SLI fund manager believes risk-averse strategy explains consistently top-quartile performance on UK Smaller Companies portfolio
Harry Nimmo believes his risk-averse strategy explains why the Standard Life Investments UK Smaller Companies fund has achieved consistent top-quartile returns since its launch in 1997.
It is the top performer out of 46 vehicles in the IMA UK Smaller Companies sector over five years to 10 May, up 86% compared to an average sector increase of 25%, according to Morningstar.
Over three years it is ranked 4 out of 54 funds, down 8.3% compared to a sector decline of 22.4%. Over one year the fund is up 33.5%.
What is your investment strategy?
It has not changed in the 13 years since we launched. The first stage is we look to buy tomorrow’s large companies today, because we are looking for predictable growth in a proven business model with lots of recurring revenues. We like to run our winners and cut
our losers.
We do not like the blue-sky conceptual stocks, and feel our portfolio is lower risk. We do not turn over the portfolio very often and tend to hold stocks on average for about four years.
The second stage is a screening process and includes earnings revisions momentum, price momentum, and director dealing. We look at the Altman Z-Score – a formula for predicting bankruptcy – and Citywatch, the UK equity ownership database.
We are trying to buy under-owned shares and track faulty institutions – see what they own, so we can own other stuff. We look at valuations, prospective P/E and yields, and earnings per share growth. We weight these factors – the high scores are buys and if we have low scores in our portfolio we use that as a sale.
The third stage is we meet companies once they have passed our screening criteria, and I call this ‘testing for false positives’. There are two things we like to get out of these meetings. One is to test the resilience of the business model and the other is to cross-check factors: Are there any rogue numbers? Are our interpretations correct, and what is behind the numbers?
What are the reasons for the strong performance over the past year?
By my reckoning we outperform 80% of the time. We tend to do better when there is increasing pessimism in the middle and later stages of the economic cycle, but in the early stages of the recovery phase – when investors are wanting risk – we underperform. And we underperformed sharply from March to start of September last year, but since then we have been outperforming.
I believe the recovery phase is now over. This means investors are actually becoming a bit more discerning about what they want to invest in, and they want more predictability. This is where we come in. This is the type of company we tend to focus on, where there is growth and predictability – companies that can actually thrive even if the economic outlook is murky.
We tend to do quite well when there is an uncertain outlook, and very well in bear markets, relatively speaking. It is our risk-averse approach to smaller companies that helps us out.
What changes have you made to holdings in recent months?
As my investment process is bottom up, I do not have any specific top-down macro template so it is really just companies coming through that score well on our matrix that I tend to start off with. But the only time when I cannot use the matrix is new issues.
I do like the new issues market, and over the past three months we have invested in a couple. The biggest is CPP Group – CPP stands for Card Protection Plan. It is a York-based company, listed in March with about £500m market capitalisation. It is a world leader and I like world leaders in niche markets.
Another one is youth fashion retailer SuperGroup, again around £500m market cap, which has about 50 UK stores and 25% of its sales abroad.
We like businesses that have never required private equity. We also like businesses which are listed on the stock market but do not need to raise money. These are signs they have a very strong cash-generative business model. Indeed, looking at the top 30 stocks in the portfolio, only three of them have ever required private equity funding, and 14 are still run by their founder. Twenty four have a chief executive of 10 years’ standing or more, which provides entrepreneurial background, continuity, focus and long-term thinking.
Other recent purchases include the FTSE 250-listed Hikma Pharmaceuticals, a £700m Jordanian generic pharmaceutical company with a leading position in the Middle East and North Africa for its products. It scored very highly on our matrix system and we bought it about a month ago. It is helpful that its key competitor is an Israeli business called Teva, which is the world’s biggest pharmaceutical company but cannot do any business in the Middle East or North Africa, apart
from Israel.
Another recent purchase is Hargreaves Lansdown, which we have topped up a great deal and is now our joint third largest holding. It achieved a very high matrix score and we think it has a very strong business model. The administration relationship, client base and sales and marketing operation is exceptionally strong. I think it will move into the administration of corporate pension schemes ultimately.
What are the strongest themes in the fund?
One strong theme is emerging markets, which accounts for about 15% of the portfolio. It includes household goods firm PZ Cussons, which mainly sells to Nigeria, and Hikma Pharmaceuticals.
ITE is another that delivers exhibitions in Russia, and we have a couple of Indian infrastructure stocks, including Great Eastern Energy and KSK Power Ventur.
We still have a lot of retailers in the portfolio but these are mainly high-growth retailers. The largest holding in the fund is the £500m online clothing retailer Asos, which has been in the portfolio for four or five years now. Our in price was only about 5p and it is now about £6.20. It is unusual because it is making quite an impression overseas – 30% of its sales are now outside the UK.
Another theme is engineering. I have not traditionally liked UK-based manufacturers but there are a number of companies now that are a bit like the last man standing operations in British engineering. They now have significant exposure to emerging markets and the more dynamic manufacturing environment there, but also to the oil and gas and mining sectors. They are also very attractive to US predators. We have already seen a bid come in for one of our electrical engineering stocks Chloride from North American firm Emerson.
Another big theme is online businesses. Apart from Asos, the second and joint third largest fund holdings are Abcam, an online distributor of antibodies, and Paddy Power, an Irish online betting company. Other online businesses in the portfolio include TeleCity and Rightmove.
If there is concern about the outlook for the market then that is an environment which will cause our fund and process to outperform because we are significantly risk averse. If you look at the underlying trading of the portfolio through the recession, we had extremely resilient performance, without having to implement dividend cuts to any significant extent.
