Liontrust Special Situations: holding up in the downturn

Liontrust Special Situations fund (GB00BG0J2688) is run according to an investment approach its managers call the Economic Advantage Process. This was originally designed by the fund's co-manager, Anthony Cross, in the late 1990s and has been applied since its launch in 2005. The process has since been refined, including after Julian Fosh joined as the fund's co-manager in 2008.

A key feature of the process is identifying companies that have what Mr Cross and Mr Fosh describe as a durable competitive advantage.  

“Certain intangible assets give companies a barrier to competition, pricing power and the ability to compound earnings,” explains Mr Cross. “Any company coming into our fund must demonstrate that it has either intellectual property, a distribution network or high contracted recurring income of at least 70 per cent of turnover. That’s where you get your sustainable durability from. Any company we own must have at least one of these [attributes], and many have two or three. For example, holdings such as engineering companies are intellectual property-based but also have distribution networks. The companies must also be profitable.”

Intellectual property can include patents or copyrights.

Companies with this “often get their competitive advantage by having spent a lot on research and development, built a product or service that is protected by patents, or having a deep know-how that is difficult to replicate,” explains Mr Cross. "[Seeking this type of] intellectual property takes you into areas like specialist engineering or healthcare companies, software businesses and media companies where the intellectual property forms a critical part of their barrier to competition.”

Examples of such holdings are Spirax-Sarco Engineering (SPX), which has a specialism in commercial steam systems, and Renishaw (RSW).

“Renishaw makes very precise measurement probes that are used in industrial manufacturing,” says Mr Cross. “The measurements and tolerances that are needed in the production of those sorts of products need to be very accurate and that’s what Renishaw’s key skills are in. It’s done the odd tiny acquisition but really it’s an organic growth story focused on the importance of intellectual property. They’ve put a lot of effort into research and development to bring out further improved products over the years. They have lots of patents on their products so that it’s difficult for competitors to replicate them. They’ve generated lots of free cash so have been able to slowly but surely build their distribution network, and opened up in new territories. Renishaw has also benefited from the desire, particularly from emerging markets and countries that have built up manufacturing capability, to become much better in terms of quality. So, for example, its products are bought by Chinese customers. Within its areas of expertise, Renishaw has built up a very strong brand and deep customer relationships.”

Mr Cross and his colleagues also like companies with big global distribution networks such as drinks company Diageo (DGE) and consumer goods company Unilever (ULVR).

“[These are] businesses that have been growing over many years,” he says. “They have put a lot of investment in building infrastructure, local marketing, brand support, and deep relationships with suppliers and customers in local territories, so these big global networks are a very powerful barrier to competition. You might get small start-ups but more often than not it’s the big companies that buy those businesses and push them through their global networks to really increase the sales. You see Diageo play that trick again and again.”

They also favour companies with modern, data-driven networks. “Their barrier to competition and durability is that they are embedded within their own customers,” says Mr Cross. “These are data providers or data-rich businesses, maybe software or market research companies. Their data is critical to the way the end customer goes about aspects of their business. So once they’re embedded within the [customer], it's very difficult for competitors to come along and push them out. And they’ve often gone into longer-term or price-protected contracts which also form a barrier to competition.”

Holdings in these areas include EMIS (EMIS), which provides healthcare software to the likes of UK GPs and has high recurring income. Craneware (CRW) provides healthcare software to US companies and particularly meets Mr Cross’s and Mr Fosh’s criteria in terms of having intellectual property, distribution and recurring income.

Mr Cross and his colleagues favour companies with a high recurring income from long-term contracts because they think that it puts them in a better position to invest for the long term. Such companies have more clarity about their profits and cash generation, so can feel more confident about doing this.

Mr Cross and Mr Fosh also assess a company’s ‘other intangible assets’ such as brands, customer relationships, culture, procedures, franchises and licences. “The more we find this intellectual capital the stronger the businesses tends to be,” says Mr Cross.

The Economic Advantage Process tends to lead them to what are considered to be quality companies, although Mr Fosh says that they do not specifically seek them out. He adds that this is a reason why so far this year Liontrust Special Situations has held up relatively well against the FTSE All-Share index and the average return for Investment Association (IA) UK All Companies sector funds. Between the start of the year and 13 November, the fund was down by 5.05 per cent while the index and sector suffered falls of 12.83 per cent and 11.10 per cent, respectively.

“The hallmarks of quality tend to be high return, and what goes along with that is strong balance sheets or solvency,” explains Mr Fosh. “If you earn higher returns and have a barrier to competition, you generate more cash than you need to grow your business and [can] use that to pay down debt, so it’s lower than average. That combination of attributes tends to do very well in recessions or sharp economic slowdowns, because investors understand that [the profits of] businesses with them will hold up better and they are more predictable than the average company. So in a period of unparalleled uncertainty [such as this year] people tend to flock to companies that have high visibility and quality. That’s when we do very well.”

A downside of investing in quality companies is that “you have to pay slightly more for them”. And when recession or periods of slow growth finish and recovery begins, meaning that investors favour cheaper companies with high economic exposure, Liontrust Special Situations tends to lag because its managers avoid such companies.

The fund's performance has been helped this year by a relatively substantial allocation to cash – around 8 per cent in late October.

“We normally carry a reasonable slug of cash so often have between 6 and 8 per cent,” says Mr Cross. “This is partly because we have 20 to 30 per cent [of the fund’s assets] in smaller companies and want to keep the liquidity up. [This is] for taking opportunities to buy things [and] if there were any redemptions having an element of cash would be particularly sensible. We allowed the cash allocation to move a bit higher during the pandemic because we also wanted to be able to support our companies if they needed to raise any finance to strengthen their balance sheets. But the only one who came to us wanting to strengthen its balance sheet was Compass (CPG) and, as that’s a big company, we didn’t need to [support it with cash] because it was very well supported through a £2bn rights issue.”

Other of the fund’s holdings have also done cash calls, for example, education software company Learning Technologies (LTG) and Keywords Studios (KWS), which provides services such as artwork and translation to video games publishers. But these were for potential acquisitions.

However, Mr Cross plans to gradually "nudge down" the cash allocation.

Holdings that have not fared so well this year include Diageo, which is exposed to areas such as restaurants and pubs which have been closed during lockdowns, and property services company Savills (SVS).

However, Mr Cross notes: “Although [Savills’] residential business has picked up a lot it also looks after transactions in commercial property so its share price has been weak so far this year. But ultimately these offices and retail units will have to be valued and change hands, so there should probably be quite a lot of activity for Savills after a quiet period. I think longer term Savills is in a good position, and may have increased market share a bit during the downturn because it's well financed. And it's a global business so it should come back strongly at some point.”

BP (BP.) and Royal Dutch Shell (RDSB) have also performed weakly. “That’s partly down to the spat between Russia and Saudi Arabia that hit oil prices,” says Mr Cross. “But since then it’s been much more about overall weak markets and a weak oil price. And environmental, social and governance [concerns among investors mean that] potential buyers of their stock are less than they were.”

Liontrust Special Situations had more than a quarter of its assets in FTSE 250 companies and about a fifth in Aim companies at the end of September. Smaller companies are considered to be more vulnerable to economic stress, but Mr Cross argues that the fund's holdings should fare relatively well.

“Many of our small companies have net cash on their balance sheets and high recurring income, so their earnings are pretty stable," he says. "They’ve also got an owner-manager culture behind them driving the business, making sure it is being managed in a conservative fashion. So I wouldn’t say [smaller companies are] always more vulnerable – there’s plenty of big-cap companies with lots of leverage in cyclical markets.”

Mr Cross and his colleagues don’t invest in smaller companies with market capitalisations below those of FTSE 250 companies unless their senior managers and main board directors hold at least 3 per cent of the equity. Mr Cross says he was influenced by research on this in the late 1990s which suggested that companies whose managers hold their shares perform better, and that owner-managers tend to be more conservative with regard to acquisitions and balance sheets.

“A lot of these owner-managers are very driven and at that entrepreneurial phase of the company, when they have equity in the business, it is very powerful,” he adds. “We might miss out on some good investments [because they don’t meet this requirement]. But you miss out on the bad ones as well.”

He says examples of more robust smaller companies held by the fund include EMIS and cloud communications provider Gamma Communications (GAMA). “It has high recurring income from a structurally growing area providing a new type of telecoms to small- to medium-sized companies,” says Mr Cross.

Wealth management businesses such as Brooks MacDonald (BRK), and investment platforms AJ Bell (AJB) and IntegraFin (IHP) also benefit from recurring income.

“We [have also] found that our market research companies with high subscription income like GlobalData (DATA) [have] stable earnings during this difficult time,” adds Mr Cross.

Liontrust Special Situations has grown in size due to good performance of its investments and inflows of investor money. At the end of October, it had assets worth about £5.4bn. Mr Cross says that this does not stop them applying their investment process successfully and the fund’s performance numbers bear this out. He also says that the investment process works with companies of all sizes, but the fund can still have an allocation of 20 to 30 per cent to smaller companies.

He adds: “As the fund has become bigger the average market cap of the smaller companies we’re buying for the first time has risen in order to get a sensible weight. The individual investment size in a company has to be bigger. So over the years = the concentration in smaller companies has decreased as the number of holdings [in them] has increased. A few quite big Aim companies such as RWS (RWS) may account for 1.5 per cent or 2 per cent of the fund, but most of our small companies now represent between 0.8 and 1.5 per cent.”