EquitiesDec 4 2014

Investing in boxy but safe?

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Each month, Fund Mole will be digging into sectors and funds, in an attempt to unearth what drives their returns, and what advisers should be looking out for. So please drop me a line if there is anything you think merits a delve.

In his popular book on statistics (yes, there is such a thing) The Drunkard’s Walk, Stephen Hawking’s collaborator Leonard Mlodinow casts a sceptical eye over claims to star investment management, arguing that with enough fund managers, somebody, somewhere, is always going to consistently outperform by blind chance: investors may simply be taken in by what in gambling is called the ‘hot-hand fallacy’.

This perspective would gladden the hearts of the sales directors at Vanguard or iShares. But that is to take a market-level view. One must also look at how specific funds do what they do. While any individual manager may be the fortunate recipient of plain dumb luck, research highlights factors which tend to beat the market over the cycle. Some are style factors, such as momentum, value, low beta or small cap. Others are attributable to management approach, such as high active share – not just as an indication of how different from the benchmark a fund is, but of the manager’s ability to add value. While none of this is definitive, analysed intelligently, it is usefully indicative.

We will start by looking at that old stalwart, UK Equity Income. The sector is often seen as the Volvo of the equity world – “boxy but safe,” for those who remember the Dudley Moore film Crazy People. In a world where growth is hard to come by, dividends become a vital component of the total return. It is little surprise then that UK Equity Income has been the net top-selling IMA retail sector in five of the past six months. In contrast, UK all companies has been the worst in four of them.

At a time when even toddlers know of Neil Woodford, it is worth looking at alternatives to the great man. Some advisers may be constrained by investment rules, or just plain caution, from investing with Woodford until his new operation has built up a track record.

Rathbone Income, managed by Carl Stick since 2000, is a strong contender. It has outperformed over one, three and five years, and since inception, with a clear investment style.

Mr Stick holds a concentrated portfolio – currently 45 stocks – of quality companies bought at a discount. Of course, ‘quality’ can be difficult to pin down. Return on equity is often used as a proxy for quality, but this is problematic. Book value is the denominator for RoE. So if book value declines, RoE increases. Therefore, if a company writes down assets or increases debt, the book value falls, which results in a higher RoE. In short, it is misleading. Stick uses cashflow returns on capital investment instead, with a focus on sustainability of returns. This, though not unique, is a better measure.

The fund’s value tilt should mean the manager avoids overpaying for quality, and provides a measure of downside protection. This aspect of safety should be further reinforced by the fund’s low three-year beta of 0.68. A low turnover of about 20 per cent also indicates a measured approach.

Rathbone Income fell significantly during the financial crisis. Mr Stick explains: “Business models that worked well before the crisis didn’t work well in it. Some of the stocks we had bought had become over-valued, or had taken on debt.”

Subsequently, the fund has performed strongly, with Mr Stick having learned from the experience and tightened up risk management. He stresses three risk factors at the stock level:

• Business risk, or the robustness of the company’s business model, the quality of its management, and so on.

• Price risk, or how much a stock is trading at relative to the team’s estimation of its intrinsic value.

• Financial risk, or how leveraged a business is.

[Mr Stick says he conceives risk as being that of permanent capital loss rather than volatility. I like this: volatility is a statistician’s measure. What matters to investors is losing their cash for good. Indeed, volatility can just give an active fund manager good entry and exit options.]

An additional risk factor is the fund’s high smid (small- and mid-cap) exposure. According to Rathbone’s data for October, smids are 27.8 per cent of the portfolio. Morningstar puts this as high as 45 per cent. Mr Stick says the team is aware of the increased price risk from smids, and the portfolio is monitored for liquidity.

[“We always ask ‘Where’s the exit?’ when we buy a stock lower down the cap spectrum,” Mr Stick adds. “Back in 2009, we bought a new issuance from Telford Homes at about 0.5 to 0.6 of book value. It came back to the market three years later, with an issuance at 1.6 times. We still think it’s a fantastic company, but we didn’t participate that time, on valuation grounds.”]

With 45 stocks, all positions should count. There is little room for a tail. That, of course, can be good or bad: the impact of a single stock blow-up will be far more pronounced.

Fund Mole will be writing once a month on particular funds. He can be contacted at fundmole@gmail.com.