Liontrust European Absolute Return Fund research update

While Western economies remain burdened with too much debt, economic growth looks likely to remain low and stock market volatility high. In this environment Gary West and James Inglis-Jones, managers of the Liontrust European Absolute Return Fund, favour companies with self-sustaining earnings growth, or which are returning cash to shareholders via dividends and share buy backs.

The single source of self-sustaining earnings and cash returns to shareholders is cash flow, according to the managers. They developed the Liontrust Cashflow Solution, a mathematical model which aims to identify companies with strong cash flow which they believe are likely to beat investors' low profit expectations.

As well as investing in companies they believe have strong prospects, the managers also seek companies with weak cash flows where they believe profit expectations are too high, and take 'short' positions aiming to benefit if their share prices fall.

They match the short positions with an equally-sized number of long positions. This net 'neutral' positioning means the fund's returns should be uncorrelated with stock-market movements, although depending on the performance of the underlying holdings the fund will sometimes have a bias to more long positions and vice versa. This approach places greater emphasis on the skill of the managers and if they make the wrong calls the fund will fall in value.

The fund's approach has not been successful recently. Stock markets have been driven by political machinations rather than the prospects for individual companies. Government stimulus, such as quantitative easing, caused investors to seek out lower-quality, more economically sensitive companies in anticipation they would bounce strongly as governments tried to boost economic growth.

In response to the poor performance the managers reduced exposure to lower quality companies on the short book. While such companies might have poor cash flow and weak balance sheets, they have appeal to other investors and can bounce strongly during stimulus-driven stock market rallies.

On the long side focus remains on companies with strong cash flow. Exposure to oil & gas companies has been increased, with Swedish-listed exploration and production company Lundin Petroleum featuring in the top 10 holdings, for example. They are also positive on brewer Anheuser-Busch InBev, which owns brands including Budweiser, Stella Artois and Beck's, which customers buy again and again, enabling the company to remain cash generative, even during harder times.

Since the fund launched in July 2009 returns have demonstrated low correlation to the stock market. Nevertheless performance has been disappointing. The fund has fallen 2.5%, compared to a rise of 2.7% for its benchmark, 3-month LIBOR.*

*Source: Lipper Hindsight. Past performance is not a guide to future returns.

This fund charges a performance fee of 20% on returns in excess of 3-month LIBOR (please refer to the KIID for further information). While interest rates and LIBOR rates remain low they do not present a significant hurdle for fund managers to beat. Furthermore with inflation remaining high there is a risk fund managers can be rewarded for beating a low benchmark while reducing the purchasing power of investors' capital overall. This is potentially an unattractive fee structure and is something investors might wish to bear in mind.

We believe the managers have a robust process in place, but it relies on investors focusing on the prospects of individual companies, favouring those growing their earnings and cash flows; and selling those with declining cash flows and earnings downgrades. While stock markets continue to be driven by political machinations and wider economic issues the process is likely to struggle. Over the long term we believe the fund's strategy should reward investors, and it remains on the Wealth 150 list of our favourite funds in each sector.

Shorting - an explanation

Traditionally investors buy assets they believe will rise in value. Shorting is different. The principle is that the fund manager borrows shares he believes will fall in value and then sells them, hoping that by the time he needs to repay the lender the share price will have fallen. The difference between the two prices is the profit or loss. For example:

1. Manager borrows 10,000 shares and sells them for £2 each = £20,000.
2. Purchases these shares six months later at 80p each, cost = £8,000.
3. Profit = £12,000.

Had the share price risen by the same amount, it would have cost more to purchase the shares than received from selling them, resulting in a £12,000 loss. Shorting can be effected in a number of ways; fund managers generally short via contracts with a broker rather than actually taking delivery of the shares. This example also ignores transaction and other costs, but it hopefully explains the principle.