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I’m looking for the next Lewis Hamilton stock and selling Sebastian Vettels

15 November 2018

Threadneedle UK Mid 250 manager James Thorne compares stocks in the FTSE 250 to the career of two high-profile racing car drivers.

By Jonathan Jones,

Senior reporter, FE Trustnet

A permanent allocation to the mid- and small-cap space has a strong justification for investors but knowing which to buy and which to avoid can be particularly difficult, according to Columbia Threadneedle’s James Thorne.

The manager of the Threadneedle UK Smaller Companies and Threadneedle UK Mid 250 funds said that finding specialists in the area is important when making portfolio construction decisions.

“As a result of having a dynamic index there is a big dispersion of returns which is a great opportunity for active managers that has worked over time,” he said.

Indeed, taking all of the dedicated, actively-managed UK mid cap funds in the IA UK All Companies sector, the peer has outperformed the FTSE 250 over the past decade by 25.05 percentage points.

Performance of sector vs benchmark over 10yrs

 

Source: FE Analytics

Within this, however, the top fund has made 403 per cent while the bottom fund has made 241 per cent – a different of 162 percentage points.

“There is a big difference between the ability of companies and the choice of management and as a result you can add a lot of value in the asset class,” Thorne said.

While investors might wish to look at an all-cap strategy to take advantage of this opportunity, there is a “slight danger” that these managers could make similar mistakes to the market if a stock is popular as they have less time to devote to analysis than dedicated managers.

The funds can sometimes he accused of “chasing what often is an error that the whole market is making in assuming that there are structural trends that are actually cyclical,” he said.

Taking examples from various periods over the last two decades, back in 2000 investors flocked to a technology company called Baltimore Technology when it entered the FTSE 250 at the height of the tech bubble.

“Obviously people were chasing what they saw as a big structural opportunity but it was actually a highly-cyclical moment and if you had invested in Baltimore Technologies you would have lost all of your money from that point,” he said.


Fast forward to the global financial crisis of 2008 when well-known UK bank Northern Rock was sitting at the top of the FTSE 250.

“Everyone was getting very excited about the banking market and stocks at the top of the FTSE 250 but everyone will know what happened there,” Thorne said. Indeed, it is another where investors would have lost all of their money.

Five years later there was the mining bubble and a lot of excitement around the sector, the manager continued.

“Lonmin has not quite gone into administration as it has been saved by the South African government effectively,” he said.

The former FTSE 100 stock has plummeted, losing more than 99 per cent of its value from 2010, when it was valued at nearly £12 to its current share price (at time of writing) of 41p.

Most recently, Paddy Power went into the FTSE 100 a couple of years ago and has fallen more than 37 per cent since its peak in 2016 as that market has matured.

Performance of stock over 5yrs

 

Source: FE Analytics

“We don’t know exactly what is going to happen but certainly that business was put on an incredibly high valuation as people felt that the online market for gambling was going to continue in perpetuity,” Thorne said.

“This will happen time and time again and I believe it can be quite dangerous to make those assumptions that long-term structural trends of what is current now will continue.”

So how can you spot the difference? Thorne said that while the perception is that mid-cap indices are centred around very high-growth stocks and areas of thematic or structural growth, this is not true.

“Nothing goes up in a straight line in markets and that provides opportunities for us,” the Columbia Threadneedle manager explained.

“What we are looking for is companies that have a strong position in their marketplace but quite often will go through periods of significant capital investment or will have growing pains.

“Or where there will be operational failures within a business which will need changes in management as it grows up.”

While not a so-called “petrolhead” the analogy he uses is that of Lewis Hamilton and Sebastian Vettel – two of the best Formula One racing drivers in the world.

Hamilton won his first drivers’ championship back in 2008 with McLaren but had to wait six years before he repeated the feat as champion with Mercedes in 2014.


In that period, Sebastian Vettel won four championships in a row when he was with rival Red Bull, dominating the sport.

“Hamilton was very successful early on in his career and then had a period of soul-searching and things weren’t working out for him,” Thorne said.

This is the same for his businesses, which are often companies with prior success – so that have products or services are already wanted by the market – but are going through that soul-searching moment.

“[Typically] they are investing in their businesses ahead of depreciation, reinvesting profitability during that period. They have high-growth margins but this is not reflected in the profitability of the business because of that investment,” he said.

“A good example of this is Howden Joinery – a dominant player in the kitchen market in the UK – which has just grown nearly 7 per cent in a market that has declined by 10 per cent. That is not, per se, a growth market but where a very strong business model can take significant market share.”

On the other side, you have the Sebastian Vettels – those that have performed very well but could be in for a period of turmoil after poor choices.

“When he was at Red Bull he won four championships in a row. We would have loved to be invested beforehand but, having identified his great talent earlier than that, we would have been a seller during that period,” the manager said.

“Since then he has been seduced by Ferrari and gone to the brand everyone knows and things haven’t worked out.”

With companies, he said he is looking for businesses that have been milking profitability, haven’t been investing enough, have a bottom line lower than their peers – suggesting they are overearning – and are on high valuations.

 

Thorne has managed the £63m Threadneedle UK Mid 250 fund since 2013, with co-manager Philip Macartney joining him in 2017.

Performance of fund vs sector and benchmark since manager start

 

Source: FE Analytics

Under his tenure it has returned 40.89 per cent, beating both the FTSE 250 index and IA UK All Companies sector.

The fund has a yield of 1.1 per cent and a clean ongoing charges figure (OCF) of 0.89 per cent.

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