SME scheme profits by shunning diversification

The £169.5m scheme has decided to focus predominantly on just 20 long-term growth-equity positions and forgo the benefits of diversification.

This strategy goes against the general trend of schemes being encouraged to diversify their portfolios across different asset classes, and therefore spread risk across their investments.

But Terry Smith, chief investment officer of Fundsmith and investment adviser to the scheme, said the “short-term, overdiversified” nature of the asset management industry was detrimental to pension schemes.

He also advocated a long-term approach to equity investing. He added high conviction equity portfolios were coming back into favour with institutional investors.

Tullett Liberty’s strategy

In 2003, financial advisory group Collins Stewart acquired Tullett Liberty, inheriting its defined benefit pension scheme. In 2004, the scheme had a deficit of £38m.

Following further consolidations, the company is now known as Tullett Prebon.

If you continue to add stocks they will be of worsening quality... there are not that many genuinely good companies in any given market

Acknowledging the poor situation, Smith convinced the trustees the investment approach of the fund had to change drastically.

“In my view it had been mismanaged on just about every level,” he said.

The strategy set out by Smith and the trustee board was to directly invest in 20 “good” companies they felt would be strong performers over the long term.

The board planned to hold the companies and “not get in the way of the performance they could provide to the portfolio”, Smith added.

“With 20 stocks about 90% of the covariance risk has been taken away,” he said.

“If you continue to add stocks they will be of worsening quality. In my belief, there are not that many genuinely good companies in any given market.”

The Tullett Liberty scheme has a turnover of 3.8%, which amounts to the repositioning of one stock a year.

Looking for quality

In 2003, Smith outlined the investment principles the Tullett scheme should follow.

These included investing in companies whose growth was driven from reinvestment of their cash flows, where no significant leverage was required to generate returns and companies that were resilient to technological innovation.

The average company in our portfolio was founded in 1892. They have survived two world wars and the Great Depression. So they will probably get through the current situation

“We are looking for companies that make a high return on capital every year and can make a return even at the bottom of a cycle,” he said.

Smith added these were usually companies that produce non-durable consumer goods.

Even though Tullett Liberty is searching for quality, it is not willing to overpay for it.

The scheme compares the free cash flow yields and dividend yields to determine the relative value within the portfolio, within its investable universe and across the market.

“We have tried to exercise an iron discipline on never overpaying, because we are not looking to profit on the sale of the stock,” he says. “We are trying to own the underlying cash flows of the business to support our pension funds.”

The scheme favours “resilient” companies. “The average company in our portfolio was founded in 1892. They have survived two world wars and the Great Depression. So they will probably get through the current situation,” said Smith.

“I always give the example of Brown-Forman, the distiller of Jack Daniel’s. Not only did they survive two world wars and the Great Depression, they also survived prohibition.”

Tullett Liberty’s investment strategy would appear to be paying off. The scheme is in surplus, outperforming the MSCI World Index and the S&P between 2003 and 2010 to register a return of 13% net of fees.

This article first appeared on www.mandatewire.com on March 21. MandateWire is a sister publication of schemeXpert.com.