Does a fund with more than 25% of its holdings in cash tell you the managers are fearful? In the case of JO Hambro Capital Management UK Opportunities Fund (B95HP81) it is a mixture of the managers believing the market is over-valued and to also have the capacity to pounce on any sudden opportunities.

Many investors may come to the conclusion that such a large cash position would be a drag on performance. It’s certainly true that this fund has lagged the rising market from time to time, such as underperforming its FTSE All-Share benchmark on a three and five-year basis.

However, the managers Rachel Reutter and Michael Ulrich have a laser-like focus on quality and their decisions could really shine when the market takes a turn for the worse.

Funds which have chased high-growth stocks on rich valuations are likely to plummet in a market downturn as stocks de-rate. In JOHCM UK Opportunities’ case, its strategy of never overpaying for a stock would suggest it could thrive when the market rotates from a growth to value focus.

SHOPPING TIME

When the UK market slumped in the fourth quarter of last year, the managers were ‘ready to go Christmas shopping’.

They added several new holdings to the fund including recruitment firm Hays (HAS), specialty chemicals producer Johnson Matthey (JMAT), and supermarket group Tesco (TSCO). More recently they invested in retailer Next (NXT). The fund is still left with 25.6% of its holdings in cash, as of 31 May this year.

Unless a business, and the management of the business, pass the fund managers’ strict    quality criteria, there is no chance of it joining the 28 other stocks in the portfolio.

Even if it does meet the quality criteria, unless it offers both an attractive free cash flow yield and above-average liquidity in its shares it still won’t make the grade.

RULE #1: DON’T LOSE MONEY

It is this single-mindedness which has seen the fund achieve 8.3% annualised gains since it was launched in late 2005, with much lower drawdowns than the market in 2008, 2011, 2015 and again late last year.

The managers’ guiding principles are to preserve capital and to remain disciplined in pursuing growth at a reasonable price. This approach has led to a concentrated list of holdings with a large-cap bias and a greater than average liquidity, which should be a comfort to investors given the potential issues with holding less liquid assets.

The managers are also careful to avoid political risk and to shun companies which take on too much debt. When British American Tobacco (BATS) paid up to acquire US rival Reynolds in January 2017, and geared itself up in the process, the managers didn’t hesitate to liquidate it.

‘The decision to sell was simple,’ says Reutter. ‘The company over-paid and over-geared itself, so we sold it to zero’.

That decision saved the fund from suffering a 45% loss on British American Tobacco shares in the subsequent 12 months following the Reynolds deal but it also took cash levels above the 20% cut-off for the Investment Association’s UK All-Companies sector meaning that the fund had to move into the Specialist sector.

LONG TERM THEMES

The managers typically have a 10-year investment horizon when they buy a stock. As well as fitting the quality and liquidity criteria they look for long-term drivers behind the businesses.

The right qualities

The team aims to hold a mix of companies which are well-diversified both geographically and in terms of their businesses.

Companies should be self-funding, i.e. debt-free, with reliable revenue growth driven in part by long-term themes and in part by barriers to entry into their business which limits new entrants and keeps margins healthy. These companies typically generate high free cash flows which can then be reinvested in the business.

For example Hays is a play on the long-term trend towards rising wages in major economies as the global pool of labour shrinks due to demographics. Crucially, for a business which is still cyclical in the short term, Hays has no debt.

And as for Johnson Matthey in the portfolio it has accelerated investment in cathode technology in order to benefit from the long-term trend towards pollution control and electric vehicles.

STRICT SELL DISCIPLINE

As the market rallied sharply in the first quarter of this year the managers took the opportunity to sell out of Howden Joinery (HWDN), Land Securities (LAND) and National Grid (NG.) completely.

After a 25% rise in its share price, Howden no longer looked good value and the team’s sell discipline kicked in. Several other stocks were reduced, including Compass (CPG), Diageo (DGE) and GlaxoSmithKline (GSK) after their share prices outperformed on what the team deemed to be positive sentiment rather than fundamental factors.

The decision to sell National Grid was due to two factors: a shift in the political environment, with direct threats from the Labour party of nationalisation, and tougher regulation by the current Government.

Like banks, which the fund avoids due to their cyclicality and indebtedness, utilities are now avoided in the portfolio due to political risk despite their obvious ability to generate lots of cash.

SHARES SAYS: We really admire the fund’s investment process and strict discipline for buying and selling. This would be a great addition to a diversified portfolio. Buy now.

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