On Christmas Eve Morningstar, an investment research and management firm, reported that it was stripping the LF Lindsell Train UK Equity Fund of its gold rating.
The fund, managed by Nick Train, missed out silver and went straight to bronze. Below bronze is a neutral rating, and below that, negative. A successful fund with a superstar manager falling down the rankings will undoubtedly bring to mind the Woodford fiasco, but this is different.
The Woodford Equity Income Fund got into trouble because its manager changed his strategy. Instead of focusing on large, cheap, and quality companies, Neil Woodford started to fill his fund with more speculative bets in smaller (even unlisted) companies. Cyclical companies began to gain favour over the defensive ones that had dominated the portfolio in the past.
Investors in the Woodford fund were no longer getting what they paid for, but this is not the case with the Lindsell Train fund.
Sticking with the plan
Nick Train started the LF Lindsell Train UK Equity Fund as a concentrated (20-30 stock), low-turnover portfolio of consumer goods, media, and software companies and stock market proxies, and this has not changed.
Given the strategy of investing in a small number of companies, large position sizes are unavoidable. As such, the risk of the fund is relatively high because one mistake is relatively costly. To mitigate the risk of concentration, Nick Train invests purposely in companies that generate a lot of cash, and that don’t need to invest heavily in plant, property, and equipment to keep going.
We come now to the reason behind Morningstar downgrading the fund. Because it has been successful (since inception it has returned 372% versus the benchmarks 121.2%) the fund now handles £9.5bn of investor money.
A victim of its own success
Since the fund invests in such a small number of stocks, the position sizes are large. For example, the fund currently has a stake of around 10% in RELX or about £950m of the £9.5bn in total assets. The daily average value traded in RELX shares is around £6.2m, which means it could take something like 150 trading days to unwind the position.
If the fund had £1bn of assets, a 10% stake in RELX (£100m) might take 16 days to unwind. Morningstar’s concern is that the fund has become too massive; it manages too much money to keep investing in a small number of stocks.
The Lindsell Train and Woodford funds share an issue with liquidity; the difference is that the former has a problem because of sticking with a successful strategy, the other developed the problem from not following one.
Morningstar does not take issue with the Lindsell Train fund’s strategy, but thinks it may be hard to carry it out effectively if it continues to grow, and stakes get larger and larger.
Closing the fund to new investors would solve the problem, but fund management thinks it can accommodate up to £12.5bn, and so it may continue to grow. If it does, would Morningstar downgrade it to neutral?
The fund is still performing well. Last year it outperformed its benchmark by almost 20%, and a bronze rating means the fund is positively rated. For now, I would continue to recommend the fund, if you like the approach it takes, but read the reports it issues, and be alert for any change in style.