Smithson’s quality bias leaves it well placed to weather the storm

The Smithson Investment Trust has held up better than many other equity funds because of its quality bias and focus on strong balance sheets.

No company is immune to the panic selling that is sweeping the market, but those that can deliver sustainable high returns on capital employed and generate substantial free cash flow, while not relying on debt, are much more likely to survive and be in a position to flourish when conditions improve.

These are precisely the sorts of stocks held by the Smithson Investment Trust (LON:SSON), which provides exposure to a concentrated global portfolio of high quality mid and small cap companies with sustainable growth characteristics. Once the managers have identified these businesses, they have a very simple philosophy: avoid overpaying and then do nothing, as this lets the returns compound into material long-term gains.

The point about not overpaying is obvious, yet it is more sophisticated than it sounds. It involves comparing the current free cash flow yields with where the managers expect them to be in four to five years’ time. This ensures that the stock selection reflects a combination of current value and future growth.

The power of compounding

Unlike some funds, Smithson is more of a long-term ‘buy and hold’ investor that will only tend to sell if the original investment philosophy breaks down. In theory this should allow it to generate superior long-term gains, as the underlying companies reinvest excess cash back into their businesses to compound their returns.

The manager normally tries to avoid companies that rely on tangible assets, as these can be easily replicated. They prefer those that depend on intangibles such as brand names, patents, customer relationships, distribution networks, or software, which provide a captive market for services, spares and upgrades or dominant market shares.

There are very few businesses that meet their stringent investment criteria. Out of the 5,205 constituents of the MSCI World SMID index, the managers have identified just 77. From these they have built a concentrated, high conviction portfolio that consists of only 29 names, with the largest holdings including the likes of Rightmove (LON:RMV), Verisk Analytics (NASDAQ:VRSK), Equifax (NYSE:EFX) and Check Point Software (NASDAQ:CHKP).

Comfortably ahead of the benchmark

According to data compiled by Investec, from the IPO in October 2018 to March 16, the NAV and shareholder total returns were 7.7% and 0.8%, both comfortably ahead of the MSCI World benchmark total return of -20.7%.

Investec believe that this outperformance is a function of the distinct quality bias and focus on strong balance sheets. They expect these to become increasingly important features in the months ahead, with many companies facing existential threats, which is why they have recently issued a buy recommendation.

At time of writing, Smithson had fallen around 32% from its peak levels recorded about a month ago and the shares were experiencing high levels of volatility. Before the sell-off it had consistently traded at a premium to NAV, but has recently slipped to a small discount. If you have spare cash and can stomach the risk it should come out of all this pretty well.