25th October 2010

Fund of the month: Schroder UK Alpha Plus Fund

Richard Buxton is Head of UK Equities at Schroders and manages the Schroder UK Alpha Plus Fund. This high conviction, index-unaware fund has delivered 1st quartile performance over 1, 2, 3, 4, 5, 6, 7 years and since launch¹.

Overview for last month of quarter - covering September 2010

The fund

The fund has continued to outperform the market over most time periods. This has recently been helped by the fund's technology holdings, particularly with Invensys, Autonomy, and Logica all performing well - the former signing a key deal with a Chinese manufacturer. In the cyclical retail sector, Next and Debenhams joined Burberry as outperformers whilst Carnival, Whitbread and British Airways have continued to impress in the consumer services sector.

One of the largest detractors recently was Home Retail Group, which we believe was largely due to the market over-reacting to an announcement about difficult trading. Despite this, we believe the stock is significantly undervalued. Argos for example is extremely cheap relative to its intrinsic value; its current price discounting an excessively poor outlook for its business model. Given our long-term investment horizon and contrarian investment philosophy, we remain confident that the fund is well-positioned to exploit pricing inefficiencies.

The Market

We expect the UK equity market to remain in the pattern of risk-on/risk-off for the remainder of this year. The key tension is between the evident health of the corporate sector and hesitancy at the economic picture. We expect a flat growth 'muddle through' outcome.

Second quarter results showed that companies have moved beyond restructuring. Balance sheets are largely restored and profits are rising. Much of the free cash flow, however, is being retained as companies, too, wait for economic clarity.

As the banks return to health, the concern is not another credit crisis but the impact of what are likely to be tough government spending cuts. The question is whether the private sector can absorb the impending redundancies.

We think it can. The process is certain to be uneven, but we have just seen a strong number in employment creation. In our discussions with companies, feedback on public sector exposure is positive, with outsourcing almost certain to be a significant factor in cutbacks. We believe that as the spectre of a double-dip recedes, companies will start to invest their cash, whether for organic expansion or M&A, and this will have a positive impact on employment.

Bond yields are historically low, but we see this as less a fear of recession and more a product of central bank liquidity. Inflation is higher than most would like, but it is unlikely to be disruptive. Credit spreads are also low, showing the market is not predicting a round of defaults. The result is stimulatory, as companies are able to borrow on the bond market relatively cheaply.

Equity valuations are, in our view, exceptionally low. In our recent meetings -- including Centrica, Whitbread, Lloyds -- we continue to hear positive stories. As the economic outlook stabilises, it seems fair to assume that there is significant room for a broad round of re-ratings.

Overall, while the course will be uneven, our conclusion is that the UK equity market will reach a breakout point in the first half of next year. The beneficiaries will be companies with robust finances and a clear plan on how to build their business in a low growth economy.

¹Source: Lipper Hindsight, bid to bid, net income reinvested, as at 30/09/10.

Protection