Spending more than 30 years as a stockbroker has given Chelverton’s James Baker the nous to successfully identify winners and avoid losers in the small and mid-cap space.
His fund, MI Chelverton UK Equity Growth, recently achieved two key milestones, hitting its three-year track record and breaking £100m in assets. In fact, Baker’s fund is now sitting on £167m of assets and riding high as the best performer in the IA UK All Companies sector over the past three years.
Indeed, a stellar run of form has seen the fund return 35% and 104.9% over three and five years, respectively, versus the IA UK All Companies sector’s 28.7% and 13.3%, according to FE Analytics. No mean feat for someone who has only been managing money since 2013.
Stockpicking acumen
Baker has been a small and mid-cap specialist since 1982 when he started out as an analyst before moving into specialist sales. His most prolonged period as a stockbroker was in the small to mid-cap sector at ABN Amro.
However, the firm was sold to RBS in 2007 and the next few years saw the bank unwind the small and mid-cap offering. This, along with changing technology and increasing regulatory pressure, led Baker to become disillusioned with the remuneration model around broking and sales-based advice. He left ABN Amro in 2011.
Baker says the buyside had always appealed but it wasn’t until 2013 that opportunity arose. It was then that he was contacted by Rathbones, one of his clients at the time, to help run the UK Recovery Fund when manager Marina Bond fell ill.
The Rathbones fund was two-thirds small and mid-cap stocks, meaning Baker was a natural fit. Bond returned in 2014 and Baker, having had his first taste of fund management, moved to Chelverton, a small and mid-cap house by nature, in May of that year.
“Rather than hire a superstar, they gave me a go,” he says modestly.
Baker says his “stockpicking ability” in small and mid-caps was what first caught Chelverton’s attention. He adds that years spent as a broker enabled him to understand different managers’ investment styles and helped inform his own investment process.
He explains: “You get to know an awful lot of small and mid-caps and you accompany these companies on roadshows and get a sense from the management about what makes a good business. That is useful in terms of how you look at a stock.”
In addition, working as a broker taught him the importance of cashflow, margin and topline growth, all of which he says makes it easier for management to run a business. “If you have negative topline growth you are just fighting battles all the time,” he says.
The fund launched in October 2014 with £2.2m from friends, family and people in the City and, of course, himself.
Winning by design
While the fund is clearly focused on small and mid-cap stocks, Baker says it is not a “classic” small and mid-cap product because the focus is on everything below the FTSE 100 down to £25m in market cap. This is largely because it is marketed at fund selectors and wealth managers who like to take FTSE 100 stock decisions themselves.
Baker’s strategy is relatively simple: buy stocks of companies that grow faster than the market and can fund that growth so that all the benefit is fed through to the underlying shareholders – with as little downside risk as possible.
The team uses a quantitative and qualitative process to pick these stocks.
The quant part involves using a financial screen that assesses the available universe of about 11,000 companies based on five criteria: the ability to convert profit into cash; topline growth in excess of GDP; sensible gearing; low working capital intensity; and high margins.
Companies need to tick four of the five boxes to progress and the one criterion all stocks must meet is the ability to convert profit into cashflow. “Cash in the bank is an important thing for us,” he says.
The screen leaves Baker with roughly a quarter of the universe, about 270 stocks, before the qualitative stage kicks in. This involves meeting the management team at all 270 companies. This process then boils the selection down to around 170 stocks the team would like to own, and then it comes down to valuations. Based on this process, the portfolio currently holds 80 stocks.
Baker says he likes businesses with high levels of revenue and visibility. About 27% of the portfolio is in technology comprising about 12 software stocks that fit this mould due to their recurring revenue streams.
“These are companies selling software as a service either as an annual recurring licence, for example Craneware, which we own, or where you have an element of fixed fee on an annual basis but you have a volume measure as well, such as Dotdigital,” he says.
The Dotdigital Group provides an email marketing service for online retailers, which involves it selling a customer a certain number of emails and rebasing the contract on volumes. Baker describes it as “clever spam”.
He adds: “We have a lot of internet-enabling companies whereby they are making it easier for companies to do business online, which is a structural growth area.”
Baker is also a fan of industrials, particularly companies that supply a component or chemical to a customer who has it “designed- in” to their product. By way of example he notes a company called XP Power, a producer of power converters, an essential crihardware component in almost every piece of electrical equipment.
“As long as XP Power doesn’t make a mess of it they will be in the next Siemens piece of medical equipment,” he says. “That is a nice 45% gross margin business. You can return 15% off the bottom line and you have great visibility once you have these design wins.
“Once you are ‘designed-in’ and you are a key part of the customer’s product, you are not going to be taken out, unless you get something horribly wrong.”
By contrast, Baker says the fund would never have bought Laird, the smartphone component supplier, because it is too dependent on Apple. “Things like that do not get in,” he says.
The fund also owns several financials but not banks because Baker believes them to be very capital intensive. It does hold Brooks Macdonald, however, because it has what he calls “sticky customers” and Sipp administrator Curtis Banks.
“It is about capturing the structural change going on where you have high levels of revenue visibility, because you are doing a boring task that is very necessary. As long as you don’t make a balls-up of it, you should keep that business.”
Rapid growth
Baker is not afraid to sell stocks that become too expensive, if margins are coming under pressure or cashflow starts to deteriorate. He also claims to be nimble when reloading on stocks that become attractive again.
“We own a portfolio of stocks that at any one time are trading between 15.5 and 17.5 times earnings, and that is hard to find,” says Baker. “Despite returning 33% last year, we are still offering quite an attractive valuation on the fund.”
That said, Baker agrees with the consensus view that the wider picture shows equities to be reasonably fully valued. But is a correction looming? “It’s possible,” he says. “World economic growth is quite good at the moment.”
The fund has what Baker terms “a reasonable amount” of US exposure on the back of the country’s “attractive” tax regime. The fund is “20-odd per cent” exposed to the US but Baker points out this exposure is not on US price/earnings.
UK exposure in the fund, meanwhile, is 53%, comprising 50% of structural growth and 50% quality cyclicals.
The fund went into the EU referendum with reasonably high exposure to UK consumer cyclicals as the UK economy was performing well, but reduced that exposure over the ensuing six to nine months because the firm was concerned about the impact of sterling devaluation on real incomes.
“We have downsized UK high-ticket consumer and kept some UK consumer defensives, such as Hollywood Bowl and Dairy Crest – cheese and bowling alleys, low-ticket items – but we have got out of Safestyle, a double-glazing business,” he says.
The conundrum for the UK, according to Baker, is that while there is relatively full employment, real incomes are squeezed as imports increase and the pound weakens.
This leads him to review the consumer cyclicals sector, particularly if the UK reaches the “right deal” on Brexit and starts to see more inward investment causing the pound to rally. “Suddenly we need to be buying the Topps Tiles and DFS’s of this world where we have tiny holdings but haven’t done anything with them as the fund has grown.”
Indeed, the fund has been growing. At its first anniversary it was £7m, before shooting up to £20m in Q1 2016. On the fund’s second anniversary it had hit £35m, quickly breaking the £50m mark and hitting £100m at the three-year milestone.
At the time of the interview the fund was £144m but had reached £167m by the time of writing. Speedy progression, but how big does Baker think it can get?
“I think when the fund gets to £250m we sit back and don’t market it aggressively, or at all,” he says. “We are not looking for this to be a massive offering because we are a private company and do not have shareholders who need to see higher returns.”
Given the current rate of growth, the £250m mark could not be far off for Chelverton – and it will need all of Baker’s discipline as a fund manager to take a back seat when the time comes.
Wealth manager comment: Ben Yearsley, director, Shore Financial Planning
The fund has had an excellent start, beating the All- Companies sector and the FTSE All-Share convincingly. I would argue it is really a smaller company fund in disguise but, having said that, it has also convincingly beaten that sector.
This fund looks nothing like an index, which is what the essence of active management should be. However, it isn’t a fund lacking coherence. The managers know what type of company they are looking for, which typically involves profitable businesses generating free cashflow.
It seems fairly uncomplicated but returns have been excellent. The fund is small, so the interesting thing to look at is whether the performance is repeatable as it gains more attention and grows. It is a nice diversifier from more traditional UK growth funds.
