Keiron Root meets a fund manager whose stock selections are determined by a clear set of investment rules

Outperformance doesn’t just happen. There are usually very sound reasons why some funds do better over time, ranging from being in the right place at the right time to benefiting from the skills of an exceptionally talented individual.

Increasingly, fund management houses are looking to establish investment processes
that make the business of delivering strong performance more certain, by identifying those factors which mark out successful companies form also-rans. A good example of this type of approach is the ‘intellectual capital’ process that drives the investment strategy of the Liontrust First Opportunities fund, managed by Anthony Cross and Julian Fosh.

Innovative approach

Fosh is a relatively new member of the Liontrust First Opportunities team. He says, ‘I joined at the start of June from Saracen, were I had been managing money for three years. I work with Anthony Cross, who has been running an Intellectual Capital process for ten years.

‘Liontrust First Opportunities features in the IMA UK All Companies sector. It is a focussed fund, with between 40 and 50 holdings – the current figure is 41 – and it will pass its third anniversary in November. The portfolio holds a mix of large and small caps. The current split is 42 per cent large cap, by which we mean companies in the FTSE 350 index, and 51 per cent small caps, including AIM stocks, with seven per cent in cash.’
Fosh continues, ‘I would expect that, over time, the large cap element of the portfolio would increase, although I wouldn’t anticipate too significant a change in the balance between small and large caps.’

Far more significant than the size of the companies in the portfolio is their ability to make the most of their intellectual capital. Fosh says, ‘Intellectual capital is capital that companies have that derives from intangible assets, particularly people. We classify intellectual capital into eight categories, of which three are the most important – intellectual property, including patents and processes; advantages in terms of distribution; and a high degree of repeat business.

‘The other categories are culture; brand; repeatable procedures and formats; franchises and licences; and customer relationships. We screen for all eight elements, but place more emphasis on the three in the first tier.’

Superior returns

Cross and Fosh believe that companies that show up strongly in these areas will outperform over time. Fosh says, ‘These companies should provide superior returns because their intellectual capital gives them a distinct competitive advantage, because it stems from their own people and is therefore very difficult to replicate.

‘We expect companies with intellectual capital to outperform for two reasons. The first is the re-rating effect that impacts on businesses with a superior competitive position. Over time, the market will latch onto the advantages these companies have and this will be reflected in their share prices.’

‘The second reason is that, if we are right and these are superior businesses, they should be able to grow faster, and for longer, than their competitors. Also, with small caps, there is another element to consider. We want employees in these companies, particularly the senior employees, to be committed to the business. So when we screen these companies, we will only invest in those where the directors hold at least three per cent of the company – although in most cases, they own a lot more.’

He adds ‘Then we score for risk, taking into account factors such as valuation, customer retention, cash flow, balance sheet strength and so on. There are no sector weightings as such as the make up of the portfolio is very much driven by the individual stocks.’

Winners and losers

This means that Liontrust First Opportunities is very much a stockpicking portfolio, although, inevitably, some areas of the market will contain more of these paragons than others. Fosh reports that ‘Our biggest underweight is in financials and that has always been the case as there isn’t much original thinking in the banking sector. The biggest overweight is in technology, which is what you would expect as there is a lot of intellectual property in technology companies.

‘The style of management looking for intellectual capital means that you are unlikely to find many of the companies you are looking for in the financials sectors or in housebuilders or retailers. So we tend to be underweight in those areas that are best avoided at the moment. Also, oil and gas companies and miners are other areas where you can’t find a lot of intellectual property.

‘We would argue that this is a style of stockpicking that will perform strongly in the current environment. This is because we are highlighting companies that have that certain something that means they are well placed to survive periods of uncertainty. Your ideal stock is one where you realise that the intellectual property is there and then gradually, over the remainder of the cycle, the rest of the market realises it as well.’

Taking a long view

Fosh adds, ‘Turnover in the portfolio is relatively low, and the general style is to keep it that way. The idea is that they are buy-and-hold investments and so you would only usually lose companies from the portfolio if they were bid for, or if you get something wrong and have to get rid of it from the portfolio.

‘We are typically looking at holding investments for three to five years. In that context, Liontrust First Opportunities is quite a young fund, but we also have another small cap fund where a number of holdings have been in the portfolio for five or six years, which is an indication that this approach works over time.’