The man with a lifelong search for value

One of Britain's best fund managers explains some of the secrets of his success to William Kay. But there are no big surprises, because the reason he attracts so many clients is painstaking research, with real, bottom-line valuation

Not for the first time in his career, much is resting on the broad shoulders of Neil Pegrum, who runs the UK Dynamic and UK Discretionary funds for Insight Investment, the fund management operation set up in July by HBOS from the embers of Clerical Medical and Equitable Life and, with the addition of Rothschild Asset Management, now handling £68bn of investors' money.

From this dual base, Insight has set about recreating its business, wading ruthlessly into the market to poach leading fund managers. Among its most prized catches was Mr Pegrum, who had been running M&G's revered British Opportunities fund for 14 years.

Such is Mr Pegrum's reputation among the financial adviser community that when they learned he was moving to Insight last September many of them promptly told their clients to ditch British Opportunities. Indeed, the whole of M&G reportedly fell off the recommended lists of most brokers, a blow the firm is only now beginning to repair.

But the responsibility of carrying thousands of investors' hopes in his back pocket sits lightly with Mr Pegrum. "I've always enjoyed the excitement of the stock market, with the challenge and interest of analysing companies and industries," he said offhandedly when we met at Insight's glassy offices in the heart of the City.

His Dynamic and Discretionary funds are very much continuing the tradition of his work at British Opportunities. He had transformed that fund from one concentrating on manufacturing companies to an out-and-out special situations investor. And so it is with Mr Pegrum's new babies.

"There is no absolutely set approach, every stock is different and ideas-generation comes from a wide variety of means," he says. "I have seen a lot of stock market cycles, and a lot of companies go in and out of favour, so I have a wide knowledge base of a lot of companies, particularly at the small and mid-cap end. And they've always been very widely spread across the market, by sector and by market cap, right the way through my investment career."

There are three key steps in Mr Pegrum's method for picking stocks: how good is a company, what is going to make it more interesting and is it worth more than the market's current valuation? "Mine is definitely a bottom-up approach," he says. "I've got a view of the world, which colours what I think will be the general economic or stock market influences on a company, and that will lead you to a more or less defensive approach to your portfolio. But, broadly speaking, my whole approach is to find cheap stocks."

Good companies, in Mr Pegrum's book, can be low-quality as long as they are doing well within their industry and protected by what he calls "sustainable barriers to entry". These can be strong brand names, reputation, long-term contracts with suppliers or customers, anything which makes it tough for new competitors to establish a toehold.

"You've got to understand the industry in which you are investing," says Mr Pegrum says. "Industries are much more fluent than they have been. You've got to be very careful to understand what has driven and will drive the industry. You've got to understand the margin structure and what drives the pricing power.

"Increasingly, fewer and fewer companies have pricing power. But also, pay attention to the cost line. For the UK, I think it's a big issue because the labour market is still tight, in the public sector inflation is growing and that could all have a big impact on margins. You need to understand that."

The second stage in the Pegrum process, looking for what could make a company more interesting, is the most intangible. It could be cyclical recovery, a share falling in or out of a FTSE index, the opportunity to restore margins to the industry's previous levels or those of international peer groups, or just hidden value such as a really interesting business which has been obscured from the stock market because the company's shares have been performing shabbily.

Mr Pegrum says: "I think the market will look to buy growth again, more and more. In a low-growth and low-inflationary background, it will be prepared to pay more for growth."

His final stage, valuation, is what he regards as his reality check. If the market's valuation of a company is the same as Mr Pegrum's, there is no point buying the shares.

He says: "I'm trying to determine if there's a valuation gap, and I have a very simple method. The key thing is to focus on forecasts and what the company can make on a medium-term view. The absolutely key thing is the quality of your forecasts, rather than some new-fangled valuations, because all valuations are dependent on the quality of the input. So I try to work out what the company can make and use the p/e ratio to work out what that will be worth on a two-to-three-year view.

"You've got to have a range of valuations because you can't be sure how high the company will be valued in the future, but you've got a good idea from history and peer-group comparisons. It's easy to put down on paper, but every company is different, and so is every opportunity."

All this is fine for a top-class professional such as Mr Pegrum, surrounded by stockbroking analysts' reports and the work of Insight's own research team. And with his buying power, he can arrange to see the chief executive of any company he is considering investing in. But he has good advice for the amateur investor.

"It's easier to get information now," he says. "You can get most annual reports and accounts off the company's web site, with information about its products and markets. You can even get copies of the presentations they make to City institutions. And there are a lot of financial web sites you can join for free or a small fee.

"But I think you have got to be very cautious in your approach. You've got to find companies that are interesting in an area you think is interesting and perhaps a market place you see is growing. It's normally easier to make money out of companies operating in a growing rather than a declining market. In the end, it all comes down to valuation.

"You look at companies' financial record, at the strength of their balance sheet. If you don't want to take on too much risk, avoid companies with high levels of debt, look for stability within boards, things like that. And track the companies for a while, don't be in a hurry to invest. It may be best to run an artificial portfolio for a while."