Focusing on companies that generate good cash-flows, are capital-light and are trading on conservative valuations relative to their peers are some of the secrets of running a successful equity portfolio, according to CRUX’s Richard. 
Pease, manager of the five FE Crown-rated FP CRUX European Special Situations fund, said the key to finding the winning companies has been to stick to the strategy of investing in those that don’t have capital requirements and can generate strong cash streams.
“There is a huge difference between the companies we like and the Carillions of this world,” noted the FE Alpha Manager, who runs the portfolio alongside James Milne.
“It’s very easy to create your own performance in less liquid stocks, but we don’t do that.”
British facilities management and construction services company Carillion went into compulsory liquidation in 2018 after the UK government refused to provide guarantees for the firm’s £900m debts, prompting creditors to withdraw support.
In April 2018, the Official Receiver estimated Carillion owed almost £7bn when it went bust, a figure more than three times higher than that the one given on the group's accounts at the end of 2016.
The insolvent construction company was left with just £29m of cash when it collapsed.
The final report of a Parliamentary inquiry said Carillion's collapse was “a story of recklessness, hubris and greed” and that its business model was “a relentless dash for cash”. “Carillion was unsustainable,” the report added.
Avoiding business models like Carillion is one of Pease and Milne’s priorities, who said they find much better businesses for their 60-stock portfolio when they stick to their convictions and look past shiny sales pitches.
“The big difference between Carillion and some of the companies we own in the portfolio is that many of these have negative working capital, Pease explained.
“Carillion had bad debt but the companies that we buy are really on top of their working capital. In Carillion working capital got out of control”.
Focusing on companies that are cash generative and have a low capital expenditure (capex) is also important, as they noted this usually results in high returns.
Global non-financial capex
Source: Arcadis’ Industrial Capital Expenditure Survey 2017
“We look for is companies with low capex of around 1 or 2 as those are the big consumers of your operative cash-flow,” James Milne pointed out.
“As a result of this low capex, these firms usually have a high return because they usually don’t have much capital that they have to employ. Over the years you get twice the return of the investment,” he added.
Some of the compounding businesses Pease and Milne have among the top 10 holdings of the £2.2bn portfolio include German real estate company Aroundtown, facility services firm ISS holdings, provider of multi-technical services Spie and chemical manufacturer Sika AG.
“For example, we own a Scandinavian outsourcing catering company that has been a great success. It has got negative working capital of 6 or 7 per cent of sales,” Pease said.
“They leveraged under private equity at something like seven times, even having made two small acquisitions and now they are under two times leveraged.
“They are growing quite nicely in terms of underlying profit but in the meantime because the business is so cash generative they don’t need the capital.”
Not only do these companies have negative working capital but Pease and Milne said they are often wrongly priced or go through periods where they de-rate before surprising investors.
“You have to look beyond the next couple of quarters if you really want the compounders,” Pease highlighted.
“We have had one of two quite interesting disappointments in the maintenance or catering outsources, air conditioning, telcos and things like that.
“And one or two of these stocks I think are looking very inexpensive as they have been de-rated. One example is the French company Spie, which we have liked for some time and now has been de-rated.”
Performance of stock over 1yr
Source: Google Finance
However, Pease noted these sorts of stocks could surprise everyone in a positive sense going forward. The key lies in thinking over the long term, as there will always be times when these businesses are “out of tune with the market”.
“We just feel if someone can steel one’s nerves and be patient, you should be very well rewarded on these sort of stories,” the veteran investor pointed out.
“In times like these you get good opportunities because the market is very nervous, I think. If you look at the portfolio we have in the Special Situations fund we have about 60 positions and 18 or 19 of them have been through private equity at some stage but that doesn’t necessarily mean that much.
“But when you go through private equity you tend to get with long leverage and the leverage is typically 6x or 7x the level of debt. Our portfolio is about 1.25x so these companies have been deleveraged but they still generate the cash and, eventually, it is always about cash,” he added.
An example, Pease said, is the fund’s biggest position, the German-listed Aroundtown Property Holdings, which not only has been very successful but is also run by someone whose management style they like.
“The director has his own money in the business and he was pretty upbeat when we met him last time, but the market doesn’t seem to appreciate some of the longer-term potential of this great company,” he said.
“Despite that fact, the company made 50 per cent return last year and it is still not looking expensive.”
Aroundtown Property has a 4.2 per cent weighting in the portfolio.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
FP CRUX European Special Situations is up 50.50 per cent since launch in 2015 compared with its sector and benchmark’s respective gains of 39.44 per cent and 41.64 per cent over the same period.
The fund has an ongoing charges figure (OCF) of 0.89 per cent.