Jumping on investment bandwagons linked to future trends, being too clever with spreadsheets and not holding businesses that can endure short-term pain are common mistakes by equity investors, but Troy’s Sebastian Lyon highlights how his process avoids these pitfalls. 
The FE Alpha Manager’s £2.8bn Trojan fund is built around ‘four pillars’ of blue-chip stocks, index-linked bonds, gold and cash. The holdings reflect his view that we are in a secular bear market, which has been running since 2000 and leaves no room to be overly confident on equities.
Nonetheless, the manager does have 11 per cent of his portfolio in UK stocks and another 28 per cent in international equities. In the following article, we take a closer look at the process that Lyon uses for these equity holdings.
The manager’s process has paid off over the long run, with the Trojan fund being the IA Flexible sector’s best performer after making a 202.41 per cent total return since its launch in May 2001. It has also doubled the return of its FTSE All Share benchmark over this time.
Performance of fund vs sector and index since launch
Source: FE Analytics
What’s more, the fund is the best performer in its peer group when it comes to a host of other metrics such as alpha generation, maximum drawdown, risk-adjusted returns as measured by the Sharpe ratio and annualised volatility.
Here, we look at some of the investing mistakes Lyon avoids, thereby boosting the fund’s performance profile.
Trying to predict future trends
Investing in equities often demands some forecasting of the future but Lyon argues that “over-optimism and extrapolated trends” have the ability to wreck significant damage to returns.
“Over the years I have been chastised at investor meetings for not doing what seemed so obvious at the time. Why not ‘buy into’ the Chinese penchant for luxury goods? Or why don’t we ‘get exposure’ to the shale boom in the United States? Isn’t biotechnology a great way of ‘playing’ ageing demographics?” he said.
“These phenomena were all real enough but jumping on bandwagons, often long after they have left town, is not our way of doing things. Today’s big winners frequently become tomorrow’s losers. When high values are ascribed to growth it invites fresh competition and disappointment will usually ensue extraordinary profits are eroded away.”
The manager adds that he prefers to look for evidence of longevity and pricing power in companies, not themes they may be exposed to, as he considers this to be a more reliable indicator that future cash flows will be sustainable and delivered to the investor.
The following table shows the top 10 holdings of the Trojan fund; it’s clear that gold aside, it focuses on defensive blue-chips that are leaders in their markets and not significantly exposed to ‘faddy’ or speculative trends.
Source: Troy Asset Management
Doing overly complicated analysis
“The introduction of Microsoft Excel in the 1990s has much to answer for,” Lyon said.
While spreadsheets allow analysts to dig into businesses’ financial performance in great detail, he argues that they have also “spoilt” analysis by giving what seem like exact answers to often vague questions.
“Anyone with a basic knowledge of arithmetic can build a complex valuation model in a spreadsheet. In our experience, however, it is preferable to be roughly right than precisely wrong,” he added.
“Investing is more art than science and we do not spend our time modelling discounted cash flows to generate specific share price targets. This is not a matter of idleness but is, rather, an endeavour to avoid overconfidence that we have the perfect answer.”
Troy Asset Management instead pays greater attention to “more rudimentary valuation methods that stand the test of time”, such as price-to-earnings ratios, free cash flow and dividend yields. However, even these metrics are second to judgements about factors like the sustainability of firms’ business modes, the value of their brands and the quality of management.
“We are long-term investors. The qualities we seek are permanent rather than temporary and compounding over decades trumps short-term ‘catalysts’.”
Becoming friends with management
Lyon and the other fund managers at Troy meet with the management teams of their holdings after each company’s year-end and following ‘results season’, but say the benefits of such research are often “overstated”.
“Some managements may give a rose-tinted view of their business and are less likely to point out weaknesses or risks unless they are already well known. Some see it as their task to market their shares to investors rather than aid the advancement of our knowledge,” the FE Alpha Manager said.
“There is always the danger of getting too close to management but becoming emotionally attached to a stock. Objectivity must be retained; shares do not know that you own them!”
Paying more for less
When meeting with management teams, Lyon is keen to discuss capital allocation as this is the area were management decisions have the most potential to create or destroy value for shareholders.
One thing he watches out for is decisions to carry out share buybacks that do not seem to be informed by “special and rational insight” into the value of companies and their prospective returns.
The proportion of non-financial S&P 500 corporates’ cash spent on share buybacks has increased from 8 per cent in 1990 to 27 per cent today. Much of this has been attributed to low interest rates, as it has allowed firms to buy their own stock with cheap debt.
But Lyon is not a fan of the practice, on the whole, given the high valuations being seen in many parts of the equity market.
“Buying back shares at excessive valuations, whatever the cost of financing, will generally yield unattractive returns on the capital invested. The error not only impairs future growth and lowers corporate returns on capital, it also contributes greatly to the clear deterioration in balance sheets.”
Source: Troy Asset Management, Bloomberg as at 26 Jan 2016
“An increase in corporate borrowing rates and/or a decline in profitability will render these debt levels less affordable, hurting earnings all the more. Such is the outlook for equities at a point when valuations are at cyclical highs. Investors are being asked to pay more for less.”
Selling on short-term pain
“We seek to invest in companies that are strong enough to endure pain without incurring long-term damage to their businesses or even their share prices,” Lyon said.
He illustrated this with the example of Nestlé – a Troy holding since 2009 – which went through a difficult 2015 because of underperforming divisions in the US and Asia, as well as the negative impact of currency fluctuations.
Added to this was a high-profile health scare that led to the withdrawal of its Maggi Noodles line from India, where the company has an 80 per cent market share. This cost Nestlé $67m and the brand was relaunched after it emerged that the tests leading to the recall were “highly unreliable”.
“The overall damage to Nestlé was minimal – temporary share price falls of a few percentage points at the time of the product withdrawal and a steady recovery thereafter. Whereas lesser companies would have stumbled, Nestlé’s broad portfolio of brands, financial strength and robust management meant a crisis passed with no lasting effects.”
