Investors who place too much emphasis on their biggest five holdings run the risk of having a “maximum allocation at the minimum point of opportunity”, according to Cerno Capital co-founder James Spence.
Spence, who also manages the £136m TM Cerno Global Leaders fund, gives each of the companies in his fund a fair chance at making a meaningful contribution to returns by running an equally weighted portfolio.
When explaining the benefits of an equally weighted approach, he said: “I think the main thing is to prevent self-harm because most equity managers will handicap their horses quite aggressively.
“They may own on average 50 or 60, but they will weight the top-five so heavily that the performance of the whole portfolio is predicated on what the top-five do.”
This means that when a heavily weighted company performs particularly well, managers can often get confirmation bias.
He said: “You start telling yourself how smart you are, that it is one of the biggest companies in the portfolio, and then you start buying more of it.
“You can often find yourself in a position where - as my colleague Fergus Shaw would put it - you have the maximum allocation at the minimum point of opportunity.”
He said this was particularly evident in 1999 in the UK stock market when Vodafone become so dominant in the FTSE 100 index that it became “vexatious” for a UK portfolio manager to underweight it.
Performance of Vodafone between 1998 and 2001
Source: FE Analytics
“I think it's providing less opportunity to trip over yourself,” Spence added. “If you have a long portfolio with a big tail and variable weighting, it's very easy to drop your standards where you ‘quite fancy’ a stock and you bring it in.
“I think in the world of active management, where we're all really under the pump in terms of justifying our reasons for existence and being better than the tracker, you've got to say what you stand for.”
Spence said what he spends most of his time doing is researching and trying to find the few great companies to include in his heavily concentrated global equity portfolio.
With only 24 holdings in TM Cerno Global Leaders at present and a maximum of 30 at any point in time, each company plays an important role.
One feature that quite a few of the companies in the fund have in common is that they are not necessarily that well-known by consumers.
“We're very attracted to companies in industries who are one or two stages, removed from the ultimate end consumer,” Spence said.
“If you think about electronic hardware, we do not own Apple - but we have quite a meaningful investment in the microchip chain through TSMC, through Samsung and through ASML.
“ASML is two stages removed from the consumer because they supply the machines that the chip makers use to fabricate chips.”
When it comes to the industry make-up of the fund, the focus is on finding the leaders, regardless of what the benchmark industry make-up looks like.
“We're looking for great companies, and we don't define what greatness is,” Spence said. “The output really is an impressive return on capital, which is sustained over time.
“That's the common denominator that cuts across all the companies that we own and the companies that we look to do work on.
“We're happy to go most places as long as the economics are good and we can develop a thesis as to the long-term growth of those industries, and then understand how the leader companies have arrived at their point of leadership, and then build a thesis as to whether that leadership can continue.
“The growth rates in the portfolio are quite varied, you have some hyper-growth companies and you have some more modest growers - but we're big believers in the positive effects of compounding over time - compound in revenues, compound in earnings, compound in dividends.”
Spence highlighted how some of the more modest growers in the TM Cerno Global Leaders portfolio have experienced some of the biggest compounding effects because of their long history.
He highlighted Swedish industrial firm Atlas Copco as an example – a firm which has a history that dates back to 1873.
“It has been doing compressors in one shape or form for closing in on 100 years,” he said. “And if you look at its first commercial compressor - it looks nothing like the machines that they make today.
“But they are still compressors and they do essentially the same thing, which is providing augmented power to manufacturing lines of the world.
“Their customer base potentially is any manufacturer of scale in the world. If you go in manufacturing operations are a few common denominators - but one will be the presence of compressors.”
Looking at more nascent trends within the portfolio, one of the latest additions to the fund is auto-parts firm Aptiv.
“Aptiv was created via demerger and what landed up in Aptiv was what we casually refer to as the brains of the modern motor vehicle,” Spence said. “It’s the power systems, it's the electronics, it's the high voltage electricity, it's the safety systems.
“If you think about the car, not of the future, but the kind of cars that rolling off the line today - particularly EVs - that part of the motor vehicle is an increasing share of the cost as we say goodbye to the internal combustion engine.
“Aptiv really has a grip on that segment of the value of the modern motor vehicle and their position is excellent, because they supply almost all the European marks, almost all the US marks and a large portion of the Asian marks.”
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
Since inception in November 2017, TM Cerno Global Leaders has delivered a total return of 68.7 per cent, compared to 53.13 per cent from the MSCI World index and putting it in the top quartile of the IA Global sector.
The FE fundinfo five-crown rated fund has an 0.85 per cent ongoing charges figure (OCF).