Today it is less apparent. “If you look at a lot of the manufacturing companies today, they are owners of intellectual property and they are big investors in R&D, but the actual manufacturing might be outsourced in other countries,” he says.
Three criteria
“Companies have become far more reliant on their intellectual capital as the years have gone by, particularly as globalisation has meant some of the more basic levels of manufacturing can be done by anyone. Owning more intellectual property is very important whereas whether you can manufacture it or not is perhaps less important.”
Believing a company’s intellectual capital to be the difference between a ‘good’ and a ‘bad’ company, there are three main criteria a company needs in order to meet the process’ requirements: strong intellectual property; a superior distribution network; and at least 70% recurring income.
If a company can claim at least one of these features, the team will take the idea to the next stage of research, which is looking at things such as brand and format power, culture, licences and franchise.
Furthermore, every name in the UK Smaller Companies Fund needs to be profitable and UK-headquartered, and the board must own at least 3% of the equity. “That marriage of intellectual capital and equity ownership were the key two drivers of the fund, and that remains so today,” he says.
Also applying economic advantage across the Special Situations Fund, UK Growth and the imminent UK Micro Cap Fund, Cross recognises nuances across the market-cap spectrum in terms of where intellectual capital is found. Smaller companies lean towards software while larger might feature more pharmaceutical or engineering names.
“In smaller companies we tend to find lots of nice software names with high recurring income. We find a good dose of intellectual property, which might again be software-based or it could be some of our little engineering companies. But what we tend not to find is large international distribution networks – they tend to come much more heavily through the large-cap end of the market.”
UK Smaller Companies tends to hold around 60 positions, with a fairly healthy life expectancy in the fund. It is run with about 10% annual turnover of holdings.
The fund tends to focus on the £150m to £400m end of the market, but can go down to about £75m if something particularly interesting presents itself. Many names feature in UK Growth as well, and from about £150m upwards a small company may even land in the Special Situations Fund.
“There are probably about 20 companies that feature in both portfolios,” says Cross, referring to UK Smaller Companies and Special Situations. He adds: “Part of running money is to try and keep things fairly simple and not have too many holdings. If you have a lower level of holdings, you tend to know your company is better.”
The big hitters
The duo’s optimum holdings, or those names that typify the investment process, are where you get all three coveted characteristics in one company.
“Some of our long-term winners have been companies such as EMIS Group in NHS and GP software, where you have got intellectual property. They have a 50% share of the GP software market and recurring income of more than 70% of turnover.
“In the past you have had very strong directors’ ownership. That is gradually been sold down but you had those great margins and returns on their invested capital, with very strong intellectual capital.”
This company also exemplifies the duo’s sell discipline, where the directors’ ownership has fallen below the 3% threshold and will be phased out over 12 months.
Positions will be gradually reduced or exited altogether if they cease to meet the main requirements or if the risk scoring changes. Cross and Fosh tend to bring stocks in at either one, two or 3%, depending on the risk profile. If gearing is taken up or the customer or product spread changes, Cross says the team might think, ‘Hang on a minute. We think you are now much more risky. We want to have less of you’.
Similarly, if the intellectual property falls away, patents expire or rivals start to close in and your barriers to competition are no longer working, the holding is reviewed, and likely reduced or sold.
Cross says: “It is basically the process in reverse. We are less trigger happy just based around valuation.”
