional deposits and the wells deplete faster.  They therefore require many more wells to be drilled than a conventional field, which is good news for the pick and shovel providers.

Shale gas deposits are trapped within rocks meaning that the gas does not flow as easily as conventional gas.  The big growth in shale gas drilling has been driven by technology allowing horizontal drilling and hydraulic fracturing using specialist chemicals and liquids which are pumped at high pressure into the well.

Speciality chemicals group Elementis produces a highly effective chemical used in these horizontal wells which require up to 10x the volume of chemicals compared to a standard well.  The third quarter saw Shale gas drilling drive the company’s oil and gas related volumes up by 84%.

Meanwhile, Weir provides pressure pumping equipment that drives the fracturing process and so far this year* their upstream oil and gas order book has increased by 232%.

F&C’s UK Mid-Cap fund holds significant positions in both Elementis and Weir.  Whilst both have been strong performers this year, I believe they both remain attractively priced relative to their strong prospects.

*1 October 2010

Last week I met with the management of a gold mining company, who were just back from the Denver Gold Forum, a conference where gold companies meet with investors to discuss the industry and its drivers. This year’s conference has seen record attendances and our mining CEO relayed to us that “Denver was buzzing”.

What this should do though is to remind us that the best time to buy gold is not when Denver is buzzing, but when the Denver Gold Forum is attended by one man and his proverbial dog (presumably because everyone else is at the Florida Real Estate Condominium Conference.)

Further evidence that we might be nearing a peak for gold comes from the unlikely source of The Sun (28 Sept) where Page 3 girl, “Peta from Essex” notes “Yesterday I noticed gold futures reached a record $1,340 an ounce after market volatility boosted demand for the metal”. 

What gets lost in the gold headlines, is that the metal is actually underperforming most other risk assets (including equity markets and other precious metals) since the recent market low at the beginning of July this year.  We should expect this as gold tends to perform in a relative sense only when markets think the world is ending. The F&C UK Mid-Cap Fund no longer holds any gold mining stocks. Bubble or not, there is no need to chase gold when equities remain so attractive.