These two funds place a big emphasis on avoiding losers

We look at the winning formulas deployed by Polar Capital and EdenTree
Thursday 15 Feb 2018 Author: James Crux

‘Most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.’

Readers would do well to heed the wise words of the legendary Howard Marks, co-chairman of US-based Oaktree Capital Management.

Indeed, the recent global equity markets sell-off has served to remind investors that equities can go down as well as up.

Analysing the things that could go wrong with an investment is as important, if not more so, than salivating over the things that could go right.

There are two funds, in particular, which play close attention to this principle, being Polar Capital UK Value Opportunities Fund (IE00BD81XX91) and EdenTree UK Equity Growth Fund (GB0008446063). We talked to the people behind both funds to better understand their investment process.

POLAR CAPITAL’S IMPRESSIVE FIRST YEAR

Polar Capital UK Value Opportunities has just celebrated its first anniversary (31 Jan 2018). Long-term capital growth-focused, the fund has returned 20.4% compared with the benchmark FTSE All-Share’s 11.1% in that 12-month period, according to Polar Capital, achieving this return with lower volatility than the market.

Bottom-up stock pickers Georgina Hamilton and George Godber rigorously apply their detailed, consistent investment process to each company in the investment universe.

The pair used to run Miton UK Value Opportunities (GB00B8KV0M06). News in April 2016 of their move to Polar Capital caused shares in parent company Miton (MGR:AIM) to fall by nearly 20% in a day, illustrating how well respected they are by investors. Miton’s loss has clearly been Polar Capital’s gain.

WHAT DO THEY LOOK FOR?

The co-managers scour the market for undervalued companies, seeking out ‘Bargain Assets’ or ‘Cheap Value Creators’.

All stocks must pass three strict hurdles that form the investment process: valuation, sustainability of returns and strong funding position.

Their rigorous evaluation of intrinsic value involves poring over annual reports and company filings, as well as meeting management.

‘We go through all the annual reports ourselves,’ says Hamilton, who goes the extra mile to avoid landmines and value traps. ‘We have to meet management teams before we invest in the shares.’

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STUDYING THE NUMBERS

Godber says their skillset is picking apart balance sheets and cash flow statements. The Polar pair has a model database of 457 stocks, with the FTSE 350 fully modelled (excluding investment trusts) and the FTSE Small Cap and AIM indices fully modelled (excluding companies that fail their safety check or liquidity hurdle rate). Tellingly, the fund’s focus on margin of safety leads to some resilience in down markets.

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Presently passing muster with the duo in the Polar Capital fund are the likes of infrastructure engineer Hill & Smith (HILS), brick manufacturer Forterra (FORT), housebuilder Bellway (BWY), textile rental specialist Johnson Service (JSG:AIM) and package holidays operator On The Beach (OTB). The latter is described by Godber as a classic disruptor which has been ‘a fantastic friend to the fund’.

Hamilton and Godber view expensive shares as risky shares, echoing the words of Howard Marks: ‘High quality assets can be risky and low quality assets can be safe. It’s just a matter of the price paid for them.’

They’ll sell stocks which have hit their target price, where their conviction has changed, or where a change in funding gives them the jitters.

In terms of the outlook, Godber says the UK market is made up of two parts: international and domestic earners.

Domestic earners are at an approximate 30% discount in valuation to the majority of overseas earners. ‘This gives us a fantastic hunting ground for shares with cheap valuations but which have resilient outlooks and high profit visibility.’

For international earners, ‘the challenge is to find cheap valuations and we are finding these lower down the market capitalisation scale in the FTSE 250 and small cap indices’.

WEARING OUT THE SHOES

Another manager who goes above and beyond the call of duty with his due diligence is Philip Harris, who alongside Ketan Patel, steers the EdenTree UK Equity Growth Fund.

The fund has returned a cumulative 78.1% over the past five years, comfortably ahead of the 50.2% generated by the IA UK All Companies sector. It has beaten the FTSE All-Share benchmark in every year apart from two since 2011, according to Morningstar.

Harris wears out the shoe leather, roaming the UK in order to analyse the operational and financial risks facing the many businesses that he meets.

‘A key part of the investment process is not only to visit companies but to do my own forecasts as well. I want to understand the companies’ financials and most importantly that the forecasts from brokers are either well underpinned or will be beaten giving a positive earnings surprise. We do this for our mid and small cap holdings.’

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He continues: ‘We look at the growth, but also the risk of an investment. Concentrating on the risk piece is what I spend a lot of time on and I spend lots of time on the road all around the country,’ says Harris. He likes management to have ‘reasonable skin in the game’, namely a personal investment in their employer’s shares.

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LOOKING FOR WARNING SIGNS

Red flags for Harris range from profits not converting into cash, overly optimistic revenue forecasts and management guidance towards dreaded second half weightings, often a precursor to a profit warning.

Ninety nine percent of the time, Harris will sell on a company’s first profit warning, since earnings alerts typically come in threes.

There are three silos of growth stocks in the fund. The ‘dependables’ are typically growing earnings at 15% and can do it relatively consistently, compounding their earnings growth over a number of years, says the fund manager.

Harris also holds select ‘super-growth companies’ as well as ‘incubators’, sub-£100m caps ‘which are probably not covered by many analysts and where the management needs some handholding and advice’.

Portfolio star turns include automation software outfit Blue Prism (PRSM:AIM), a British tech champion that joined AIM in March 2016 at 78p, since bid up to an astonishing £13.78.

Blue Prism provides software to take on complex but highly predictable tasks, says Harris. ‘The rate of growth has been phenomenal but forecasts look conservative. Globally, there is
an enormous opportunity and this is world beating software.’

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RECENT PORTFOLIO ACTIVITY

Harris has taken some profit on posh tonic water specialist Fevertree Drinks (FEVR:AIM), a ‘wonderful classic growth company’ which recently overtook Schweppes to become the number one mixer brand by value in UK shops and supermarkets.

EdenTree UK Equity Growth participated in the IPO (initial public offering) of video games developer Sumo (SUMO:AIM) and has started a new position in veterinary services consolidator CVS (CVSG:AIM).

One of the ‘incubator’ picks particularly exciting to Harris is Applied Graphene Materials (AGM:AIM), a Redcar-based supplier of graphene-based products.

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‘Graphene is a wonder material that has been talked about for some time,’ says Harris, who believes Applied Graphene is very close to signing big deals with aerospace and paint manufacturers. ‘The material can be produced consistently and I suspect Applied Graphene will be taken over at some point.’

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