The FE Alpha Managers say that more cyclical sectors have benefited from the recent rally, leaving behind the quality companies that are the cornerstone of their particular management style.
"Quality companies are trading at their least expensive multiples since 2009," Cross said.
As a result, the five crown-rated Liontrust Special Situations fund has lagged its peers over the last 12 months, picking up 17.55 per cent while the IMA UK All Companies sector has gained 26.66 per cent. The FTSE All Share made 22.93 per cent over this period.
Performance of fund vs sector and index over 1yr
Source: FE Analytics
However, Fosh says this lag is to be expected.
"There’s been a violent recovery in cyclical shares and weak performance from quality, which was expensive but is less so now," he said.
Cross added that the last year has been tricky for the pair, since a rally in value stocks combined with a surge from UK domestic shares left many of their quality, globally focused businesses out in the cold.
"The last year has been the toughest environment for this kind of style," he said. "However, when you look at the longer term and include even our worst year, I still feel the process delivers over the cycle."
This is borne out over the longer run as the managers’ flagship £1.1bn fund has made 186.81 per cent over the last five years, well ahead of both the sector and index, which gained 105.68 per cent and 100.91 per cent respectively.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
Another reason the pair think that quality is the best route to take in the current economic environment is fear over what will happen when interest rates do, inevitably, start to rise.
So while cyclical companies have seen a stellar rally of late, the managers believe this is a dangerous place to be in.
"Interest rates are going to be rising. I wouldn’t want to back bad balance-sheet companies in a time when interest rates are rising," Fosh said.
He adds that the rally has been more sentiment-driven than based on fundamentals, pointing out that there has not been a big uptick in earnings revisions for UK companies.
Fosh and Cross follow a strict, three-pronged investment style, looking for companies that have specific economic advantages – intellectual property, distribution networks and recurring income.
Fosh says companies that fall into the intellectual property category, such as GlaxoSmithKline, are based on know-how.
These companies have patented products that no-one else can make, which means they have cornered the market in that particular area.
The second characteristic they look for is a strong distribution network, with companies that are able to disseminate their products around the world efficiently and at a low cost.
"It’s been 100 years in some cases of companies building up unrivaled global distribution programmes," he said.
Finally, the pair look for recurring revenue, which means the company has a stable, repeatable process that can deliver over the long-term.
One of the fund’s favourite stocks, GlaxoSmithKline, has come under criticism recently because its most recent drug push, Darapladib, failed to reduce the risk of heart attacks and strokes in the first of two Phase 3 clinical studies.
The stock has underperformed the FTSE over the past six months.
Performance of stock vs index over 6 months
Source: FE Analytics
Still, the managers think the long-term income-generating prospects for the blue chip firm are strong.
"Glaxo is most normally thought of under intellectual property, but it also has big distribution strength," Fosh said.
"It has found it harder to find its own blockbuster drugs, so it has used its sales force to distribute other people’s products."
"Glaxo has failed to find blockbusters and growth levels have been low and disappointing, but if you focus not on earnings but on return on capital, they have managed to keep the return on capital high."
A high return versus cost is another cornerstone of Fosh and Cross’s philosophy.
They highlight that Glaxo, though it has borne the brunt of negative news, has managed to consistently deliver high returns on capital while a firm such as International Consolidated Airlines Group has only once in the last decade returned more than it spent.
A similar principle holds true for banks, where the pair have yet to find any real value.
Barclays is one clear-cut example. While the firm performed very well against its costs prior to the financial crisis, it fell to pieces when the market tanked.
"What is interesting about Barclays is that even on forecast it’s not projected to get back to a positive return on equity in the next year. Despite the fact that returns are improving, there aren’t any investable banks yet," Fosh said.
The managers stress that they are looking for businesses with recurring revenues and while firms such as Barclays made quite a bit of money in the good times, the pattern is unlikely to be repeated.
Liontrust Special Situations requires a minimum investment of £1,000 and has ongoing charges of 1.88 per cent.
