Lifting the lid on our UK investments

With so much talk about an AI bubble, many investors are looking to de-risk their portfolios.

There are different ways to do this. The simplest is to increase the proportion of cash in your investments. But for investors with a longer-term focus this is itself a risk. Shares have outperformed cash over the years and have proved a better way to stay ahead of inflation.

So, if you want to lower the risk of your portfolio while staying invested, another sensible approach might be to focus on the characteristics of the underlying holdings in our portfolio and to weight our investments towards quality, value and income. Traditionally these features have provided ballast and given investors a smoother ride.

When the dot.com bubble burst in March 2000, it was this kind of Steady Eddie company that fared much better than the high growth but often volatile technology stocks that had led markets higher during the boom years.

• Read: 6 'Steady Eddies' for a stress-free retirement

Diving into the data

In order to decide which funds might provide us with one or more of these characteristics, we have to understand how to recognise them in the underlying holdings of the funds we are considering.

To do that, I recently took a deep dive into Factset, an investment database with a wealth of information on individual shares.

I was able to gather data on all the shares in the FTSE 100 and then rank them according to a range of different measures.

To identify quality, I looked at:

• Return on capital. The profits companies are generating as a proportion of the assets they are deploying in their businesses.
• Persistence of Earnings. How sustainable a company’s profits are.
• Volatility. How much share prices move up and down.

The measures of value that I selected were:

• Price-earnings ratio. How much investors are paying for each unit of profit.
• PEG ratio. How the PE compares with the rate at which profits are growing.
• Dividend yield. How high a share’s dividend is relative to its share price.

Narrowing down the universe

I wanted my starting point to be a shortlist of the highest quality companies within the FTSE 100. Defining quality is not a simple matter so I decided to focus on a quick and easy measure. I took the companies with the 20 highest returns on capital. Here is the list:

My next job was to narrow this shortlist down further by looking for supportive quality and value characteristics. To do this I ranked the FTSE 100’s constituents on the other five factors: earnings persistence, volatility, PE, PEG and Dividend Yield.

This allowed me to identify the mid-point for each factor. I could then focus just on the companies that were in the top half of the index for each one. For example, I discarded any shares which yielded less than 3%, or which had a PE ratio of more than 15.

Having gathered all the data together I was able to draw up a subset of the 20 companies above which were in the top half of the FTSE 100 on at least two of the other measures.

Identifying potential winners

To take one example, Imperial Brands has an attractively low price-earnings ratio of 9.4, yields an above average 5.1% and displays low share price volatility and high earnings persistence. It, therefore, qualifies on both quality and value grounds.

A slightly different example is RELX, the business information group formerly known as Reed International. It scored highly on earnings persistence and volatility, but it is relatively expensive with a PE ratio in the 20s and a low dividend yield. It is a high-quality company but offers less in the way of value.

A company that scored highly on value but less so on quality was Hiscox, the insurance company. It only just crept into the top 20 in terms of return on capital, but it scored well on valuation and yield and was middle of the pack in terms of volatility.

The final shortlist of shares that qualified on at least two factors in addition to being in the top 20 for return on capital is as follows:

Armed with a shortlist of companies scoring highly on quality, value, income, or all three, it was time to see what was under the bonnet of the UK funds in the Select 50 list of preferred funds that we have curated with our partner Fundhouse.

The UK category of the Select 50 has three actively managed funds, focusing respectively on quality, value and income. There are also two index trackers, one matching the performance of the FTSE 100 and one the FTSE 250.

• See our Select 50: funds selected by experts

Liontrust UK Growth Fund

Fundhouse describes this fund as having ‘several traits that broadly represent ‘quality’ characteristics’. This was borne out by a comparison of its top 10 holdings with our quality shortlist.

The tables below indicate whether a company in a fund’s top 10 also appears in the top 20 ranking for each measure.

The Liontrust fund scores more highly on the three quality characteristics than on the value measures, which is what you would expect from Fundhouse’s description.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.