The manager says that investors need to dig a little deeper when looking at why funds underperform, because he feels in the long-run buying poor quality, highly indebted companies that are witnessing a rebound will come back to haunt them."There is almost one single cause for our underperformance and that is because we haven’t held Thomas Cook," Beal (pictured) explained.
"We calculated that not holding Thomas Cook has cost us around 400 basis points [4 percentage points] this year."
"We would never hold a company like that because it specialises in a very congested industry that is subject to changing macro conditions."
Performance of trust vs index year to date
Source: FE Analytics
"It also has a very over-indebted balance sheet and the management team had to hold a fund-raiser to raise capital."
Thomas Cook recently dropped out of the FTSE 250 and into the FTSE Small Cap index. A recent surge in the share price means that it now makes up a hefty chunk of the manager’s benchmark.
"You get big companies like that, like Yell in the past, which have run into cyclical or difficult financial situations and fallen from the FTSE 100 and FTSE 250 indices into the small cap index. Thomas Cook now makes up 1 or 2 per cent of the index, which is very unusual."
"Once they have fallen into the index, often their share price bounces back. But I would never hold a company like that, because of the lack of quality," he added.
Thomas Cook had a disastrous 2011, but since the second half of last year the share price has bounced back by more than 400 per cent.
Performance of stocks over 5yrs
Source: FE Analytics
Multinational directories and services company Hibu – formerly known as Yell – saw an initial jump in its share price when it fell out of the FTSE 250. However, it was all downhill from there, and it has now lost more than 98 per cent over a five-year period.
Dunedin Smaller Companies IT has been the fourth best-performing trust in the IT UK Smaller Companies sector since Beal took over, in December 2005.
It has returned 120.64 per cent over this time, beating the FTSE Small Cap ex IT index by 88 percentage points.
Performance of trust vs index since Dec 2005
Source: FE Analytics
However, so far this year Dunedin Smaller Companies has returned 5.47 per cent compared with 16.02 per cent from the index.
Beal says that his strategy involves looking for quality companies with strong balance sheets that can grow into larger companies over time – not recovery stories.
"My strategy is the same as the Aberdeen investment process, which is built on buying the best-quality businesses we can find, at the best valuations," he said.
"However, the valuation part always comes second and I would never want that dynamic to turn around. Those criteria usually mean taking a three- to five-year view on a company, but a vast amount of the holdings in the portfolio have been there for 10 years."
"There is an element of running your winners and we won’t necessarily sell if a company grows out of the index. The only FTSE 100 stock we hold is Weir Group; we bought it when it was a small cap but we feel it is still attractive, so we will continue to hold it," he added.
He says that as a company’s valuation always comes second, he will continue to avoid Thomas Cook for the foreseeable future.
"I recently had a meeting with the share holders and the board and as I was explaining why the trust had underperformed, they stopped me and said: 'We would absolutely expect you not to hold Thomas Cook and we would hope you would never hold a company like that'."
"The shareholders said that they wouldn’t want me to sacrifice the trust’s long-term performance by chasing returns from poor-quality businesses, so it is good to supported by shareholders that are like-minded," he added.
Jason Hollands (pictured), managing director of business development and communications at Bestinvest, highlights the importance of judging fund managers in the long-term – particularly those that focus on sectors such as UK small caps.
"Beal has a good long-term record and the trust has consistently beaten the FTSE Small Cap ex IT index since he has been manager," he said. "You clearly don’t want to form a negative view on a fund’s long-term performance from a short period of underperformance."
"Investors do need to look a little harder at a fund’s performance; however the problem with this industry is that managers can be judged over a short period, when in fact they are focusing on the long-term."
"Styles can go out of favour, especially when managers focus on smaller, less liquid companies and have a buy-and-hold mentality, whereas managers who are more active traders outperform," he added.
While Beal is steering well clear of Thomas Cook, other high-profile managers are taking a very different approach.
FE Alpha Manager Mark Barnett counts it as a top-10 holding in his Perpetual Income & Growth Investment Trust and Steve Davies recently told FE Trustnet that he was buying the company for his Jupiter Undervalued Assets fund.
In total, 10 open-ended funds and four investment trusts hold Thomas Cook in their top-10.
Dunedin Smaller Companies is trading on an 8.01 per cent discount to its NAV, which is slightly narrower than its three-year average. The trust is geared at 3 per cent and has ongoing charges of 0.98 per cent, but it does implement a performance fee.
Beal also runs the Shires Income trust.
