Collins Stewart is about to launch a new fund focusing on stocks that are unloved and under-appreciated – but which might actually be on the cusp of something great.

There are currently 2,200 listed companies capitalised at less than £250 million in the UK, according to Sean O’Flanagan, a fund manager at Collins Stewart. That’s a lot of choice for small-cap investors and, as O’Flanagan points out, no doubt includes plenty of interesting opportunities.

The recently launched Collins Stewart UK Catalyst Fund, managed by O’Flanagan, aims to capitalise on exactly this sort of undiscovered – or in some cases forgotten – potential. He explains, ‘In the UK market, things are the wrong way round right now. A lot of the broking industry’s time is spent on new issues or existing businesses that require additional funding.’ He says that droves of companies that don’t fall into these categories get ignored and/or suffer from a lack of independent research, despite their strong growth potential.

Defining the fund

O’Flanagan wants to use the fund to exploit this gap – and the gap left by closet index trackers. He claims investors are often paying an active fee for funds that do nothing more than hug the index to some extent in order to reduce portfolio risk. The UK Catalyst Fund, on the other hand, is unlikely to replicate the index, says O’Flanagan.

Roughly two-thirds of the fund will concentrate on businesses capitalised at less than £250 million, with the remaining 28 per cent invested in those over the quarter of a billion mark. It will offer an actively managed, focused portfolio of high-conviction UK stocks.

‘Although we’ve called it the Catalyst Fund, we are not looking to be activist shareholders,’ says O’Flanagan. ‘We are looking for world-leading businesses, in terms of shape and size, with organic growth potential. Those with free cash flow generation ability and an experienced and committed management team are likely to feature heavily.’ O’Flanagan’s ambition is to discover businesses ‘at the right price and stage in their cycle’. But how is that different to the general objectives of any other fund manager?

Identifying the catalyst

The answer to this is in the name of the fund. The defining purpose will be to identify stocks that could potentially offer considerable upside once some form of catalyst is introduced. For example, recent or imminent regulatory or structural change may offer potential opportunities, as could the introduction of new management. Another catalyst could be market misperception and this is a running theme among the examples of holdings that O’Flanagan discusses.

He believes that Liontrust Asset Management, for instance, has under-performed due to a misconception that the business is now ex-growth after ten years of expansion. ‘Liontrust’s operational gearing is fantastic but it has fallen out of favour because the market says it is not growing its funds under management,’ he adds. The development of a European team to complement Liontrust’s existing UK-focused investment team should drive growth, making Liontrust a perfect investment candidate.

Another is Delcam, a global leader in the CAD/CAM market (see pages 10-11). It lacks institutional support despite above-average returns and the fact that it trades at a significant discount to industry peers. ‘Delcam is self-financing so the city overlooks this because it has no need to come back to the market for funding,’ O’Flanagan explains. ‘The catalyst is that it is misunderstood and unknown by the market and therefore it is undervalued.’

Whether O’Flanagan’s strategy of identifying overlooked value in this sector will succeed or not remains to be seen but it will certainly be an interesting fund to keep an eye on after its 1 May launch.