Intellectual capital focus boosts returns

Volatility in the UK Smaller Companies sector over the past few years, as the tech bubble and interest rate falls have made achieving consistent returns a hard task for fund managers.

In 1998 the best performing fund in the sector, the Discretionary Unit Trust, finished 1999 ranked 64 out of 66. Similarly in 1999 the Close Beacon Investment fund topped the sector, yet in 2001 it had underperformed by 13.2% and was ranked 59 out of 70.

Anthony Cross's Liontrust Intellectual Capital Trust, however, has never had a calendar year outside the first or second quartile and is one of only four funds to post first quartile returns over five years.

Since the fund launched five years ago, Cross pioneered an investment approach known as the Cross Report in which he seeks consistent top-half returns by focusing on a company's intelligent capital.

How would you describe your investment approach?

I start thinking about the stock market from a pretty cynical beginning, in that there are not many good investments around. The problem facing most companies is that competition has increased hugely over the past 10 to 15 years, stemming from the deregulation of markets, the removal of barriers to trade, shorter product life cycles, easier access to finance and low inflation.

As a result, most companies are experiencing margin pressure and those companies which have been able to get away from this have done so by focusing on their intangible assets.

These assets, now commonly referred to as a company's intellectual capital, have become extremely important.

What is an example of a company's intellectual capital?

The assets are, for example, customer relationships, repeat business, database skills that shows a company's knowledge of their customers, distribution networks, intellectual property and a company's particular procedures and formats within their business and culture that make them successful.

The intangible assets are very important because they are often difficult to replicate and it is this difficulty of imitation that allows a company to maintain its pricing power.

So, in this more competitive world, finding companies with intellectual capital I believe is more likely to allow you to invest in businesses that will be able to maintain their margins and pricing power.

How do you find intellectual capital?

I use a database which screens companies looking at a number of ratios, for example, their research and development spend, the average employee costs and the mix of assets used compared with sales.

These ratios have helped me to screen through businesses and identify companies which I then analyse further to try and gauge what it is they have in terms of intellectual capital which is allowing them to maintain their margin through the various economic cycles.

How important is equity motivation in companies?

When you are dealing with intangible assets and with increasingly people-based businesses, motivation is vital. Studies in the UK and the US have shown that equity motivation leads to better performance in companies.

As a bare minimum the directors in every company I hold must own at least 3% of the listed equity. With such a level of director equity I find my holdings perform more strongly than the FTSE All-Share.

This owner/manager culture also helps protect shareholder value because the directors are far more careful about their balance sheets and about how they go about acquisitions.

After identifying companies with intellectual capital and equity ownership, how do you construct your portfolio?

In my experience, too many managers get excited about upside, earnings growth and potential market size. I spend a lot of time looking at it another way and worrying about the chance of earnings collapsing.

As such, I look at customer spread, product spread, financial gearing, whether the market is tried and tested or blue-sky, and what the trading environment is like.

I will then score a company according to these various criteria. If a company has lots of customers, lots of products or geographical spread, is not overly financially geared, is in a good trading environment and is in a tried and tested market, I will invest 2% to 3%. If a business is inherently more risky, for example, a single product software company with few customers, which is burning cash in a blue-sky market, I will invest only 0.5%.

I have four investment bands, -0.5%, 1%, 25% and 3%, added to which is a FTSE Small Cap weight if the company sits within the index. The importance of this portfolio construction is that the bulk of the fund sits in companies I feel comfortable holding.

They are not the sort of companies that will suddenly collapse overnight, where the risk/reward ratio can mean the share price can be damaged quickly if something does not go right.

How else do you diversify risk?

Understanding the trading environment of companies via newsflow is also important. I spend 30% of my time looking at newsflow and writing up a newsflow diary examining the results of companies, how the risks are changing within a business and how the intellectual capital is developing, to make sure the emphasis between sectors reflects the trading environment.

Looking at newsflow carefully gives me the chance to move the portfolio between sectors and change the weightings of companies prior to the stock market. In general catching up with what is happening.

How many holdings do you run in the portfolio?

We run between 60 and 70 stocks. I initially buy any company that sits below the FTSE 250, which fits the criteria. If it then moves into the FTSE 250 I am happy to continue to hold it until I have found an alternative investment.

How many sectors can you actually find intellectual capital in?

Intellectual capital is a very broad subject, it is not all about intellectual property, media companies and IT. The fund would not have performed as it has if it was skewed aggressively towards only a couple of sectors.

You can find it in consulting engineers, construction, outsourcing, product manufacturers and financial companies.

What are your views on smaller companies?

Overall I am a big fan of smaller company investing. People tend to have a very generalised view about them. If you take the past five years, the FTSE Small Cap has performed in line with the All-Share, but the average smaller companies fund has beaten its index and the All-Share.

This is because smaller companies managers have the choice of some 2,000 companies and if you cannot build a portfolio out of that and deliver strong share price growth over the long-term and beat the All-Share then arguably you are not doing your job effectively.

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