These three ‘disruptive’ shares could be FTSE 100 firms of the future

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today, I'm joined by Jean Roche, who is the fund manager of the Schroder UK Mid Cap Fund (LSE:SCP), which is an investment trust. Jean, thank you for joining me today.

Jean Roche, fund manager of the Schroder UK Mid Cap Fund: Very glad to be here.

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Kyle Caldwell: Jean, could you first run through how you invest? I understand there's a big focus on finding disruptive businesses. What are the key qualities that you're looking for in such companies?

Jean Roche: Well, I was thinking about this when I was cycling across Westminster Bridge this morning, and I think really what we're looking for are companies which we think can grow to be the FTSE 100 companies of the future, so looking for the large-cap companies of the future.

They might be disruptors or they might be existing, well-established companies that are reinventing themselves, responding to disruption in various markets.

Kyle Caldwell: And when you look at those companies, are there certain key attributes that you're looking for?

Jean Roche: Yes, there are a number of attributes. I think looking for growth in earnings and cash flow, looking for strong management teams, looking for good balance sheets, and looking for the fact that they'll be operating in niche markets. They might be unique in terms of in the quoted market, or they might be one of two options in the quoted market, for example. They will be offering scarcity of some sort, generally speaking.

Kyle Caldwell: And given your focus, does this lead you to certain sectors of the market? Which sectors are you favouring most at the moment?

Jean Roche: I think when somebody thinks about a disruptor, you might typically think about, say, a Tesla or Amazon, something in the tech sector, and interestingly enough, my market, the mid 250, 5% of that is tech and actually only 1% of the FTSE 100 is tech.

And so you might say, Jean, you must therefore be looking at tech, but there's far more disruption in other sectors as well. If you want, I can give you an example. One that might not be obvious is Inchcape (LSE:INCH), and that is an automotive distributor, and there there's a lot of disruption going on in terms of the digitisation of that market and in terms of buying up smaller distributors in areas where it hasn't been professionalised yet. And so that's a less obvious example of a disruptor at a very, very much cheaper price than, say, Tesla or Amazon.

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Kyle Caldwell: Could you give a couple of other examples of stocks? I mean, I know you probably could pick out any of the companies in the portfolio. I was wondering if you could give a couple of examples of companies that really are disrupting the respective industry or sector that they operate in?

Jean Roche: I think one that I could mention might be, when you talk about a disruptor, you might say it's creating a new market, actually. And I think you could therefore look at maybe the self-storage companies, so Safestore (LSE:SAFE) would be one of those, and that was a market that didn't exist really in the UK maybe 15 years ago, and now you have two companies, Safestore and Big Yellow (LSE:BYG), which are growing.

Before this, people weren't paying £100 a month to store their old sofa and their old bike in a shed, and now they are. And once they put it in there, they're not taking it out again. So that is the beauty of that model. I would consider that to be a disruptor in terms of creating a new market which didn't exist before because nobody was doing that 20 years ago in the UK, because my market is specifically the UK.

Another stock which I think is really interesting is IP Group (LSE:IPO), which is a collection of investments in small, usually disruptive, companies. For example, one of their investments is a company called Hinge, which is an app where you can do your physiotherapy and that is disrupting the drugs market in the US for various aches and pains. Instead of buying drugs, you remove the medicine and you do your physio online on the app and it improves. What is really interesting about it is it improves your compliance with your treatment plan as well because the app is telling you, by the way, you need to do five knee lifts.

So it's quite ingenious and in some ways may be replacing the human physio as well. So that is an example of a company that has many disruptors within it, in clean tech and health and Oxford Nanopore Technologies (LSE:ONT), which is very well known to be disrupting the medical market, that came out of IP Group. So, I think that's a very interesting collection of potential disruptors.

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Kyle Caldwell: You mentioned earlier that you also invest in established companies. How much of the portfolio is in these types of companies? And I understand that the focus is looking for established companies that are reinventing themselves?

Jean Roche: Yes, one example of that could be Dunelm (LSE:DNLM), which acquired World Stores, which is a pure play online retailer. Dunelm was operating in a market where people didn't really buy homewares online, but what have we seen over the last couple of years?

Everybody's buying homewares online, but before all that began to happen, Dunelm, which didn't have a very good website about five years ago, bought World Stores and learned to be an online retailer. And so at the height of the Covid lockdowns, Dunelm was doing 70% of its previous sales only online, which was amazing, given that probably if you tried to buy a mug from the Dunelm website seven years ago, you'd have given up in despair.

So, really, an unbelievable transformation and Dunelm deciding that it wasn't going to let itself be disrupted, it was going to embrace it and crack that nut. So, I think that's a really good example of an established company reinventing itself and making things hard for the pure play online homeware companies.

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Kyle Caldwell: Is there a rough percentage a split between established and disruptors?

Jean Roche: I would probably say that most of the companies are responding to disruption, so they are doing something disruptive because you can't stand still, but ‘pure disruptors’ is probably a smaller part of the portfolio, maybe 5%, 10%, because that's much more difficult to find.

And I think it might help people to understand better, the classic examples of disruptors have actually gone into the FTSE 100, kind of proving the point here, and I would say those are Auto Trader (LSE:AUTO) and Rightmove (LSE:RMV), both companies which completely changed the way we buy houses and cars forever.

An AutoTrader and a Rightmove don't come along every day, so that's by its nature, a smaller part of it. But often what these companies are doing, maybe the bigger companies, the established ones, they start to compete to try and do the same thing that those companies are doing and to kind of start moving towards offering those services or competing in that new market that those disruptors are creating.

I would estimate that the split is probably 10%/90%. However, I think many established companies would say they have a lot of disruptive qualities, so it's difficult to be scientific about it.

Kyle Caldwell: And what's the average holding period for a company? And I was wondering if you could also pick out the one share that you've held the longest in the trust?

Jean Roche: So the average holding period is, because we don't have very high turnover, about four to five years, which means we get to know the companies extremely well, clearly. I think I mentioned Safestore earlier as one of the stocks we've held for a very long time, but I could also talk about, for example, Telecom Plus (LSE:TEP), and that's one which you might know, as well as Utility Warehouse, which is currently offering customers a £300 discount relative to what the Big Six can offer in energy. So it's come in, it's a challenger to the Big Six in energy because of its contract that it has with its supplier to buy gas at a 15% discount to what the Big Six can buy it for, and therefore they're able to be a challenger in the market, so I think that's one that we've had for a long time in the portfolio beyond five years, and one that I still have high conviction in.

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Kyle Caldwell: In the event of a company moving from the FTSE 250 index to the FTSE 100 index, are you then a forced seller? And more generally, what are the main things that you look out for, which may lead you to sell a company?

Jean Roche: So, yes, we do sell when a company goes into the FTSE 100, but I don't like to see it as a forced seller. I like to see it as the fund strategy working because I'm trying to invest in companies that are going to go into the FTSE 100, and there's an opportunity to then invest in new holdings.

Other reasons that we might sell companies might be when we see significant capacity building in the sector, when we see significant changes for the worse in ESG (environmental, social or governance), or sustainability behaviours, when we see frequent expensive acquisitions, if we feel the quality of the accounting is questionable, and those would probably be the main reasons that we would look to move out of a shareholding in the company.

Finally, if we feel that the company's not responding correctly to disruption, we will also divest of the holding. And, of course, as you would expect me to say, valuation is extremely important, so if we see peak margins or valuations that are looking very stretched, we're not afraid to get out of a position as well.

Kyle Caldwell: Jean, thanks for coming in today.

Jean Roche: My pleasure, really nice speaking to you.

Kyle Caldwell: That's all we have time for today. You can check out the rest of our Insider Interview video series on the interactive investor YouTube channel, where you can like and subscribe. Hopefully see you next time.