I’m often quite dismissive of active fund managers. Most fail to beat their benchmarks and overcharge for doing so. But I do believe that ballsy managers who are willing to take risks can outperform by using very focused stock-picking strategies. These “properly” active managers don’t run closet trackers, stuffed with a huge range of stocks. Instead, they pick a few stocks carefully, and sit tight.
Such managers are rare – but the good news is that there are a disproportionate number of them within the investment trust world. Two funds in particular have caught my interest of late. Both have very focused mandates, good track records and both have recently raised a decent amount of capital.
Why small firms should outperform
The first is River & Mercantile UK Micro Cap (LSE: RMMC). RMMC raised around £50m on listing last December, and has just raised an extra £19.5m via a share issue. At 119p a share, the market cap is £80m. One virtue of the fund is that manager Philip Rodrigs plans to cap its size at £100m. There just aren’t enough opportunities among the really small companies he targets to run a fund in the hundreds of millions of pounds.
This is the big draw here – the fact that really small stocks might beat their bigger siblings over the next decade, assuming you can sort the quality from the dross. Firstly, as Elroy Dimson and Paul Marsh of London Business School point out, small caps outperform over the long run, and really small caps – micro caps – do even better. Of course, the failure rate is high, volatility is huge, and trading costs are substantial. So to reap the extra returns, investors need to be very patient and to avoid the inevitable blow-ups.
However, there’s an added long-term reason to buy small caps that fund manager Gervais Williams covers in his Slow Finance books – as we enter an era of slower-than-average growth, smaller businesses could be the main beneficiaries. Many large caps are now too expensive and are growing too slowly. Smaller, more agile firms, especially micro caps, are better suited to benefit from such an environment (not least because they will end up being acquisition targets). These arguments make sense to me – but you need to be realistic about the risks. Don’t put a huge chunk of your money into small and micro caps – maybe 20% might make sense.
The fund invests in UK micro caps, typically with a free float market capitalisation of below £100m. As of the end of September this year, it held 39 stocks, with the top ten representing 35.8% of its value. It holds a lot of tech stocks (just over 25% of the portfolio) and has little exposure to consumer goods (less than 1%). The largest holdings include specialist IT group Ideagen, vehicle tracking group Trakm8, and engineering consultant WYG.
In its first year, the net asset value (NAV) rose 18% against 9.7% for the Numis Smaller Companies Plus Aim (excluding investment trusts) index, although this outperformance has all come in recent months – the NAV is up 9.6% since the start of September, compared to a rise of just 0.3% for the benchmark, much of which has come via two takeovers of stocks held within the portfolio.
The charging structure is another thing to like about this trust – it has an annual management fee of just 0.75%, plus a performance fee equal to 15% of its NAV outperformance of the benchmark.
A quiet activist with a tight focus
The second fund to watch is Crystal Amber (LSE: CRS), managed by Richard Bernstein. Bernstein has a long track record, much of it in funds that have focused on growth stocks and especially tech businesses. Crystal Amber is a conviction-led stockpicking fund, like River & Mercantile, but with two key differences. Firstly, Bernstein invests in slightly bigger companies. Secondly, he is more of an activist – though it’s more about gentle persuasion than “barbarians at the gate”-style activism. It’s what some call a “public market, private equity” strategy and has a long track record of working – Strategic Equity, another specialist fund, has a similar approach.
As a result, Crystal Amber focuses on a small number of businesses where real value can be added. As of 30 June, it held 23 positions, with the top ten accounting for 72.5% of NAV. There has also been a shift towards companies with larger market caps, which was the driving force behind the company raising £32.3m via a placing in January. Bernstein’s aim is to find quality businesses, reasonably priced, where he can make an absolute return in all markets. The fund has done well over the past three years, with NAV total returns of 15.4% a year, despite the fund often running a sizeable net cash position (which can drag on performance).
The total NAV return for the year to 30 June 2015 was 5.0%, including a 0.5p dividend. Since then, the NAV is up a further 1.0%. Profits have been lifted by holdings in several companies that have been the subject of takeovers, such as Aer Lingus and Thorntons. In this, Crystal Amber shares a key theme with River & Mercantile – we’re mid-way through a frenzy of mergers and acquisitions, with quality smaller businesses being snapped up by larger firms keen to tap new sources of growth.
As for the future, I like some of the fund’s big bets, in particular its largest position, Grainger, one of the UK’s biggest private residential landlords. Other key holdings include Balfour Beatty (Crystal Amber’s manager reckons its private-public-partnership infrastructure assets “virtually match the value of the firm after netting off debt and pension deficits”) and Pinewood, a film studio operator that’s midway through a big expansion phase. The trust’s shares currently trade on a discount of 6.5%.