Dour Scots dig in for the big freeze

David Stevenson at Ignis sees his UK Opportunities vehicle as a fund for all seasons. But he is picking companies with strong balance sheets to endure a two-year winter in the debt markets.

If it’s feeling cold out there, it’s only going to get colder. According to Cartesian, a Scottish investment manager, don’t expect a thaw in debt markets for as much as two years.

David Stevenson, manager of the Ignis Cartesian UK Opportunities fund, says that earnings forecasts are still far too high, especially in the small and mid-cap sector.

“Earnings prospects are impaired across the market,” he says. “You can’t hide. Our analysis is based almost entirely on balance sheets. You want a balance sheet to get you through the next one-to-two years, and it could take that long to see debt markets unfreeze.”

Stevenson scoffs at the forecasts made by the sell-side analysts. “In the first half of 2008 they still had earnings growth forecasts of 10% and dividend growth to match. Now they are indicating minus 10% and flat dividends. Some of the analysts seem to have only just caught on as to where we are.”

He reels off some of the events of recent months: Lehmans, AIG, WaMu, B&B, Hypo, the Icelandic banks. “The list goes on and on. These are not normal markets.”

The earnings forecasts for small and medium-sized companies are still indicating falls of just 2.5%. “Yet we know the UK is in the worst position of all major developed economies. Basically, we still don’t believe the earnings forecasts.”

Stevenson is a meticulous fund manager. Cartesian is an investment boutique that sprang out of SVM Asset Management, and all the managers there are either accountants or actuaries. “Our default setting is cynicism,” he says.

Cartesian opened in December 2005 and manages a mix of long-only, hedge, 130/30, retail and institutional money adding up to about GBP 600m. “We want to be a one-stop boutique for the UK market,” says Stevenson.

The company is reaching its third anniversary on several portfolios and so far the figures are sparkling. Its hedge fund is up 20% in absolute terms this year and the group is considering a soft close as it approaches GBP 200m in size. Beware, though – minimum investment is GBP 50,000 (GBP 45,000).

But having a top-performing hedge fund does not make Cartesian a black-box, magic-tricks-style fund manager. “We are plain vanilla and proud of it. We have followed the same process for 10 years,” Stevenson says. The process is about developing long/short ideas, identifying stocks where Cartesian has a high conviction about absolute returns. “We are absolutely not benchmark driven,” he says. “You should never be swayed by what everyone else is owning.”

The main retail offering is the UK Opportunities fund. It’s a roam-anywhere fund, with a focused portfolio usually in the region of 30-60 stocks but now with 40 stocks. It is top quartile over one year and is likely to be top quartile (possibly top decile) over three years this month. The bad news is that top quartile means you have just lost lots of money, not all your money. Over one year, investors in the fund have lost 29%, compared with 33% for the sector.

Given Stevenson’s views about the outlook for small and mid-cap earnings, it’s perhaps not surprising that the fund is almost entirely large-cap. Significant holdings include BG, BP, Centrica, National Grid and Serco.

“We look for companies with long-term earnings quality, a strong balance sheet and maintainable funding,” says Stevenson. “People will badge us however they want, but we’re not a special situations fund. I like to think of us as a fund for all seasons, invested on an all-cap basis.”

He likes to examine net debt to ebitda (earnings before interest, tax, depreciation and amortisation), which he says is sustainable if it is in the ratio of 1.5-3. The trouble is, companies were encouraged to gear up their balance sheets to drive earnings and now do not have the balance sheet strength to survive the downturn.

He gives as an example the pub groups, many of which were on debt multiples of two to three but are now on six to seven and will have difficulty surviving the credit crunch. Many face what was probably a predictable cyclical downturn, but now in an era of frozen credit markets. Stevenson also marks out water companies for burgeoning debt levels.

Turnover in the fund is a relatively modest (for such a focused portfolio) 50% a year, so each stock is held on average for two years. “We are longer-term investors. We like to see companies accruing returns on a sustainable long-term basis.”

Launching the fund in late 2005 meant it caught the upswing in markets throughout 2006. But Stevenson admits he was early calling the slowdown. “Markets often rotate through a two-to-three-year cycle. We got the 2006 story. But as 2007 went on our concern about the outlook began to grow. As recently as the second quarter of 2008, markets were still being driven by deep cyclicals – metals, mining, chemicals and so on. We didn’t understand where that mind-set was coming from.”

Stevenson says the signs of a generalised slowdown were evident from the retail sector quite early on. “But the market kept on buying into the international growth and decoupling theory way beyond where we thought it would go. It did mean that the fund was off pace in the first half, but it paid back significantly in the second half.”

He likes National Grid because of the predictability of its earnings – of which 95% are regulated. He points out how even National Grid is having to write bonds at 9% now. “Essentially what we are seeing is a repricing of debt after five years in which it has been wrongly priced.”

Other companies with strong balance sheets and predictable earnings include Tesco and Vodafone, he says.

Maybe the earnings at the oil companies are somewhat less predictable, given the slide in the price of crude, but Stevenson is confident that they will maintain their dividend.

But it’s not dividends that particularly interest him. This fund is not run with a particular yield mandate. It’s because with interest rates now at their extraordinarily low level, the hunt for income will become ever more intense. If there is a place to hide during the recession, it’s likely to be in the dividend payers as everybody else tries to buy into them.