A value fund with a decidedly fine focus

Active management can work if a fund is small and focused. Adam Rackley has big plans, he tells Merryn Somerset Webb.

When Adam Rackley was setting up his fledgling value fund last October, he focused on what he sees as the industry’s biggest problems: size and fees. He will “soft close” the fund at £100m (no new clients will be able to invest) and “hard close” it at £200m (existing clients won’t be able to top up). That £200m will be invested in a very concentrated portfolio of equities – the top ten holdings currently make up more than 55% of the fund and he doesn’t plan to have much more than 20 holdings over the long term. That’s quite something in an industry where holdings in a big fund will easily top 75.
But in today’s industry, it makes sense too.

“One of my goals… was to provide genuine active management against a backdrop of mega funds that over time have no choice but to become market trackers,” says Rackley. If you have £1bn in a fund and, as a result, have to hold 80 stocks, your stock picking – and the performance of any individual stock – is “neither here nor there”. Hence, huge funds almost always end up as de facto index trackers.

Look at Warren Buffett. Rackley is a “big fan”. He has even (as have I) made the pilgrimage to Omaha to Berkshire Hathaway’s AGM and we agree that it’s hard not to be in awe of the US investor’s long-term record. But now that he runs a $350bn holding company “his original style has drifted” away from value and his returns have drifted down. His best years were the early ones: he outperformed by 23%, 16% and 21% in the 1960s, 1970s and 1980s, but the past few decades have been less thrilling (2.5% in the 1990s and 7% in the 2010s).

So that’s the size issue. (You don’t have to worry about the closings yet as the fund is only at £4m so far, but if you invest you will always be in reasonably select company.) On to fees. On these, Rackley mostly agrees with me (too high; not nearly transparent enough; and the ad valorem structure incentivises size over performance). I’m trying to persuade someone to take on the Financial Conduct Authority’s new favoured structure, the all-in price for each fund (one number that covers everything). Rackley isn’t yet convinced – but the structure Cape Wrath has settled on is pretty good. “If we behave like a tracker we get paid like one,” he says. So there is a 0.3% annual management charge. The total expense ratio (TER) is then capped at 0.45% – no padding out expenses to up the manager’s take.

There is, however, a 20% performance fee (0.3% on £200m won’t fund a full fund management operation for long). How does that work? The fund has to beat a high water mark; it has to beat its chosen benchmark (for the A-share class, that’s the MSCI UK IMI Net with dividends reinvested); and it has to deliver a positive absolute return: if Rackley merely loses less than everyone else, “we don’t charge”.

There is also a B-share class (not available on most of the platforms readers will be using) which has a slightly different structure: the performance fee kicks in above an annual return of 8% a year – Rackley’s mentally targeted return. That’s quite ambitious, I say. It is, relative to what the benchmark has done over the past few years, says Rackley (more like 5%). But he managed 8% with the money he was running before this fund, so he reckons it is as good a target as any.

Discipline on the way in, and the way out

So how’s he going to get this 8%? Value investing is a “broad church” (everyone has their own idea of what constitutes value). But “what makes us different is that we are disciplined about valuations on the way in and on the way out”. Many value managers are disciplined on the way in, but then their value stock “becomes an earnings growth story or a momentum stock and they get relaxed about valuations”. There is also a lot of emotion here: it’s hard to sell stocks that everyone else is beginning to love. And that, says Rackley, is why so much of successful value investing is about understanding behaviour – “arbitraging other people’s biases”.

So what does “disciplined on the way in” mean for him? What makes a stock a buy? It starts with at least two weeks of research in an effort to find “fair value” for the company he is interested in (it “doesn’t have to be a great business” – just to look as though it might be a value investment). That means looking at all the usual metrics (price-to-earnings, price-to-book, etc) but also at company-specific ones.

For example, his third-largest holding is Gulf Marine Services, an oil-services business. It operates in a highly cyclical sector. So to value it, you have to look at its earnings through a cycle. This year will be a “trough” year – earnings will be very depressed. So if you had been looking at the company from 2016 (when the fund bought it) to 2017, it would have looked very expensive. “What I am interested in is winding the clock forward” to see what future earnings will be, assuming that oil neither goes to $20 a barrel or $125, but knocks around the middle. That can then be discounted back.

Makes sense, I say – but it’s all incredibly subjective. The value is in the eye of the beholder. We agree on that and move on. The biggest holding is Enquest, which operates in the North Sea and has had a “pretty stretch   ed balance sheet”. There are, says Rackley, “many reasons to hate it”, but those that do aren’t accounting for the way that operating costs in the North Sea have fallen. “This year they will be somewhere close to $20 a barrel.” You haven’t seen that kind of “operational leverage” elsewhere.

Look at Rackley’s top ten stocks list and you can find reasons to hate all of them. I pick on Mothercare. It has been a value stock (always in some trouble or other) for most of my career. What’s going to change now? Hopefully the margins, says Rackley. Mothercare has astonishingly low gross margin for a retailer (more like 8% versus the norm of 40%). This is in part due to the existence of Kiddicare, a rival that has long been effectively selling below cost. This is unsustainable, so the rational assumption has to be that this irrational competitor will either leave the market or raise prices, giving Mothercare a chance to restore its own margins. That spells a “huge operational leverage opportunity”. The share price is now around £1.25 – “my target is about £2”.

Rackley goes on to talk about Mothercare for rather longer than I am interested in Mothercare. That’s a good thing – good value investors should be far more knowledgeable about individual stocks than the rest of us can be bothered to be. It is clearly a style that suits Rackley. “I love investing,” he tells me on the way out. “I love picking stocks and this is a structure that allows me to do it without being answerable to an investing committee or a 9am meeting.”

Fact file: Adam Rackley, Cape Wrath

Adam Rackley, 35, began as an analyst at Alliance Trust. He went on to run a small-cap income fund at Montanaro Asset Management, then taught the CFA qualification at BPP University. In 2010 he and a friend, James Arnold, rowed the Atlantic in 76 days, a feat recounted in his 2014 book Salt, Sweat, Tears. In 2015, he founded Cape Wrath Capital with a view to running a small, value-orientated, very concentrated fund of small-to-medium-sized UK equities. The VT Cape Wrath Focus Fund can be bought on the Hargreaves Lansdown and AJ Bell Youinvest platforms.