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Fund Manager Focus - February 2012

Andrew Holliman & Richard Wilson, Polar Capital - London

Andrew Holliman

Richard Wilson

Polar Capital was founded in 2001 by former members of a very successful technology team at Henderson. Over 10 years the firm has grown assets under management to $4 billion across both long and long/short strategies and has diversified from its technology roots in recent years. Its latest move at the end of 2011 was to launch a North American fund managed by two established fund managers recruited from Threadneedle.

Andrew Holliman is lead manager of Polar Capital's North American Fund. He started his career in 1997 and has been managing money since 2000, spending seven years at Threadneedle, after starting his investment career at Baillie Gifford. Andrew graduated from the University of Edinburgh in 1997 with a first class BCom (Hons) degree in Business Studies.

Richard Wilson is co-manager of Polar Capital's North American Fund. He started his investment career in 1999. At Threadneedle, Richard was a US Equity Fund Manager. He previously worked for Merrill Lynch Investment Managers and for Newton Investment Management. Richard graduated from the University of Edinburgh in 1999 with a Master of Arts degree (first class honors).

The North American Fund is an all-cap, long-only equity product which focuses on long-term quality and value. The fund has "a tough hurdle of 5% per annum gross against the MSCI North America Index, which is our benchmark over rolling five-year periods, but I think we're capable of achieving that".

Congratulations on the new fund. How much have you raised so far and what's the target?

"As of today we have $96m - we were pleased with our launch in what was a horrible environment. We had a very good roadshow with excellent feedback and I think if we do what we say we are going to do and deliver as we have done in the past then, we can build quite significantly from here. However, long term we will review capacity at around $2 billion- that's some way from here but the key point is that part of Polar's client driven culture is that we close funds before diseconomies of scale could impact performance. We will not face those diseconomies either now or in the long term even if we grow successfully from here."

The fund is long only – correct?

"Yes we are resolutely long only. We don't short - we've had experience shorting in the past and whilst we enjoyed the experience we did find it distracted us from our bread and butter of long only equity investing."

Polar is well known for its technology and healthcare investments - what's the rationale for breaking out of the specialist mode?

"It has broadened out quite a bit in the last few years. Technology was the founding area of Polar as the two founders, Tim Woolley and Brian Ashford- Russell were tech fund managers at Henderson and then it built up from there so the two largest strategies are tech and Japan but then we have other sectors, healthcare and we have a very good financials team which came out of Hiscox insurance in 2010. The firm has also branched out geographically adding the very successful Framlington emerging markets team in 2010. Polar had been looking for a North American team for a while and although they recognised it is a very competitive area in the US, they felt it was underserved in London."

How will Polar's specialist expertise impact the way you and Richard manage your portfolio?

"We will very much make our own decisions in tech, healthcare and financials but we have a fantastic best in class resource to take advantage of. We have 13 investment professionals working there and those three sectors make up about 50% of our market so it's a great resource. We can take advantage of their knowledge and take advantage of any investment opportunities that coincide with our investment philosophy and process but as the North American team we very much take ownership of the investment process and of the ideas that go into the portfolio. So we will use those teams as an industry resource and can use them as a source of ideas but ultimately we take ownership of what goes into the portfolio."

Richard Wilson, also ex Threadneedle, is co-manager of the fund, will you split sectors?

"We will both continue to be generalists as we think it is much more beneficial as you are taking ownership of the stocks you are investing in and it's much better for cross comparison purposes. But we will take advantage of our respective areas of expertise. Richard has followed industrial companies for the best part of his career, so for the last 10 years he's been an industrials analyst as well as being a generalist. I have spent a lot of time looking at Canada, energy, utilities, software and retail so it makes sense to take advantage of that experience. But in general we feel a generalist approach is best."

How will you build your portfolio?

"The portfolio is a reasonably focused portfolio with 40 – 60 names and that was a very conscious decision having run more diversified remits at Threadneedle. We feel the benefits of diversification over around 50 stocks tails off significantly and there are both return and fundmanetal risk benefits when managing a more focused portfolio."

Do you have any market cap constraints?

"We tend to invest in companies with market caps above $750 million. We don't take neutral positions or underweight positions. We are only investing in businesses or stocks that we deem attractive. It's primarily a bottom-up driven construction process although it doesn't mean we don't take account of macro factors. They can be important in influencing the long term dynamics of a busibusiness but ultimately we're weighing up the value of the long term business fundamentals of a particular business and assessing the long term valuation and these are key criteria for getting into the portfolio. It sounds simple but I think a long term fundamental approach to investing is increasingly rare in today's myopic investment landscape."

What's your market cap sweet spot?

"We tend to have a mid cap bias and that is simply because there are 2,000 companies in our universe and we are going to find more ideas outside the top 100 than in the top 100. That being said, in recent years many of the mega cap companies have been substantially de-rated and we are seeing some very good value there."

What percentage of the fund will you invest in Canadian stocks?

"We don't have any limit. At the moment we have about 7% in Canadian stocks and that is very much driven from the bottom up where we see opportunities on a stock by stock basis. We own Canadian Oil Sands, Fairfax Financial, Mac- Donald Dettwiler and TMX Group."

Are SRI factors considered?

"We look at how businesses are run in the interests of shareholders, try to understand that decent corporate governance is followed and understand how management is compensated. However, it is not an SRI driven strategy."

Do you vote your proxy?

"We take a low key approach unless something attracts our interest."

US investors are often very short-term focused. What is your average holding period?

"We have a three to five year view when we go into a stock. We therefore evaluate the business credentials and valuation on a three to five year view. But we take a pragmatic approach to turnover - in the past I have held stocks for many many years but have also held and sold stocks for only 6 months where they re-rated sharply - this was the case in 2009 for example. The important thing is to buy and sell stocks for the right reasons- for example driven by the long term fundamental and valuation case rather than trying to second guess a company's reaction to a quarter. But overall we would expect to have lower turnover than the market."

Do you have a target price in mind when you buy a stock (i.e. 20% upside)?

"It depends on the kind of business. We assess the long term business value of a stock we are invested in. We are looking for double digit per annum total return. Typically above 12% per annum. If it's a higher risk business we'd want somewhere north of that."

You've been quoted as saying "the market tends to overpay for growth" – does that mean you are value investors?

"We are pragmatic value – or similarly pragmatic quality investors. By this I mean that we do not invest solely in value - we want also to see some return from the underlying business and not be reliant on a re-rating from the stock market. Equally - we don't just invest in quality - we want to buy that quality at a reasonable price. Empirical research shows that investors often overpay for growth or at least extrapolate short term growth so we certainly are very value disciplined and one of the screens we do is a value screen. But we are also cognisant of the mistake that many value investors make by investing in value traps and therefore we want decent businesses with good long term value creation and to buy into those businesses at attractive valuations."

You've also said that cash generative companies tend to be "ignored by the market" – any examples?

"Advanced Auto Parts is our biggest holding. We see everyday that the market and the sell-side in particular, spends a disproportionate amount of time trying to work out if a company's sales are going to grow at 4% or 5% in a year and completely ignores what a company is doing with its cash flow. A company such as Advanced Auto Parts gives 8% of its market cap back to shareholders and actually last year gave 10%. If it does this consistently like its main competitor Autozone has been doing for nearly 15 years then that use of cash has a massive impact for shareholders, more so than a percentage point or two in sales growth. If it gives you 8 per cent back a year then that in itself is an attractive low risk return to begin with and gives you almost a free option on operating profit growth. The market does appreciate cash flow a bit more than it used to be but it is still overly focused on short term trends."

What screens do you use?

"Quantitatively we use a value screen but we supplement it with qualitative work as well. So the value screen enables a valuation discipline throughout the process. The valuation screen looks at four measures: price-to-earnings; free cash flow yield; price-to-book and capital return which is a combination of dividend yield and stock buy back. We find by looking at the best value quartile in that area that it gives us a long term head start versus the index to begin with. We then support that with qualitative measures such as the balance sheet strength and we combine that with typical qualitative screening such as company meetings, research and experience."

What's your active share ratio (i.e. how far will you invest away from the index)?

"We have a high active share. Typically north of 75- 80%. We want the fund to be an active fund, we are not index huggers!"

Your target is to have between 40 – 60 stocks in the fund, what is the maximum percentage of the fund that could be invested in one stock?

"1 – 3% is the usual active size position with a maximum 5% absolute position."

Favorite sectors and why? You are overweight the consumer discretionary sector and favor: Time Warner, CBS and also Advanced Auto Parts and McDonalds. Can you expand on why you like these particular companies?

"Advanced Auto Parts is a very steady business, an oligopoly with margin expansion potential. It has a huge amount of cash flow and therefore high single digit return from cash return alone and then the top-line growth and operating margin on top of that so that's a business where on a three to five year view it has 15%+ per annum business value creation and it's attractively valued at an 8% FCF yield which also gives you a free option on it being re-rated. We like to get a good return from the underlying business and then by buying these businesses cheaply you get a free option on any re-rating.

It's the same with Time Warner and CBS, media companies that are cheap on a free cash flow yield basis. They are decent businesses, they have good content franchises and at the moment they have pricing power. Again, they are very cash generative. Five or ten years ago these companies were destroying value but they seem to have been scarred by past misdemeanors of previous managments and have learned their lesson and are giving cash back to shareholders. So again, you are getting very high returns just from that cash return alone and you get a free option on the underlying growth in their strong franchises.

McDonalds – it made it into the portfolio but we've been paring it down on valuation grounds. It's a high quality business at a reasonable valuation. We want companies with a quality and valuation advantage and McDonalds is very much one with a quality bias. It got in on the 6% free cash flow yield (from quant screens) and it probably has been re-rated slightly. It gives most of that cash flow back to shareholders, fantastic long term franchise and inflation hedge. We think it is lower risk than most sovereign debt in that regard and it is executing very well. But we have been paring it back a little bit on valuation grounds."

You are market weight consumer staples and favor Colgate, Philip Morris and Procter - can you expand on these choices?

"These stocks are favored for their pricing power, international exposure, durable franchises, cash-flow generation and reasonable valuations."

You are underweight energy but hold Helmerich and Payne and Canadian Oil Sands – please expand.

"We haven't found the companies on a free cash flow basis. We are cognisant of that underweight and are not actually bearish on the oil price. We are looking for other opportunities but we've not found the combination of organic growth and cash generation. World Fuel Services is on our reserve list. It is a company we like a lot and have held before but it got re-rated and it is just a little bit too expensive for us but we are monitoring it."

In financials – you are market weight to overweight and favor ACE Ltd, Arch Capital, Willis and Marsh McLennan, Travelers, Berkshire Hathaway and Fairfax Financial within the insurance sector. Other financial names you favour include: Ameritrade and Jones Lang Lasalle. Please explain your reasoning.

"The underlying insurance businesses are trading at roundabout book value and the businesses we've invested in have a good track record of value creation and you have the option of a turn in the insurance pricing cycle which we don't know when it's going to come through but we think you have a free option on that. Willis the insurance broker is also well placed, it's more of a cash generative business over the long term but also positioned for any insurance pricing cycle."

Within healthcare, you like McKesson, Henry Schein and Laboratory Corp – why?

"McKesson is very cash generative business, an oligopoly with high barriers to entry, steady growth, drug distributor, high cash flow yield. It is giving money back to shareholders through dividends and buy backs. Henry Schein is similar. A very well run business over the long term. It's not giving much cash back to shareholders but that's because it is a very good consolidator. Also it won't be hurt by healthcare reform over the next five to 10 years or the fact that healthcare spend has to be addresed. Laboratory Corp has a steady business, throws off cash and we rate management highly on their deployment of cash flow. Operating cash flow has slowed a bit but it's still a very good business at a low valuation."

In industrials you are overweight and like Wesco, Roper Industries, Flowserve – expand?

"Wesco is an industrial distribution company, it's a very fragmented industry and they've done very well gaining market share in the last five years and we expect that to continue. Again we rate management very highly and we think there are opportunities to increase margins both from ongoing productivity and they've generated good profits in spite of the low level of activity in the construction market in the US. So we think any improvement in the construction market which is surely likely off multi-decade lows will be good for them but they are not dependent on that to grow cash-flows.

Roper is an industrial conglomerate which has a very strong record of capital allocation over a long period of time. It's a low capital intensity business then cash flow is used to make acquisitions and grow the acquired businesses. It's a company with a fantastic long term record and we see 12 – 15% per annum value creation over a five year view."

Technology is another sector you are overweight and you like Google, Oracle, Amphenol and IBM?

"IBM – we like the stability of the cash flow. It is low revenue growth but we still see reasonable operating profit growth and you get some cash back to shareholders so there is 12 – 13% value creation for the next few years. It has been re-rated in the last few years but we still think the potential return and the safety in that return is very attractive. It's a diversified global franchise."

Least favorite sectors and why?

"As a sector, utilities is the most expensive it has been versus the market in over 40 years. We see more attractively valued better cash generative defensives elsewhere."

Cash flow deployment is important to you, what's your view on the dividend vs. buy back issue?

"We look at it on a case by case basis. We like the consistency of dividends but our investors tend to get charged higher tax rates on dividends. When it comes to buy backs we do want to see a sensible and consistent strategy. We don't like cyclical businesses only buying their stock back when they are generating maximum cash flow and when usually their stock is at a peak - that tends to lead to value destruction. If a company is to buy back stock it should be a consistent buy back or at least be driven by a reasonably sensible and systematic approach - not during times of maximum cash or alternatively not just to appease the market to make a quarter."

Do you like to meet management?

"We like to meet management as we are fundamental investors but we do not see it as a means to gaining an information advantage or edge. When we meet management we tend to focus on things like capital deployment and long term strategy rather than the next quarter. You can get very good information from earnings calls, the corporate web-site and the annual report but sometimes you have questions you want addressed that you can't get answered from calls and/ or the annual report."

Outlook for US market in 2012?

"We still see a lot of risk around the world when it comes to the fiscal situation of developed countries. But US companies have good momentum and there is very good value in equities and good capital return and in a universe of 2000 companies there are plenty of opportunities. Despite the macro risks we are pretty constructive on equities from a long term perspective, especially versus alternative asset classes - but then we would say that!"

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