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VT Downing Unique Opportunities Fund (DUO): Some reflections on the first three years
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VT Downing Unique Opportunities Fund - Third Birthday
Three years after its launch, as markets hit their nadir and the UK entered its first lockdown, Rosemary Banyard, manager of the VT Downing Unique OpportunitiesFund, reflects on the challenges businesses and investors have faced, and how the fund has performed over that period.
On 24th March 2023, the VT Downing Unique Opportunities Fund (DUO) celebrated its third birthday. What a time it has been! Launched into the teeth of the Covid 19 pandemic, the fund started life within a week of the bottoming of the market after that first initial shock. This was followed by successive lockdowns, unpredictable swings in government policy, and massive financial injections via furlough schemes and the like. Later came the shortages of components, raw materials, containers and port capacity, and above all labour (The Great Resignation). This, fuelled inflation and drove central banks to raise interest rates to levels which some, myself included, would consider more normal. Throughout this period, the world’s second largest economy remained generally closed for business, while the UK suffered the political turmoil of three prime ministers in a single year. Last, but by no means least, we saw the invasion of Ukraine: the first war in Europe in most of our lifetimes.
Small & mid-cap investment focus
Given such a volatile and difficult backdrop, it is pleasing that the accumulation units in DUO rose by 43.5% from launch to the 31 March 2023. This was a little behind the peer group in which the fund is placed, the IA UK All Companies Sector, where median performance was +46.0%. As a reminder, DUO does not invest in companies with market capitalisations above £10bn, which eliminates roughly the top 40% of constituents of the FTSE 100 Index. DUO’s focus on small and mid-capitalisation companies (our median market cap is about £860m) has been a headwind in the past 18 months against this peer group.
The table below illustrates this, giving DUO’s average weightings by index (noting that one or two names may have shifted between Mid-250 and Small Cap during the period) and the performance of those indices over the three years:
DUO average weighting
Index performance (+)
FTSE100 ex Ics
Mid 250 ex ICs
FTSE Small Cap ex Ics
VT Downing Unique Opportunities Fund (DUO)
Source: FE Analytics 25 March 2020 to 31 March 2023
The table suggests that DUO’s stock selection has been very strong in its chosen markets. This is especially so, given we avoid investing in the highly cyclical sectors of oil & gas exploration and mining. Encouragingly, DUO outperformed the peer group in 20 out of the 36 months since launch.
Positive sector exposure
Our average cash weighting during the first three years was high at 14.8%, and a drag on performance. This can partly be explained by our caution towards deploying seed money in the early months (we took three months to get to over 90% invested in strongly recovering markets). Cash weightings have been easily below 10% for the past year.
Our largest sector exposure has been software and computer services, with an average weighting of 23.4%. Every single investment in this sector has made a positive contribution, with Kainos (digitalisation services for government and corporates) and Alfa Financial Software (leasing software) being the second and third best performers in the fund.
Another strong performer has been financials. We avoid investing in banks because of the opacity of their businesses and the risks emanating from the enormous leverage applied to a thin slice of equity. Our successes have instead been in asset management (Impax AM and Tatton AM) and in platforms (Mortgage Advice Bureau).
The top performing investment, and those that disappointed
The top performer was 4Imprint, which is a leading US platform for sourcing corporate promotional materials. 4Imprint did not lay off staff during the pandemic and the group has been rewarded as business activity has recovered and it has been able to meet strong demand and take market share. It has also delivered significant margin expansion as it promotes its own brands with customers and steadily reduces reliance on Google paid search.
The two worst performers over the three years were James Fisher and XP Power. Both have displayed falling returns on equity and capital employed, coupled with rising levels of debt, and both holdings have been sold. Other disappointing performances came from housebuilder MJ Gleeson, and EKF Diagnostics. The former fell victim to the collapse in mortgage availability after the unfunded Kwarteng mini-budget last autumn, while the latter scored an own goal by reinvesting a “Covid dividend” derived from manufacturing Covid test kits into a poor acquisition, since divested.
The graph below shows the total return of the current holdings in the fund over this period compared to the Return on Average Equity of those businesses.
Source: Factset & Downing LLP, 25 March 2020 to 31 March 2023
The power of compounding interest
It is clear that the highest stock market returns came from businesses with the highest returns on equity, vindicating a key part of our investment philosophy, namely that the market tends to underestimate the power of long-term compounding in businesses with superior returns on equity. It is also clear that some of the weaker stock market performances correlated with respectable but lower returns on equity. Acknowledging that there were one or two weak performances from high return businesses too, we think that Strix was penalised for high debt levels, and Rightmove and Spirent could have been better timed purchases.
We saw few takeovers relative to the wider market, reflecting our preference for investing in businesses with significant management or founder stakes, these being less likely to sell out to private equity and preferring to take the long view. We exited our investment in EMIS, a leading provider of GP and pharmacy software in the UK, following a bid from US giant United Health, and note that this bid is now embroiled in a CMA investigation. We continue to hold speciality chemical producer Elementis, which rejected two trade bids at above the present market price.
There have been relatively few sales, which are usually because of deteriorating returns arising from poor capital allocation decisions by managements in making expensive acquisitions. These sales include Avon Protection, Aveva and Craneware, all of which sit well below the price at which we exited.
Reflecting on the first three years of DUO, we conclude the following: the case for investing in businesses with high returns on equity and little if any debt remains compelling; software remains an attractive sector where the UK is still home to some strong businesses in specific industry verticals, and where the shift from perpetual licenses to software as a service has aided predictability; debt has become more dangerous as interest rates have rapidly normalised (DUO only has six holdings with any net debt at all); and the biggest threat to performance continues to be the erosion of returns on equity by those management teams, often with little skin in the game, who make expensive or ill-judged acquisitions.
Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please note that past performance is not a reliable indicator of future results. Capital is at risk.
This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments. This document contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England No. OC341575. Registered Office: St Magnus House, 3 Lower Thames Street, London EC3R 6HD.