A little-known global equity fund called Nutshell Growth (BLP46Q1) last year gave Fundsmith Equity Fund (B41YBW7), one the most popular investments among UK retail investors, a good run for its money in terms of performance.

Between 1 January and 15 December 2021, Nutshell returned 27.9% versus 20.1% from Fundsmith, according to FE Fundinfo data. It also beat another widely held global fund, Blue Whale Growth Fund (BD6PG78) which returned 18.4% over the same timeframe, and Lindsell Train Global Equity (B644PG0) which essentially made no money at all for investors in the period.

Unfortunately, in the past month or so global equity funds have faced a major headwind in the form of inflation and expectations for rising interest rates, which has caused damage to investors’ portfolios. All the funds named above have suffered from falling asset values.

IMPACT OF RISING RATES

Many global equity funds hold stocks that trade on premium ratings because of the potential for these companies to deliver large profit growth in the future.

Higher interest rates mean analysts and investors deploy an increased discount rate in their models to calculate the net present value of future cash flows from long-term growth stocks. A higher discount rate means lower net present value, and that in turn means a lower theoretical value of the equity and therefore a lower share price.

Blue Whale, for example, has various stocks in its portfolio which trade on price to earnings multiples of around 50 times including laboratory equipment supplier Sartorius whose share price has fallen by 16% in the past month. The fund itself has declined by 10% in value since mid-December.

What’s interesting is how Nutshell and Fundsmith have also fallen by roughly 8% to 10% over the same time period despite both saying they would never pay a top price to own a stock. Fundsmith’s motto even includes the line ‘don’t overpay’.

PE COMPARISONS

Fundsmith’s key holdings include PayPal which trades on 33 times forecast earnings for 2022 – while less than some of the ratings seen inside the Blue Whale Portfolio, it is still quite a high level compared to the sub-10 price to earnings ratios to be found among the value stocks that are enjoying a renaissance.

Fund manager Terry Smith would probably argue that PayPal is a better-quality business than the oil, financial and tobacco stocks in the value category and which are among the top share price performers year to date.

However, the market seems to be selling down higher rated stocks indiscriminately, so anything remotely tech-related is getting hurt, whether it makes profits today or not for years to come. This might explain why Fundsmith and Nutshell have fallen in value along with their peer group.

‘BETTER VALUE’

Nutshell’s chief executive and chief investment officer Mark Ellis told Shares in November 2021 that Nutshell Growth Fund’s portfolio was better value than its global equity fund peer group.

‘The path to zero rates made some earnings yields look attractive and price to earnings multiples have exploded for some companies,’ he says. The direction for interest rates is now upwards and so the market is looking differently at a lot of stocks that were once considered invincible.

‘Some of our peers are holding stocks on a PE multiple of 70, 80, 90, over 100 when historically these companies have been on more like 25 to 30-times,’ comments Ellis. ‘We bake that mean reversion of PE over the next 10 years into our numbers for the expected rate of return. We have a better edge on finding quality and not overpaying for it.’

Despite these comments, Shares notes that Nutshell’s portfolio includes such names as Veeva Systems which trades on a high PE multiple of 54.7 times forward earnings. In its defence, the portfolio also features Regeneron Pharmaceuticals which trades on a mere 12.8 times earnings, and biotechnology group Amgen which is on 13-times.

TRADING IN AND OUT

Launched in May 2020, Nutshell Growth Fund is run differently to many other global funds as there is a lot of buying and selling going on. It certainly doesn’t fall under the category of ‘buy and hold’ which one might associate with the likes of Fundsmith whose motto also includes the phrase ‘do nothing’ – the opposite of Nutshell.

Ellis says he recalibrates the portfolio twice a month based on various factors including valuation and momentum which are used to produce scores on stocks. ‘All traditional managers buy and hold. They aren’t catching the extra juice that comes with a really disciplined rebalancing technique like ours,’ he adds.

‘One of the dilemmas for a lot of our peers is that they do a lot of work finding the rare exceptional company they really like, then they buy and hold forever. They don’t know when to sell. We have this automatic valuation element to our portfolio construction that just trims around the edges.’

For example, in 2021 Nutshell had a position in the US listed version of Domino’s Pizza when billionaire investor Bill Ackman took a stake through his Pershing Square vehicle and the share price jumped.

‘As Domino’s rallied, the free cash flow yield dropped, the PE ratio increased, a lot of the valuation metrics we look at changed and the score for those factors dropped, therefore the score of the stock dropped.

‘We trimmed it on valuation factors becoming richer. When the froth came out of the stock, and it reported stronger earnings, we added back to that position.’

Despite this constant tinkering at the edges, Ellis argues that Nutshell’s cost of trading in and out of stocks is low.

CAPITAL PRESERVATION ANGLE

Many investors might be asking if Fundsmith’s recent valuation decline has gone too far. The same question could also be posed for Nutshell, particularly as it pursues an element of capital preservation in its portfolio.

As well as looking at growth prospects and valuation, the fund’s research also looks at how a stock has performed historically on bad days in the market and during recessionary periods. ‘We want stocks which participate less on down days and participate more on up days,’ says Ellis.

Nutshell is unproven in the eyes of most investors, given it has been running for less than three years, and the current sell-off has certainly derailed its momentum. Nevertheless, this tougher backdrop is a good test for its investment process. A successful recovery could help convince more people that its fund is worth backing.

DISCLAIMER: The author (Daniel Coatsworth) has a personal investment in Fundsmith Equity Fund

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