High-conviction investment trusts can be a risky but rewarding ride

Trusts with high-conviction portfolios of a handful of stocks, such as Nick Train’s Finsbury trust, may be highly rewarding but can also be a bumpy ride.

Investors are often told that they shouldn’t put all their eggs in one basket. However, there is an alternative option: put all the eggs in the same basket but pick the eggs with care and guard that basket really, really closely.

The investment trust structure allows fund managers to take punchier positions in their portfolios. Open-ended funds do not allow their managers to hold more than 10% of the trust’s assets in any one company. There are also rules on how much of an individual company they can own. Investment trusts aren’t subject to the same restrictions.

Many high-profile trust managers use this ability to take high conviction positions to good effect. Nick Train, manager of the Finsbury Growth & Income trust (FGT), for example, holds almost half of his portfolio in just five companies – The London Stock Exchange, Relx, Diageo, Unilever and Burberry. His long-term Warren Buffett-style strategy is to buy meaningful stakes in great companies and hold them for a long time. It has proved a successful approach for Train’s many grateful shareholders.

Private-equity style

Some trusts take this one step further, using a more private equity-style approach. Strategic Equity Capital(SEC), for example, takes large stakes in smaller companies and then engages with the company to improve shareholder value. Stuart Widdowson, previously the manager of the Strategic Equity Capital trust, has now set up Odyssean (OIT), which is run along similar lines.

The latter cohort of trusts take a company where there is unrealised value. They may have good intellectual property but have been through value-destroying merger and acquisition activity or have had management problems. Either way, the managers of the trust aim to help companies back on their feet and realise value for themselves at the same time.

However, recent problems for some of the higher profile proponents of this concentrated approach have brought it into question. Train ran into problems with his holding in Hargreaves Lansdown, which was caught up in the Neil Woodford scandal in 2019. Alexander Darwall, who left Jupiter last year to set up his own fund management group, apologised to shareholders of European Opportunities (JEO) this year for his 17% stake in Wirecard. The German payments group was caught up in an accounting controversy (it denies any impropriety), which saw its share price slide. Darwall continues to back the company but admitted that his stake had been too big.

Thomas McMahon, senior investment trust analyst at research house Kepler Partners, says: “The nature of concentrated investing is that often the best examples of ‘failure’ are short-term periods in the careers of those who have been highly successful over the long run... Both [Train and Darwall] are clearly highly talented investors with well-thought-out rationales for holding on to their current portfolios over the long run.”

This illustrates the two sides of holding concentrated positions. On the one hand, it is active managers being genuinely active, taking calculated risks and differentiating themselves from passive investments. Thomas Becket, chief investment officer at wealth manager Punter Southall, says: “Managers should back their ideas with conviction, otherwise why not simply buy passive? My ideal fund is to have a good manager with a portfolio of 25-30 holdings.”

Practical advantages

Equally, there are practical advantages in nurturing a smaller basket of holdings. McMahon believes there can be a real advantage in focusing on fewer companies, rather than spreading research effort thinly over more holdings: “It might be possible to know 20 or 25 businesses really well, but is it possible to know more than 30? Of course, many managers rely on analysts and deputy managers to cover the ground, but all this creates friction and chances for insights to be lost, watered down or ignored and perhaps for small positions to be retained even when conviction has dropped.”

McMahon believes it may also incentivise fund managers to get their calls right. They are taking a greater risk on each holding and should therefore work harder to ensure it doesn’t go wrong on them.

Simon Elliott, head of the research team at stockbroker Winterflood, says that it also allows a strong performer to drive performance. Fund managers can ‘run their winners’, which may be more important for overall performance than avoiding weaker companies. Elliott says: “All too often, behavioural finance studies tell us that investors are conditioned to take profits on their winners, while holding on to losers, reflecting a reluctance to realise their losses on the basis that things may improve. This is of course the opposite of what a successful investor should do.”

However, the downside is that if any company does badly it is more likely to lead to underperformance. As such, it is important that investors have faith in the trust manager. There are also liquidity considerations – it could become hard or impossible to sell at a reasonable price if the company runs into trouble. This may be a particular problem for trusts invested in smaller companies or trusts with significant assets under management.

Another consideration is whether the fund ends up being a major shareholder in an individual company. For some, such as the Odyssean trust, this is deliberate. Widdowson wants a big stake so the team can engage with the company and realise value. However, large stakes come with some responsibility. Investors may end up involved with the day-to-day management of the company. McMahon says that this is fine where it is a deliberate strategy, but not where it happens accidentally.

The Strategic Equity Capital/Odyssean approach brings an additional layer of risk. They are essentially relying on their skill to revive a company that is in difficulties. When it works, it can be very profitable, but not all small companies can be saved and even the best-laid rescue plan can be derailed by ‘leftfield’ elements such as a coronavirus or recession. Smaller companies may also feel any liquidity problems more acutely.

Equally, says Becket, a concentrated approach can be inappropriate for certain strategies. For example, in ‘deep value’ strategies, where there is a danger of companies going bust, it is better to have broader diversification.

If a trust does have larger positions, they need to be tougher on risk management. This can take two forms, says McMahon. One is to aim to balance factor risks across the portfolio. This should limit the extent to which style, sector, size or geographical factors, rather than simple stock-picking, drive returns and can limit the greater volatility in a more concentrated approach. Whether the manager has picked the right stocks will then dominate relative returns.

A second approach is for the fund manager to buy the stocks they rate most highly and let the chips fall where they may. This is the way that Fundsmith Equity’s Terry Smith and Nick Train both invest, for example. It means that some stylistic or sector exposures can build up which could lead to a period of underperformance.

Train’s style leads him firmly to ‘quality growth’ companies, an approach that has been perfectly suited to the post-financial crisis environment, but he admits that it will not work in all conditions. McMahon adds: “There is no right answer, although one could argue that the second approach is likely to be a purer form of stock-picking with less likelihood that lower conviction ideas make it into the portfolio.”

Elliott says that a concentrated portfolio can be a good tool in the right hands: “It is important for investors in trusts to understand the manager’s approach and their attitude to risks. ”

How selected focused trusts have fared

Note: as at 9 April 2020. Data source: FE Analytics

Flying below the radar

The under-the-radar £194 million Manchester & London (MNL) investment trust prides itself on having beaten its more famous but ‘over-bought’ (its words) investment trust competitors – Scottish Mortgage, Polar Capital Technology and Lindsell Train, as well as the open-ended Fundsmith Equity fund. Up 72.9% in three years, its top 10 holdings are a romp through the great-and-good of global technology – Facebook, Amazon, Alphabet, Microsoft, Tencent, Salesforce.com – and it has chunky holdings in each. It also takes significant positions in futures and options.

The trust is focused on three main growth themes: software as a service, the public cloud and e-commerce. Manager Mark Sheppard believes these trends can endure far longer than investors think possible. Despite being top quartile over all time periods in the AIC Global sector, and weathering the March sell-off very well, the trust is still on a discount of 6.5%.