SVM Asset Management

Firstgroup operates bus and rail transport in the UK and US, and is capitalised at £2.5 billion. In buses, it is in more than 40 major towns and cities, with a fleet of nearly 9000 buses. As a rail operator, it manages almost one-quarter of the UK's passenger rail network. In the US, it operates yellow school buses and the long distance Greyhound buses.

Firstgroup entered North America in February 2007, with the $2.25 billion acquisition of Laidlaw. The group believes it is still on-track to deliver $150 million in synergies. Already, management has reversed Greyhound's declining revenue trend. We believe that further value can be unlocked, but a disposal of this business may be a more attractive option. The group's recent first quarter trading update evidenced a strong trading position, with UK bus passenger revenue up 6.4% and UK rail revenue up 10.7%. Also, as fuel costs have risen, customers are switching to public transport, often encouraged by employer support.

We believe that this trend will continue to help offset other cyclical risks. The potential for fare increases contrasts with a likely margin squeeze in many other consumer businesses. We believe that the shares have defensive characteristics, growth potential, and an attractive dividend yield. The shares have performed less well than some other transport groups, and we believe its lower rating is unjustified. The group generates good cash flow and we believe that the shares have the potential for an improvement in rating.

For some months, the Fund has used hedging to maintain low overall exposure to consumer sectors. These include retail, food retail, media and pubs. The portfolio also excludes food manufacturers and housebuilders. We believe that the overheating in the UK housing market will lead to a sharp fall in consumer confidence.

Some shares of consumer businesses have been supported by high dividend yields, but we expect a pattern of dividend cuts. Many consumer businesses are operationally leveraged, and the impact of slower sales will be magnified by competitive pricing and rising input costs. Food and energy costs are rising, and not all can be recovered from customers. Additionally, a feature of a number of consumer companies is higher balance sheet debt. Buy backs and stock tenders in recent years, combined with high levels of dividend distribution, have meant that many consumer businesses enter the slowdown with a weaker balance sheet. We believe this will trigger dividend cuts and reduce scope for further buy backs. Some may be forced to renegotiate banking covenants. Already this appears more likely to occur with some UK housebuilders. We expect weak trading to combine with margin pressures and balance sheet problems to trigger further share price falls in many UK consumer businesses, and the Fund will maintain a defensive strategy by limiting exposure.

Invensys is an engineering company focused on two main businesses, process solutions and rail signalling systems. Over the last three years Invensys has undergone significant restructuring, disposing of a number of businesses, reducing debt and improving margins. The company is now well positioned in growing markets.

In process systems, the major end markets of oil, gas petrochemical, refining and power remain strong. Indeed, management are confident that recent revenue growth can be accelerated given the strength of the order pipeline. The rail business continues to benefit from the need to upgrade ageing infrastructure both in the UK and internationally. In contrast to both the process and rail businesses the controls division is enduring a more difficult time. A heavy exposure to household appliances, where demand is weakening, has put the business under pressure. In response, management have removed a large proportion of the fixed cost base and have so far succeeded in not only protecting, but improving, profits.

Despite operating in a number of attractive long cycle markets the group continues to trade at a discount to the peer group. If this discount does not close we believe that with a strong balance sheet and an improving business mix, the company may well be an attractive target for a number of its bigger competitors. Overall, we expect the shares to be a rewarding investment.

This month’s feature focuses on a sector, rather than an individual holding. Financials is a major sector in the UK, representing one quarter of the value of the FTSE All-Share index. Banks represent more than half of the sector, with other areas including insurance, property and general financials. The whole sector has performed very poorly over the past twelve months, and SVM UK Active Fund continues with relatively low exposure.

In 2007, we identified the risks in the banking sector and made further sales. This stance recognised not just the risks in US lending, but that the business model for banks had become very risky. With bank executives incentivised on growth in earnings per share, and shareholders reassured by high but unsustainable dividend payments, there was little regulatory constraint on overexpansion on a relatively slim base of hard assets.

We believe that unwinding of this “banking bubble” will take some time, and is not resolved by the recent news. The recent rights issues may be insufficient to rebuild equity to a sound level. More importantly, it is likely that the future business model for banks will involve less risk, with lower returns for investors. This makes comparison with previous share price levels, or use of simplistic measures like dividend yield or earnings per share, less meaningful. We believe that there are more attractive areas of the stockmarket, with superior dividend growth prospects and lower risks.

Capitalised at £16 billion, Imperial is a major international tobacco company, with its main market positions in the UK and Europe. After a strong performance, its shares fell back in early 2008 on concern about further capital raising. This followed Imperial’s acquisition of Spanish tobacco group, Altadis, in 2007.

We believe that Altadis offers attractive synergies to Imperial, and that the funding issues can be resolved soon. This will probably involve a rights issue, which should be the catalyst for further share price performance, reflecting the group’s strong cash generation and potential for steady growth. There is the potential for sale of Altadis’ non-core assets. Altadis also took Imperial into number one position in cigars in the US, France and Spain. Cigar brands include Monte Cristo and Dutch Masters.

Further major deals are unlikely, but there is potential for further smaller acquisitions in Eastern Europe, which should assist Imperial’s growth. In a weakening consumer environment, we believe that tobacco will be more stable, and that Altadis will accelerate Imperial’s growth. The Fund has invested 2% of its portfolio in Imperial.

Jubilee is an AIM-listed platinum mining and exploration business. Capitalised at £67 million, it is a UK based company with acreage and exploration programmes in South Africa and Madagascar.

Jubilee’s drilling focuses on platinum and nickel, and it has a strong drilling programme in 2008. Its main project is Tjate, a platinum exploration prospect in South Africa. In Madagascar, it is drilling for platinum, nickel and copper. We believe that Jubilee is currently primarily valued on the basis of its platinum exposure in South Africa, with little value attributed to the Madagascar exploration programme. Drilling to date in 2008 has been encouraging, and the programme has the potential to deliver a significant uplift in value. With merger activity in precious metals businesses, we believe that success in the programme would make Jubilee attractive to larger groups.

Man Group is a global provider of hedge funds and funds of hedge funds, capitalised at £9.5 billion. It also operates a futures broker, Man Investments. The group has £36 billion of assets under management, spread across a broad range of funds and strategies, generating approximately £1.4 billion of revenues.

Strong cash generation has allowed growth, share buy-backs and a progressive dividend policy. Although a portion of earnings depends on performance, Man's broad range of strategies has achieved some stability in fees. Against a good year for the hedge fund industry in 2007, Man's flagship AHL Fund delivered 16%, with RMF & Glenwood funds of funds achieving 10% returns. The main weakness was in new manager selection. While net inflows have slowed in recent months, this should be put in the context of the challenges for the financial sector overall. The business is still growing, and to date has been able to maintain the financing arrangements within its structured products. Although there is some margin pressure, the business is strongly financed and cash generative. Free cash flow yield over the next three years is attractive.

SVM UK Active Fund has very low exposure to financials, with no bank exposure. The Fund has an investment of 2.6% of the portfolio in Man Group. Man's shares are not highly rated for a business with a leading position in a growing industry, with good cash conversion.

Randgold Resources is a gold mining and exploration group, listed in London and capitalized at £1.3bn. Its reserves exceed 7 million ounces, and there are additionally exploration projects in six African nations. The company trades at a discount to its peers in relation to new present value of future production. The group has two cash-generative mines in Mali and a strong pipeline of exploration and development projects.

As with oil, the days of 'easy gold' are over. Miners are being forced to go to greater lengths to locate gold, whilst the reserves they do find are increasingly impure. As a result, the majors are now scrambling for gold in an environment of rising prices. Smaller operators are well placed to benefit from this situation, with Randgold being one such example.

In the market for gold, a mismatch has developed between constrained supply and high levels of demand. Uncertainty surrounding global growth has led investors into gold, traditionally seen as a 'safe haven'. Increasing discretionary spend in developing countries, particularly China and India, has also increased appetite for gold jewellery. Randgold has a good reserve base, and as with all resource companies, the ability to find and extract at a cost below sale price is key. Randgold, whose Morila and Loulo operations have exceeded expectations, has shown that it is capable of achieving this. We expect a higher gold price, as the US Dollar weakens; and expect Randgold's earnings estimates to be raised further.

BG Group is now the Fund’s largest investment, following strong price performance. This reflected BG’s participation in the world-class Tupi discovery in Brazil’s Santos basin. We believe BG is emerging as one of Europe’s leading liquid natural gas suppliers. Its operations comprise exploration & production, liquefied natural gas, transmission and power generation. It operates major pipelines and distribution networks and has a substantial exploration programme. There are a number of potentially favourable catalysts for BG’s share price.

BG shares in participation in the Tupi Field with Petrobras. The field has had four successful wells, with two good discoveries. BG has a share of the potentially larger structure in the region which could add further to reserves on successful drilling. Estimated recoverable barrels of oil and gas are now in the region of 5-8 billion. Tupi is a major world-class discovery, and fully supports the recent share price gain.

We believe the discoveries and potential in Brazil support some 85% of the group’s value, and the shares do not fully recognise further E&P potential. We also expect further strength in the oil price, which would add to BG’s value. We expect further consolidation within the oil and gas sector, and BG would be an attractive target for integrated oil majors.

Weir Group is a manufacturer of pumps and valves for the oil and gas, minerals and power industries. The company also has a significant business supplying maintenance services to their customers.

Several years of restructuring, under the aegis of CEO Mark Selway is now bearing fruit at a time when the company’s end markets are booming. Demand for Weir’s pumps rose 18% in the first half of the year whilst margins rose strongly. A focus on higher margin contracts held back service sales, however margins increased materially. Working capital management has also been impressive as the company cuts supplier numbers aggressively, and introduces new lean manufacturing practices.

Following sales of non-core assets, the company has bought SPM, a harsh environment oil pump producer, which has developed new industry leading products. The company will be able to exploit Weir’s global distribution network to ensure strong growth going forward. Given the company’s strong balance sheet and growing reputation for making astute acquisitions, further deals are anticipated.

With some 75% of sales now accounted for by the oil & gas, minerals and power markets, there is an argument that the company should be valued with reference to the more highly rated oil service companies rather than more traditional engineers.

The management team are keen to keep expectations down, however we believe that current levels of activity combined with good operational gearing will result in further earnings upgrades as the year progresses.

Kirkland Lake is a gold and silver mining company, with listings in Toronto and London. Although on AIM, market capitalisation exceeds £300 million. The group has significant gold producing properties and has a substantial drilling programme. Its five main properties in Canada have historically produced some 22 million ounces of gold. Over the past five years, the company has increased reserves by 160% to more than 2 million tonnes with good grades, representing a total of almost 1 million ounces of gold.

The Kirkland Lake region as a whole is Canada’s second most prolific historical gold mining area, and currently Kirkland Lake Gold is producing 60,000 ounces a year. It plans to step up production to 150,000 ounces and is prospecting in 16 new mineralised zones.

Although the shares fell in July and August, this profit-taking just took the share price back to its level of early 2007. The investment has more than doubled since entering the portfolio. In late September, the group gave a favourable update on its current drilling programme. We believe that a weak US Dollar will lead to further strength in the gold price.

Capitalised at £4 billion, Tullow is close to the size needed for inclusion in the FTSE 100. It has grown organically and by acquisition, from a North Sea operator to a significant explorer for oil and gas globally – in Africa, in particular. It has built this exploration acreage through the acquisition of Energy Africa and, in January 2007, of Hardman Resources. In Mauritania it has interests in eight contiguous offshore blocks, both producing and undeveloped. In total, it has 120 licences in 22 countries, and produces 76,000 barrels of oil equivalent per day.

The shares stand at a premium to the value of proven and probable reserves, but do not reflect the huge potential in its current drilling programme. Recently, Tullow has raised expectations for the Mahogany Field in offshore Ghana, beating market expectations. Furthermore, results from potential high impact wells in Uganda and offshore Namibia, are due to be reported during the next six months. Tullow offers strong drilling potential, combined with current cash flow, and further growth should take it into the FTSE.

Innovation Group provides software and associated services to the global insurance industry. Focussing on claims management, the group has grown both organically and through acquisitions. At present around 75% of group revenues are derived from outside the UK.

Claims management represents the largest cost item for insurance companies, with only a small proportion being outsourced. As the only global ‘all solution’ provider (via a partnership with IBM) of outsourcing services to the industry, this presents an opportunity for Innovation. The recent five year contract win with Royal & Sun Alliance gives us confidence that the business model will be able to capitalise and attract new business.

Due to market deregulation, the US is the largest insurance market in the world yet, it is less developed than the UK market. This means the region should offer premium growth prospects for the next five to ten years. Realising this opportunity, Innovation recently made a number of acquisitions in the US, both of which were earnings enhancing.

Currently, the share price does not recognise the group’s potential. Trading at a discount to its peers, despite strong revenue growth, the shares represent good value. With a larger proportion of revenues derived from recurring revenues (c. 75% of today’s revenues versus 35% in 2002), Innovation’s quality of earnings is not recognised in its current rating.

BT is the incumbent UK telecoms operator, with a large fixed line business. BT has gradually had to relinquish its UK monopoly, but it operates globally, providing communications services in 170 countries. These include national and international telecoms services, networked IT and higher value broadband and internet products and services. It has four main lines of business: BT Global Services, Openreach, BT Retail and BT Wholesale.

The stock appears lowly rated as a semi-utility, and offers a well above average dividend yield. Its history has left a preponderance of negative sentiment, which has only gradually been dissipated as BT moves into growing and higher margin areas. It has announced a £2.5 billion share buy back which should support the share price whilst also underlining strong cash generation. We estimate it will move to a below market rating over the next two years, and continue to look extremely lowly rated on EV/EBITDA. It is targeting £600 million cost efficiencies this year, with larger savings still to come. The management appears increasingly confident that it will deliver 15% margin in the Global Services over the medium term. We believe that the prospect in Global Services is not rated by the market, and that the company will be able to releverage further in 2008. We believe the shares are more than 20% undervalued, and that the company could restructure its balance sheet to reflect its utility-like stream of earnings.

Capitalised at just under £1 billion, Venture is an Aberdeen-based North Sea oil and gas producer. Its southern North Sea production area comprises five producing gas fields, averaging 26,000 barrels of oil per day. A further 19,000 barrels are produced from other North Sea fields. The company has a strategy of acquiring and developing stranded reserves, and efficiently producing and extending the life of older mature fields. Venture does not target high-risk exploration wells.

Venture has a strong pipeline of development opportunities, which could provide production and volume growth over the next three years. However, it may also acquire additional reserves. We believe there is little in the share price for these prospects, with the shares underpinned by the value of current production.

Venture has recently commenced dividend payments. The company last month announced unsuccessful drilling, and this gave the opportunity to add to the Fund’s investment. The Fund has benefited from bids and bid approaches as the oil and gas sector consolidates. In 2005, Edinburgh Oil & Gas was bid for, as was Hardman Resources in 2006. Premier Oil repelled an approach in 2006, and could be vulnerable again later in 2007.

International telecoms group, Cable & Wireless, is in the FTSE 100 and capitalised at £4.5 billion. However, the share price at 187p stands at little more than one-tenth of its peak level of 2000. Previous management destroyed value with poor acquisitions in the TMT bubble and new management were brought in to rationalise, cut costs and restructure. Both the UK and international divisions have returned to profits growth, and we believe there is further recovery potential.

The shares look expensive in terms of price/earnings ratio, prospectively 30 times, but are better valued in terms of dividend, EBITDA and sales. The UK business should be generating free cash flow by 2008 and the pension scheme is fully funded on an actuarial basis. Revenue is exhibiting strong growth internationally. As this recovery progresses, there is the potential for the group to be broken up, selling its UK and international businesses separately. There is the potential for further earnings upgrades, and for value to be released by restructuring. Management is heavily incentivised via a long term incentive plan to deliver shareholder value, with rewards geared to achieving a share price 20% above current levels. Recovery in the UK business is key to restructuring potential, but we believe management can deliver additional shareholder value over the next 18 months.

Novae is a reconstructed and refinanced insurer, formerly SVB Holdings. The company currently writes around £300 million of gross premiums. In the late Nineties, Novae suffered from poor underwriting and appeared insufficiently capitalised to deal with a tail of US losses. However, its new management has built credibility, demonstrated satisfactory provisioning, and it appears increasingly likely that no further problems will emerge.

The Fund bought its investment via Novae’s refinancing in May 2006. This issue gave management the potential to create an FSA-regulated insurer to write mid-sized commercial risks. Novae aims to build a profitable business as the management resolve the older legacy issues with Lloyds business. The management has done an excellent job of re-focusing the business and running-off problems. The team is highly incentivised to succeed and the current underwriting team has a record of success. Novae’s recent results show it has made less use of provisioning than originally feared, and this should give management an earlier opportunity to resolve the legacy issues. Lloyds businesses are attractive to US and Bermudan insurers, and we expect further M&A activity in this sector. Novae is rated well below the sector average, relative to assets.

Morrison is one of the UK’s four major food retailers, operating almost 400 stores. The company damaged an excellent long term track record in March 2004 with the acquisition of Safeway. Morrison’s management did not seem prepared for the problems of integrating Safeway, although the price it paid was well underpinned by property assets. As a result, Morrison’s shares under-performed the market for two years, even lagging its competitor Sainsbury, which faced similar industry pressures.

However, this under-performance took the share price down to a level at which the shares were almost entirely supported by our calculation of underlying asset value. The City did not appear to recognise the potential for margin improvement in what was becoming a more benign environment for food retailing. The shares entered the portfolio in 2006, and since then the company has favourably surprised the market with its results, jumping 6% after an encouraging trading statement in January. The shares have also responded to the speculative interest in Sainsbury, but have lagged Sainsbury’s performance despite, we believe, Morrison having similar attractions for private equity buyers. Even without that, we believe that margins should surprise the City on the upside, and expect profits forecasts to be revised upwards. The Company will shortly announce progress on its strategic review.

Biffa is a waste management business, providing waste collection, treatment recycling and disposal. It services industrial, commercial and municipal customers, offering a range of specialised services covering solid and liquid waste. It also uses methane produced in decomposing waste to generate power for export to the grid. In late 2006, the business was demerged from Severn Trent, and it may therefore take time to build up full research coverage and broad institutional ownership. However, capitalised at £1.2 billion and operating in a growing industry, it is likely to attract coverage.

A changing legislative climate is offering significant opportunities in waste management, and in a concentrated sector, there is limited price competition. Although Biffa trades at a premium to the market, in price/earnings ratio - in relation to sales and its gross earnings, it is still valued at a discount to some recent bids in the sector. We believe that Biffa’s growth potential is undervalued, and that it will beat earnings expectations. There is an additional prospect of a bid at some stage, as the industry is consolidating.

Compass Group, which provides food catering services globally, fits the pattern of shares performing well in the current environment. It is a major FTSE 100 company, which has a troubled history but is now being turned round by new management. This means that investing institutions are gradually returning to the shares, while at the same time City analysts are raising profits forecasts. The shares are still well below their highs of five years ago, and also below the level for 2004 prior to their first major profit warning. The business operates in a challenging environment, but management plans could see steady margin improvement over the next five years. If economies pick up in Continental Europe this will give a further boost. The shares have already outperformed in 2006,and stand at a small premium to the market averages. However, it operates in a sector with entry barriers and should be able to achieve better profit margins if it can control costs and ensure that contracts allow cost inflation to be passed on. Successful execution of management’s plans could justify a much higher valuation.

British Airways has performed well in 2006, but still stands well below its peak share price of the 1990’s. The business is undergoing a remarkable transformation, dealing with higher fuel costs whilst cutting other costs and improving load factors. Although a FTSE 100 company, British Airways is arguably still misunderstood and under-owned by UK institutional investors. Despite competition from low cost carriers, BA has aggressively cut costs and managed its pricing well. BA also has had additional problems due to a weak balance sheet, but has worked steadily to resolve debt and pension fund deficit issues. We believe it is near a resolution with the unions on its pension fund.

A number of other portfolio investments, such as Invensys, have similar characteristics in terms of appearing challenged but steadily resolving problems and releasing underlying value. We expect BA to see further earnings upgrades as it resolves problems, and its potential for further recovery is not reflected in its current rating. The opening of Terminal 5 in 2008 will significantly increase capacity, whilst also being structured to operate at low cost, handling passengers more efficiently. Passenger yields are improving as BA moves away from economy flights, in an environment where landing slots and capacity is limited. British Airways has a substantial franchise in Heathrow which can be better exploited by present management.

Uranium producer, UrAsia Energy, is one of the largest stocks on the AIM market, which it joined in August. Capitalised at £780 million, UrAsia's main assets are located in Kazakhstan. It has potential to increase production significantly over the next seven years as two new development projects come on-stream. It is developing Kazakh uranium assets in partnership with the State-owned uranium producer. The company also has a development asset, where drilling aims to convert the Soviet classified resources into Western classified categories.

The company is well financed for these drilling development programmes and should benefit from the strength of the uranium price. Nuclear power stations supply 16% of the world's electricity, and demand for uranium is growing as new power stations are commissioned around the world. Russia plans to make nuclear power the source of 25% of its needs by 2030. Utilities are increasingly buying forward to secure supply.

More recently, a flood at the Cigar Lake mine in Canada lifted the uranium price to US$60 per pound, highlighting the need for utilities to diversify supply and pointing to the risk of a medium term supply crisis. We believe UrAsia is well placed to benefit from increasing demand from utilities, as governments attempt to reduce carbon emissions.

Novae is a reconstructed and refinanced insurer, formerly SVB Holdings. The company is capitalised at £200 million and currently writes around £300 million of gross premiums. The company suffered from poor underwriting and appeared insufficiently capitalised to deal with a tail of US losses. However, its new management has built credibility, demonstrated satisfactory provisioning, and it appears increasingly likely that no further problems will emerge.

The Fund invested in Novae at its refinancing in May, giving management the potential to create an FSA-regulated insurer to write mid-sized commercial risks. This aims to build a profitable business as the management resolve the older legacy issues with Lloyds business. The management has done an excellent job of re-focusing the business and running-off problems. The team is highly incentivised to succeed and the current underwriting team has a record of success. However, the refinancing came during a weak period in the market and the underwriters were left with stock. This overhang has now been cleared, giving the Novae share price scope to recover. We believe the shares are still under-rated, and the value will gradually be recognised, as it becomes clearer that the business has stabilised and the team can build value with the new business.

Stagecoach is a rail and bus operator, with businesses in the UK and US. Capitalised at £1.2 billion, the group was once in the FTSE 100, but fell from grace after problems with a US acquisition.These issues have since been successfully resolved, with the company returning capital to shareholders as it focused on its UK business and retrenched to East Coast USA bus operations. Management is entrepreneurial, and their interests appear closely aligned with shareholders.

Stagecoach is currently awaiting a decision on the renewal of the South West Trains franchise. Failure to secure this might adversely impact the shares. However, following the sale of its London bus operations, Stagecoach appears overcapitalised. Once the South West Train franchise decision is made, there is the potential for Stagecoach either to return significant capital to shareholders or make an acquisition. Also, stabilisation of the oil price would be helpful.

Stagecoach shares have lagged the stockmarket over the past two years, but have recently begun to recover.We believe the value of the business is not fully recognised by the stockmarket, and believe that the shares could perform more strongly when the decision is made on South West Trains.

International Power is a UK-based generator and distributor of electricity. It has interests in 28,800 gross megawatts of power generating capacity spanning 18 countries. It is benefiting from a strong market globally for energy, with high UK electricity prices, and the company enjoys strong free cash flow. Load factors have also improved, and forward contracting is good. The US market is continuing to recover. Recent results should be the catalyst for further earnings upgrades for 2006 and 2007. We believe that the group's growth prospects continue to be under-rated within the utility sector, and the opportunity was taken in July to add to the Fund's investment.

Invensys is capitalised at £1.3 billion and provides controls systems for a range of industries including construction and rail.The group was formed in 1999 by the merger of two struggling engineering companies, BTR and Siebe. Since then it has faced a range of problems including debt, pensions liabilities and tough trading conditions. However, new management, disposal of non-core assets, and debt restructuring are all now helping to turn the company around. The shares are now valued at just a fraction of their peak level. Some value has been destroyed, but this year should see further restructuring and resolution of pensions and some debt problems. Invensys is currently re-financing debt via a rights issue, which should allow further business restructuring.We believe that the company's previously weak balance sheet had left the shares trading at a discount to its peers. Revenues over the next three years are likely to be flat, but margins and return on capital should improve.There are still risks, but the potential for recovery is also substantial if management can successfully make disposals and complete the restructuring. With £2.6 billion of turnover, the business then could be an attractive acquisition for a larger group.The Fund has taken up its rights.

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Carphone Warehouse

Investment Rationale