A Fund To Follow

Published in Investing Strategy on 21 July 2010

This investment manager has been outing shareholder value for more than a decade.

There's much talk these days about companies delivering -- or not delivering -- a fair return for their shareholders.

Directors' remuneration, dividend policies, and the role of non-executives in looking after shareholders' interests have all come in for criticism. Most of us, I would guess, whether we invest in blue chip banks or AIM microcaps, feel we've had a raw deal from many companies in the last few years.

Private investor activism

A number of Foolish investors have become increasingly active in pushing for change at under-performing small cap companies in order to unlock shareholder value. Tandem (LSE: TND), which I wrote about recently, is one such firm.

One of the frustrating things for private investors exercising their responsibilities as part-owners has been the level of complacency amongst many institutional shareholders.

However, there are exceptions to the rule. Not only can they teach private investors some useful lessons on engaging with companies, but also they can provide us with some interesting share ideas.

An activist institutional investor

You probably haven't heard of the Hermes Specialist UK Focus Fund ('HSUKFF'), managed by Hermes Focus Asset Management, which is part of the Hermes Group, an investment company owned by the BT Pension Scheme. HSUKFF runs some of that scheme's money as well as money for other institutional investors.

HSUKFF's whole strategy, like the other Hermes Focus Funds, is built on implementing structural changes at under-performing companies – and it's been quietly going about this business since 1998.

What HSUKFF does

The fund invests in a relatively small number of UK companies, around 12-20 at any one time. It targets companies whose core business is essentially sound, but which, for one reason or another, have not been delivering shareholder value.

HSUKFF builds a typically significant minority shareholding to pursue a high-intensity – but usually private – engagement with management, directors, and other major shareholders, in order to bring about changes that will, ultimately, result in a substantial share price rise.

The fund is not interested in micro-managing the companies it invests in, but seeks to change their 'governance culture' to one where directors and managers are aligned with the interests of its ultimate owners, the shareholders, and therefore will deal effectively with the problems that have been causing the under-performance.

In many cases companies collaborate willingly; but in some the engagement may become confrontational. An academic study (downloadable here) of HSUKFF's activities in the period 1998-2004 found that in collaborative engagements the fund's median investment period was 469 trading days; in confrontational engagements it was 1,284.

HSUKFF routinely pushes for some, or all, of the following changes:

  • divestment of non-core or non-productive divisions and assets;

  • restrictions on making diversifying acquisitions;

  • limitations on capital expenditure;

  • replacement of recalcitrant CEOs or chairmen;

  • replacement or addition of non-executive directors to strengthen the independent element of the board;

  • alignment of directors' remuneration packages with the interests of shareholders; and

  • increased cash payout to shareholders.

The academic study found that HSUKFF was successful in implementing its target changes in the vast majority of cases.

The fund's annual return, net of fees, was 8.2% during the period studied, out-performing the FTSE All-Share index by 4.9% a year, with the academics estimating that 90% of the excess return was down to the outcomes of HSUKFF's activist agenda.

Free-riding on HSUKFF

From the point of view of private investors like us, the most interesting thing about the study was its finding that other investors could have profited handsomely by buying into the engaged companies at the time of the first announcement that HSUKFF's holding had reached a publicly disclosable level.

Such an investor would have achieved an annual 12.6% return if mirroring the fund's subsequent trading moves; 14.3% a year if simply continuing to hold the companies until the end of the period covered by the study.

It seems that HSUKFF's institutional investor base, low-key private interventions in companies, a number of changes to the fund name over the years, and often hard-to-spot disclosable holdings (the wider Hermes Group or even the BT Pension Scheme Trustees are sometimes recorded as the 'notifier') have all probably contributed to the fund being largely invisible to private investors.

From 2008 …

I wouldn't recommend that anyone blindly ride on the coat tails of HSUKFF. By definition the fund's target companies have issues, often needing access to open capital markets for raising finance or making disposals. Whilst HSUKFF outperformed its benchmark during the liquidity crisis of 2008, some of its individual holdings performed less well than others.

Nightclub-owner Luminar (LSE: LMR), for example, has reported bad news after bad news. Its share price has continued to collapse, and although it now has a new chairman (the former CEO of Hermes Focus Asset Management), chief executive and financial director, it's priced to go under. It is, as my Foolish colleague Cliff D'Arcy recently wrote, 'a classic binary-bet situation.'

… to 2010

Despite the havoc wreaked by the credit crunch, and the hangover suffered by companies such as Luminar, a measure of normality has now returned and HSUKFF is a fund whose disclosable holdings I'll be keeping a close eye on.

Given HSUKFF's typical two- to five-year holding period and the inevitable ups and downs en route to bringing about corporate change, I'm sure there will be opportunities to invest in one or two companies in the HSUKFF stable with big upside potential at depressed prices.

One I currently have my eye on is Speedy Hire (LSE: SDY), in which it was announced that HSUKFF had passed the disclosable holding threshold in November 2009. The Norwegian institutional giant Norges Bank Investment Management, who manage Norway's sovereign wealth, also increased its stake recently.

A quick google for 'Hermes Specialist UK Focus Fund' picks up several other companies that could also merit further investigation by contrarian private investors.

More from G A Chester:

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