Strictly following fundamental criteria, maintaining a concentrated portfolio to generate alpha and only focusing on organic company growth are among some of the investment ‘rules’ that the Marlborough Special Situations fund is breaking, according to Eustace Santa Barbara (pictured). 
Santa Barbara, who co-manages the four FE Crown-rated fund alongside FE Alpha Manager Giles Hargreave, said there are a wealth of opportunities for growth further down the market cap spectrum in the UK.
However, he pointed out that successfully investing in small-caps takes significant due diligence, as there is a wider universe to choose from and companies are often under-researched.
“The last time I checked, the average number of sell-side analysts covering a FTSE 100 constituent was over 20, for a FTSE 250 stock it’s over 10 and, within the Special Situations fund, the average analyst covering any one of our stocks is five,” Santa Barbara said.
“It just shows there are less intelligent eyeballs looking at these names so there are opportunities. There is more alpha out there.”
The managers’ investment process has clearly stood the fund in good stead as it has outperformed its average peer in the IA UK Smaller Companies sector over one, three and five years.
Over the last decade (Santa Barbara joined the helm of the fund in 2014 but its process has remained unchanged over this time frame), Marlborough Special Situations has outperformed the IA UK Smaller Companies sector average by 99.81 percentage points with a total return of 242.03 per cent.
For reference, this is an outperformance of the FTSE All Share index (which it is not benchmarked against) of 168.09 percentage points.
Performance of fund vs sector and index over 10yrs
Source: FE Analytics
In the below article, Santa Barbara outlines five rules typically followed by UK equity investors which himself and Hargreave are not afraid to break.
Managers need a concentrated portfolio to generate alpha
According to data from FE Analytics, Marlborough Special Situations has a top-quartile alpha generation – which measures returns made in addition to the benchmark – over the last decade.
While many investors believe that a concentrated portfolio and larger bets on individual names is the key to alpha generation, Santa Barbara said this is not necessarily the case.
“We hold 200 stocks,” the manager said. “If you look at the IA UK Smaller Companies sector - which is our peer group – the average disclosed number of holdings in those funds is about 75.
“So, if we hold 200, essentially we own two and-a-half funds. But it’s the way that Giles has always run the fund and it’s a way that we think is a good way of capturing a lot of the outsized returns that you can get in the small-cap space, while protecting ourselves if companies profit warn and fall quite sharply.”
The fund’s top 10 largest weightings account for 15.6 per cent of the overall portfolio. No individual holding exceeds 2 per cent of the fund.
“Some managers run 30 to 50 [stocks in a portfolio],” Santa Barbara continued. “It can work beautifully and, when they get it right, they can nail it. But that’s just not the way we’re going to run the portfolio.
“We are essentially trying to achieve an above-average risk-adjusted return throughout a cycle.”
There’s less need to meet companies in a highly-diversified portfolio
Santa Barbara, Giles Hargreave and their team of analysts aim to meet the management team of every single holding within the portfolio.
This means that, between them, they tend to meet approximately 50 management teams per week.
“We’re very lucky investing in smaller companies because a lot of them won’t have an investor relations department, which means we get to meet the CEOs and CFOs outright on a regular basis,” the manager said.
“There is no quick way to create a portfolio and, actually, because these companies are smaller and more agile, some of the time the dynamics can change very quickly. So you really need to see them at the end of their half-year results and at the end of their full-year results.”
Managers should always follow pre-determined fundamental criteria
One of the benefits of meeting every company’s management team, according to Santa Barbara, is that they can find attractive stocks even if some of their metrics don’t seem appealing at first glance.
“There is no way of narrowing that universe down quickly and we tend not to use screens,” he explained. “We certainly don’t use negative screens and, by that, I mean we wouldn’t rule out a meeting with a company based on whether its P/E ratio is too high.
“While we favour good balance sheets, we wouldn’t necessarily rule out a company because of strict benchmarks.”
He added: “In the small-cap space, you need to use a little more art in addition to the science of fundamental analysis.”
Managers shouldn’t keep running their winners
Rather than set a target valuation and automatically sell, Santa Barbara and his team will base their decision to sell on the circumstance of each stock.
“We’re very happy to run our winners and that can mean adding along the way,” he said. “A lot of investors will say: ‘I love that stock and I had a fantastic meeting with them, but I want it 5p cheaper’.
“Actually, a lot of times these are under-researched companies where we may well know the story quite well because they’ve been on our radar since they were very small.
“A lot of the time you need to pay slightly higher multiples because some of these companies do deserve to have premium ratings. There’s nothing better than looking at a list of our trades in a stock and it’s been added to along the way because we gradually understand the revenue drivers better.”
For instance, the fund’s second-largest holding is premium tonic manufacturer Fever-Tree. Since its IPO in November 2014, it has returned 1,229.45 per cent compared to the FTSE Aim All Share’s return of 47. 13 per cent.
Performance of stock vs index since IPO
Source: FE Analytics
“Essentially, what we’re trying to do is look beyond the one-year P/E ratio and assess what the intrinsic value of this is company over the next three, four or five years,” Santa Barbara said.
Every company must succeed due to organic growth
While some investors believe a stock’s success should be down to pure organic growth, Santa Barbara believes carefully-planned mergers and acquisitions can enhance investments further down the cap spectrum.
“Some of our most successful investments have been those that are able to supplement good organic growth in a measured, sensible way,” he said.
“With the cost of debt being where it has over the last few years, these companies have been able to supplement their organic growth with what we would deem to be attractive, earnings-enhancing growth acquisitions.”
The manager argued that, in the mega-cap space, acquisitions can prove to be value-destructive for shareholders.
“Yes, the holders of the equity of the acquired company do well, but there’s enough economic literature to suggest they are vanity M&A moves which don’t add a lot of value to the new shareholders,” he reasoned.
“The difference in the small- and mid-cap space is that, actually, a lot of these companies are able to find earnings-accretive, strategically-enhancing acquisitions.
“This is probably because it’s a big universe and it’s an under-researched space – the same reasons we like them are probably the same reasons why they’re able to find those good deals.”
Marlborough Special Situations has a clean ongoing charges figure of 0.8 per cent.