Have you ever wondered how a fund manager picks a stock? Some investment trusts and funds run screens on equity valuations, income statements and balance sheets. Others may place greater emphasis on meeting management and deciding whether they like the story or not.

Occasionally you find an asset manager which sticks out from the crowd such as GVQ Investment Management which runs small cap-focused investment trust Strategic Equity Capital (SEC). Its process isn’t unique but it is certainly unusual when looking at the broader investment trust universe.

Strategic Equity Capital’s objective is to apply private equity investment techniques in public markets. Admittedly asset managers Downing and Gresham House do something similar although the former tends to focus on turnaround situations which are of no interest to Strategic Equity Capital.

HOW IS IT DIFFERENT?

Helping Strategy Equity Capital to stand apart from the crowd is an advisory panel which features experts including the former boss of Rentokil (RTO); the ex-finance director of industrial groups Weir (WEIR) and Meggitt (MGGT); the former numbers man at media giant Daily Mail & General Trust (DMGT); and a couple of specialists from the private equity industry.

Jeff Harris, fund manager at Strategic Equity Capital, says his team present the panel with two ideas each month. ‘We want them to discuss whether these are good companies rather than whether we should invest. Is the business strategy good? Do they know anyone in the business? We want to tap into our advisers’ network.’

Harris says the panel members are all retired and view their participation like a book club. ‘It keeps them engaged with the world of business.’ Some of them also attend site visits when Harris and his team are meeting companies so they can help comment on whether a company has the right equipment or is running an efficient operation, among other aspects.

The fund manager says other parts of the due diligence process include speaking to customers, suppliers and competitors. In addition, it draws upon a network of private equity practitioners and external consultants where necessary.

A recent example of an investment aided by the investment trust’s advisory panel is pharmaceutical services group Ergomed (ERGO:AIM). Strategic Equity Capital has a good network in the healthcare sector including panel member Lindsay Dibden who owns a female healthcare clinic in Guildford and was a founder partner at private equity group HgCapital.

The investment trust has been a long term shareholder in Clinigen (CLIN:AIM) and its former CEO Peter George is now Ergomed’s chairman. ‘The company conducts clinical trials for potential share of any upside in a treatment. It also carries out ongoing regulatory reporting for drug companies. The new strategy is to stop the former and concentrate on the latter. Pharma companies are increasingly outsourcing work which is good for Ergomed.’

In addition to working with panel members and third parties, Strategic Equity Capital also sometimes confers with fellow shareholders in certain stocks. Rather than act like a traditional activist investor and shout about problems which need fixing, this investment trust talks to other investors if one of its holdings is faced with challenges. The fund manager looks to put through changes in a consensual way and in private.

For example, last year Harris engaged with publisher Wilmington (WIL). ‘The chairman had been on the board for 13 years and we met to discuss succession planning. We felt there weren’t enough people challenging the management to react to changing times in media and the company also wasn’t good at investor relations.

‘A new chairman is now in place, ex-Daily Mail & General Trust, and whom is more up to date with the media landscape.’

ALL ABOUT THE CASH FLOW

Another part of its stock picking process involves more traditional financial analysis. The investment trust places a large emphasis on cash flows; looking to see what a company has to spend to stay competitive (also known as maintenance capex).

Last year it made an investment in Alliance Pharma (APH:AIM) when it was unloved by the market after taking on a lot of debt to finance an acquisition.

‘Many investors do not screen for stocks trading above a certain level of net debt to EBITDA and so they ignored Alliance Pharma. Through detailed cash flow analysis, we saw the opportunity for Alliance Pharma to de-gear the balance sheet. The transfer of value from debt to equity has subsequently resulted in a share price re-rating.’

Cash flow analysis also played a key role in the decision to sell a stake in Goals Soccer Centres (GOAL:AIM) last September. Not only had Harris spotted a worsening consumer environment last summer which could lead to reduced demand for the company’s five-a-side football sites, but he also thought that Goals may encounter some financial pressures as a result of changing its business model due to increased competition.

The decision by local authorities to convert some of their land into five-a-side courts prompted Goals’ management to try and go upmarket. Harris was concerned this would result in higher renovation costs and that maintenance capex would also eat away at its cash flow over the years.

VALUATION BENCHMARCK

Strategic Equity Capital places a high importance on real world multiples when it is seeking potential investments. For example, it looks at other relevant transactions in the same space as a particular company. This helps to provide a benchmark by which to consider selling a holding should its valuation approached this real world multiple.

That’s exactly what’s happened with share registrar Equiniti (EQN) which is one of the investment trust’s biggest holdings; albeit Harris has recently been taking some profit as its shares have re-rated as the business has grown in size (remember this is a small cap fund).

HOW HAS IT PERFORMED?

Strategic Equity Capital hopes to achieve annualised total returns of 15% over a three to five year holding period for stocks.

Shares in the investment trust are down 7.5% in value year-to-date thanks to a few setbacks with two holdings.

However the long-term track record is very good with the shares having more than doubled over the past five years – its share price has appreciated by 110% versus 21% from the FTSE All-Share index.

The downside of having a concentrated portfolio (currently 19 stocks) is that it only takes a few pieces of bad news to dent the overall performance.

One of the stocks which contributed to recent negative performance is EMIS (EMIS:AIM). ‘It did well last year but a new CEO identified some service level issues which triggered a share price decline. It is related to isolated legacy issues and the share price is now recovering,’ says Harris. ‘There is ongoing consolidation in this market at premium valuations to EMIS’s current multiple (14x vs.10x EBITDA).’

Another holding, Medica (MGP) grew very strongly at 18% organically last year but the market was expecting 22%, which led to a fall in its share price. There was a slowdown in the fourth quarter due to NHS capacity issues during the winter crisis. However, the fund manager notes the long term structural drivers are strong and Medica is the market leader.

He adds that it continues to offer double digit earnings growth and is trading on a PEG ratio of less than 1-times which implies it is cheap. ‘Its cash flow yield is very strong and it has no debt. Our position was reduced last year as it re-rated but this year we’ve been buying back on weakness.’

BENEFITS OF A CONSISTENT PROCESS

The investment trust’s manager GVQ has used the same investment process since it was founded in 2002. It believes it is possible to generate superior returns for investors over the medium term by focusing on four drivers which it believes to create equity value, namely: growth, value, de-gearing and the potential for corporate activity.

It is confident this approach leads to more consistent returns over time, as opposed to an investment mandate that is focused on one or two drivers such as growth or value.

‘There are times in investing when you have to stick to your guns,’ concludes Harris. ‘People like a defined process and our process doesn’t change.’ (DC)

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