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Gary West (photo) and James Inglis-Jones say the Liontrust European Long/Short Fund they manage has enjoyed solid growth this year amid the gloom f

Gary West (photo) and James Inglis-Jones say the Liontrust European Long/Short Fund they manage has enjoyed solid growth this year amid the gloom for most hedge fund strategies by exploiting apparent contradictions: that more investment doesn’t lead to more profit, but less investment can lead to greater profit.

HW: What is the background to your company and fund?

GW/JIJ: The Liontrust European Long/Short Fund we manage was launched in December 2006. Between us, we have 30 years of investment experience in long-only and latterly long/short equities. The fund has returned 45.7 per cent since launch and 12.2 per cent in 2008 up to October 31. The fund, which is listed on the Irish Stock Exchange, has grown to more than USD85m in assets under management and is managed using the ‘cash flow solution’ investment process, of which more below.

HW: Who are your service providers?

GW/JIJ: The fund’s audit firm is PricewaterhouseCoopers, the fund administrator is Butterfield Fulcrum Group, the prime broker is Goldman Sachs and the law firm is Carey Olsen.

HW: How and where do you distribute the fund? What is the profile of your current and targeted client base?

GW/JIJ: The fund is targeted at sophisticated institutional investors, private banks and multi-manager funds. The main distribution market is western Europe but as the fund grows there is increasing interest from investors in the US.

HW: What is the investment process of your fund?

GW/JIJ: Our approach is designed to exploit the inaccuracy of profit forecasting by company managers. Common mistakes are made by managers in forecasting returns from investments. People often deal with information emotionally and irrationally, making their forecasts unreliable. Investment decisions taken by managers to support their forecasts often create profit expectations in the stock market that are unsustainable, particularly at key stages of a company’s development.

Company managers’ belief in their forecasts can be assessed by looking at the amount of cash they spend to support their forecasts. Companies willing to spend large sums relative to their size are frequently too optimistic about their forecasts. When they are proved wrong, the misguided investment often causes profits to collapse. Companies that spend very little to meet their forecasts for growth often produce better than expected profits.

At the extremes of these forecasting biases, the following apparent contradictions can catch a lot of investors by surprise – more investment doesn’t lead to more profit, and less investment can lead to greater profit.

The change in valuation after such a ‘surprise’ is often dramatic and very rewarding if you can spot it before it occurs. The aim is to predict these profit surprises by examining a company’s spending patterns and investors’ expectations for company profits.

HW: How do you generate ideas for your funds?

GW/JIJ: We look for two different types of company. For our long book, we want companies that are generating lots of cash, have conservative profit forecasts and where investors have low or modest expectations for future profits growth. For our short book, we want companies with very ambitious profit forecasts that are spending huge sums on operating assets such as equipment, property and stock or on M&A to try to achieve them, and where investors share the optimism of the company managers.

We have a screen that enables us to discard quickly companies that are very unlikely to have the characteristics we have just described. It contains two cash flow ratios that measure company cash flows relative to enterprise value and to operating assets. We rank our universe from best to worst and only focus on companies that rank at each extreme of our screen as the source of our ideas.

Once we have a list of stocks to work with, we spend considerable time sifting through the list by scrutinising their annual report and accounts, looking for the two types of company described above. We have developed quite a bit of expertise over the years analysing company accounts. James Inglis-Jones’ background as an accountant helps, as does Gary West’s 20 years of experience working with accounts. Often, a detailed knowledge of accounting is required to identify the sort of companies we are looking for.

We don’t speak to brokers or read their research and we don’t need to have company manager meetings because we are not interested in forecasts. Both brokers and company managers tend to be far more focused on a formal forecast of future profits growth, whereas we are only concerned with the hidden clues of earnings surprises to be found in a company’s report and accounts. What we tend to end up with is a portfolio that is contrary and unusual relative to many of our peers. The obvious benefit of this is that our portfolio tends to be very lowly correlated with other funds.

HW: What is your approach to managing risk?

GW/JIJ: A number of risks need to be managed. First, there are limits on stock positions, on both long and short side, to ensure no single position becomes too large within the portfolio. Once we buy a stock, our expectation is that it will go on to deliver positive earnings surprises – in most cases this will lead to positive price momentum, and we want to allow the most successful companies we own to get bigger in the portfolio subject to a maximum holding for risk purposes of 10 per cent.

In the short book, positions that are getting bigger are obviously those that are not working well for us, so our rule is that if a position grows to 3 per cent of our NAV it must be cut back to its original weighting again. This strikes the right balance between allowing some volatility with a short position as it develops in the portfolio and mitigating the risk of too big an impact on the portfolio if a short goes badly wrong. Typically, we have 50 per cent more shorts than longs, so our unit holding for a short tends to be below 2 per cent, whereas for a long position it tends to be 2 to 3 per cent at cost.

In addition to limits on individual stock positions, we also set a limit on overall predicted portfolio volatility at 10 per cent, referring primarily to the Barra risk model but also looking at other models. We are deeply sceptical about a slavish adherence to any risk model, irrespective of its past explanatory power. Unfortunately, bitter experience tells us that no model can accommodate the all-too-frequent black swans.

The key for us is to ensure that the vast bulk of our risk is stock-specific or idiosyncratic, followed by some sector risk. What we don’t want is some large common factor risk laced through the portfolio. In practice, the majority of our risk is stock specific. We are happy to take some sector risk as well as we know that our approach is predictive of sector as well as stock returns.

The final area of risk control is in the gross and net exposure of the portfolio and the portfolio’s beta. We want to offer non-directional returns so we restrict net exposure of the fund to between plus and minus 20 per cent and the beta to be between plus and minus 0.2. We would be uncomfortable if our gross exceeded 200 per cent and in practice keep the gross between 150 and 200 per cent.

HW: Has the performance been as per budget and expectations?

GW/JIJ: The fund was launched with the expectation it would deliver annual returns of 15 per cent over the long term. Performance has obviously exceeded our expectations since launch.

HW: What opportunities are you looking at right now and what events do you expect to see in the year ahead?

GW/JIJ: In selecting our stocks from the extremes of our screen, we find that we get pushed toward either a value or a growth stance at different times in the cycle. Between 2000 and 2005, the process had a value tilt. From 2006 to 2008, the process took on much more of a growth tilt.

Recently, the process has started to move toward value, with the clearest signs being on the short side. We have started to short more defensive companies. They are becoming much more expensive on a relative basis as they are being perceived as a safe haven through these troubled times.

We believe, however, that in a number of cases this perception of defensiveness is misplaced. On the long side, and for our long-only funds, we started the process of buying more contrarian value this year. As the recession deepens, we expect to be buying a lot more contrarian value as a result of changes in the kinds of companies generating positive cash flows.

Owing to the changing dynamics of working capital through the business cycle, you often find that companies generating the best cash flows in the depths of recession are those whose sales growth has recently collapsed, and as a result they tend to be at bargain basement valuation levels.

When growth is abundant, however, companies that have the best cash flows tend to be growth companies. This is because accounts payable are more significant drivers of cash flow than receivables and inventory as many good growth companies are securing upfront cash advances for the goods or services they provide.

HW: What differentiates you from other managers in the sector?

GW/JIJ: We don’t have an intimate knowledge of other funds and the approaches they adopt. We have been told by clients, however, that we have a unique approach, and the low correlation of our returns with other funds would support their observation.

We are not aware of anyone else who looks at a company with our single-minded attention on report and accounts, ignoring broker views and eschewing company manager meetings. We have also been told it is unusual for a fundamentally-driven long/short strategy to derive so much alpha from the short book. Our portfolios have always been non-directional, therefore requiring a large short book. We have only ever shorted single stocks and have never shorted any indices.

HW: Do you have any plans for other product launches in the near future?

GW/JIJ: We have plans to launch a short-only fund following interest for such a product, particularly from institutional investors in the US. Similarly, we are looking at launching a Ucits III version of the European Long/Short Fund early in 2009. Liontrust is also currently researching the viability of a UK long/short fund.

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