This September, investors in the Eaglet investment trust will have the chance to vote on one of the most radical shake ups in the 140-year history of investment trusts. With shareholders’ approval, out will go the trust’s current focus on undervalued small companies, and in will come a new strategy based on following company directors’ dealings. But is this an exciting move that will definitively prove or disprove the theory that it’s worth following company directors when buying and selling shares, or is it just the reckless destruction of what was once a market leading investment trust?
Knox D’Arcy, the activist investment management company that took over Eaglet from founder Peter Webb, has been planning the directors’ dealing strategy for three years. The preparation has been meticulous and relatively expensive, costing £1m. Knox D’Arcy compiled a database of 14 years’ worth of information on directors’ trading, containing 182,000 trades. It then delivered this mound of information, together with some expensive computers, to professors at the University of Bristol and the University of Exeter. Eighteen months later, the professors returned with a series of findings revealing how investors could profit from directors’ dealing although, according to Richard Steele of Knox D’Arcy, the findings merely proved what they suspected already.
So armed with these findings, which suggested that strategies based on directors’ dealings could outperform a benchmark index by up to 13 per cent per year, Mr Steele set about finding an investment vehicle. Initially he considered setting up a new investment trust and, with hindsight, he says that such a route would have been simpler and quicker than what eventually transpired.
The route that he chose involved wresting control of the underperforming Eaglet investment trust from Mr Webb and transforming it into a different beast entirely. Mr Steele is no stranger to controversial changes of management at investment trusts. In 2002, he resigned as manager of what was then called the Knox D’Arcy Trust after shareholders backed an alternative management team. The Trust was taken over by Platinum Fund Managers but was wound up last year after the High Court ruled that it was liable to pay a performance-based termination fee to Knox D’Arcy for five years after Knox ceased managing it.
Mr Steele has been in charge of Eaglet for four months, and he’s been slowly liquidating its positions and turning them into cash – at the moment half of the fund’s holdings are in cash. It’s not been an easy task – given the perception that Eaglet is a forced seller of smaller company shares, Mr Steele says that he has had to fight tooth and nail to get a fair price, and will continue to do so.
The next stage is to win shareholder approval for the change of strategy and then to start turning all of the theory into practice. The fund will take a rules-based approach to investment, with no judgement at all from the management team (which will comprise Tom Howard and Nick Shah, but not Mr Steele). Essentially, if the computer says “buy” then the trust will buy, regardless of whether or the managers believe the company to be poorly run.
Exactly what the trust will buy is less clear. The research divided directors’ buying according to certain characteristics, such as the timing of the trade, the motivation for the trade and the size of the trade. It then devised and tested strategies based on combinations of these characteristics. According to Mr Steele, it is the combinations that are key to the strategies’ success. However he is unwilling to disclose exactly what the strategies are, arguing that, by doing so, he would allow anyone to follow the strategies that he has spent so long researching.
Once the shares have been bought, they will be held for a pre-set period of time, such as 140-180 days, before being sold. The period differs depending on the strategy used. Trades that lose ground in the early stages will be monitored carefully with a view to a quick sale. The trust will only follow directors’ buying, and will not go short of shares that directors’ are selling.
The trust will hold 60 to 80 shares at any one time, and will have a bias towards small cap stocks. However it won’t invest in anything on Aim, and it won’t invest in companies that have a market capitalisation of less than £25m.
Initially, the fund will be worth around £50m but Mr Steele is planning to raise more money via a share issue following the launch. It will also be able to borrow to finance new investments, although Mr Steele insists that any borrowing will be a short term measure for a specific purpose rather than a long term strategy of gearing up the portfolio. There will be a maximum of 30 per cent gearing or, on the other side, 30 per cent in cash. There will also be a discount management strategy in place to prevent the trust’s share price from varying too much from the value of the underlying assets.
Mr Steele is bullish about the prospects for the trust. “We don’t know that it will work,” he says, “but the data tells us that it will.” The statistics are certainly impressive. Back testing of the intended combination of strategies shows that the fund would have outperformed the FTSE Small Cap index in seven out of the last eight years with an average annual outperformance of 14.3 per cent.
Whether it can deliver similar performance in the real world remains to be seen. Certainly Knox D’Arcy has an interest in it doing so. Together with its allies, it controls 39 per cent of the trust’s shares, and there’s also the small matter of a management fee (“between 1 per cent and 1.5 per cent depending on who wins that argument”) and a performance fee which could be up to 20 per cent, and which would be payable in warrants in the trust.
Knox D’Arcy is claiming plenty of private investor support for the strategy. Mr Steele says that, while a quarter of the trust’s private investors want out, the remainder are planning to stay in if the conversion goes ahead.
