Anthony Cross and Julian Fosh are the managers behind this £1.4bn Liontrust fund, which invests in UK companies the fund’s factsheet defines as “special situations”.
Mr Cross acknowledges that a special situation fund is usually associated with investing in “recovery-type stocks”. Instead, the managers invest on the basis of intellectual capital or intangible assets.
Mr Fosh explains: “The starting point for us is intangible assets. There are three that we think are important: intellectual property, distribution and repeat revenue. So [the company needs] to have at least one of those strengths to get into the portfolio. In this era of technological change, you need to focus very much on companies’ intangible assets, not on their tangible assets, to discover the real winners of tomorrow.”
Turning to the process of identifying stocks for the portfolio, Mr Fosh elaborates: “Every company that we want to invest in, we ask: does it have either intellectual property strengths, or distribution strengths or recurring revenue strengths? If it does, that should allow it in theory to earn higher returns than the average company and should give it a competitive strength to be able to fend off competition and keep its returns higher for longer.”
The next stage of the investment process is to determine whether a business has consistently proved it has the ability to earn higher returns than its cost of capital. Finally, the managers take a closer look at valuation. Mr Fosh observes: “We use five standard value metrics, because we think one of the mistakes the market makes is using the wrong valuation metric. Price to earnings – which is the most widely used metric – doesn’t really take into account the cost of growth, whereas return on capital does. So that in a nutshell is the investment approach.”
The managers have an extra rule for small caps where the directors of the firm need to own at least 3 per cent of its equity. Mr Cross reasons: “The experience of having invested in smaller companies for more than 20 years is that when you have management that have got equity, they are motivated. They’re also committed to running their businesses sensibly.”
The aim is to have between 20 and 30 per cent of the portfolio in smaller companies – roughly 30 per cent in the FTSE 250 and 40-45 per cent in the FTSE 100. The managers recognise that their fund has a much bigger percentage in smaller firms than the FTSE All-Share index in the belief that this is where they can find companies that are not “trawled over by the market”.
For Mr Cross, their definition of special situations is very clear: “Where you won’t find us is in areas where there are dubious, very questionable barriers to competition or a lack of evidence of strong financial returns on invested capital. So there are quite a number of pockets of the market – and quite sizeable pockets, such as mining and retail banking – where we have no exposure.”