Unicorn Outstanding British Companies: April 2022 fund update

• Unicorn is a specialist smaller companies investor and we think the group has a real niche in this area
• Chris Hutchinson has a great long-term track record, boosted by his ability to select outstanding businesses
• Recent performance has disappointed, partly held back by the managers’ growth-focused investment style
• The fund was removed from our Wealth Shortlist in October 2021 following concerns about the governance processes that sit behind it

How it fits into a portfolio

The Unicorn Outstanding British Companies fund aims to grow your money over the long run by investing in high-quality UK companies of all sizes, although it invests more in small and medium-sized companies than most other UK funds. We think smaller businesses have great long-term potential, but they're higher-risk. This fund could be added to a more adventurous portfolio, or work well alongside funds focused on bigger businesses.

We removed the fund from the Wealth Shortlist in October 2021 due to concerns about the firm's governance framework, which we believed could have been better at managing investment activities and mitigating risk. We also thought Unicorn carried a high degree of key-person risk, with one individual responsible for a number of the firm's important functions.

Since then, we’re pleased to see that the investment risk function at Unicorn has received more resource which has helped reduce key person risk. Overall, we believe the firm is moving in the right direction, but we want to allow these changes to bed in, and will continue to monitor any further changes.

Manager

Chris Hutchinson has two decades of experience investing in and researching smaller companies. He also has experience managing VCTs (Venture Capital Trusts) which invest in early-stage businesses that need investment to develop and grow. The Unicorn Outstanding British Companies Fund gives him the flexibility to invest in companies of any size, and we think he's done a good job since launch in December 2006.

Hutchinson also manages the Unicorn AIM VCT and serves as a Director of Unicorn Asset Management. These responsibilities have taken up an increasing amount of Hutchinson’s time in recent years, and day-to-day management of the Unicorn Outstanding British Companies fund has fallen to co-manager Max Ormiston. Hutchinson still has oversight of the fund, and gets involved in the bigger decisions, such as new purchases and sales, but we expect Ormiston’s influence over the fund to continue to grow.

Ormiston has been a member of the Unicorn investment team since joining the firm in 2014, and formerly spent four years with Brewin Dolphin where he worked as an investment manager. We think Ormiston is a capable investor, but our original conviction in this fund was based on Hutchinson’s knowledge and experience.

The duo are also supported by the wider Unicorn investment team.

Process

The managers look for five main things in the companies they invest in:

Simplicity – businesses that are easy to understand and sell products and services that customers couldn’t do without. Many of the companies they invest in operate in niche areas, which often go overlooked by larger firms.

Consistency – businesses that have a strong track record of growing earnings, revenues and dividends over the long term.

Transparency – the managers must be able to understand the company's financial accounts in full. They like to see companies stick to what they know and focus on growing their business over the long term. Ideally, they should under promise and over deliver, not the other way around.

Alignment – founders and management should retain a meaningful stake in their own businesses after listing on the stock market. This ensures management teams are more risk averse. They focus on growing the business over the long term and appropriately rewarding shareholders through dividends.

Permanence – they're not looking for businesses that grow quickly in the short term because they're trendy or fashionable. They want to be long-term partners with businesses over a period of five years or more.

Truly outstanding companies are hard to come by, and the managers don’t think there are many out there. They tend to invest in a fairly small number of companies. It means each one can make a big contribution to performance, but it's a higher-risk approach.

Recent investments include industrial software developer Aveva. The managers believe the company has an attractive opportunity to pivot its charging model to include an annual ongoing fee, thereby boosting recurring revenue. In contrast, they reduced an investment in financial services company London Stock Exchange Group following a period of strong performance.

The Unicorn Outstanding British Companies Fund has around 37% invested in AIM-listed companies. We're encouraged that the managers' investments in this area have made great returns for investors over the years and it's a market they know well. But investments in AIM-listed companies add risk and past performance is not a guide to the future.

Culture

Unicorn specialises in smaller companies. Companies will often transition from Unicorn's VCT product, through its Smaller Companies fund and on to the Outstanding British Companies fund as they grow larger. This allows the managers to build strong, long-lasting relationships with the companies they invest in. We think this detailed knowledge gives them an edge over other investors.

Unicorn is a smaller operation than many of its competitors, but they outsource any functions not considered core to managing investors' money, such as sales and marketing. This means managers can focus on their fund management responsibilities. The Unicorn Outstanding British Companies Fund is also smaller than many of its peers in the IA UK All Companies sector. This means it’s more agile and the managers can quickly take advantage of new opportunities as soon as they become available.

The Unicorn investment team has remained stable over the years. Hutchinson and many other Unicorn fund managers are shareholders in the business meaning they're dedicated to its long-term success. Overall we're comfortable that the managers' interests are aligned with those of investors. As mentioned above, we do have ongoing concerns about the risk management framework at Unicorn, though note there have been improvements in recent months.

ESG integration

Environmental, Social ang Governance (ESG) integration has become more of a priority for Unicorn in recent years, as expressed by the company’s decision to commit to the UN-backed Principles for Responsible Investment (PRI) and the Net Zero Asset Manager’s Initiative. Unicorn funds don’t invest in controversial weapons, and avoid oil & gas, mining, gambling and tobacco companies. These companies don’t meet the financial characteristics demanded by the firm’s investment processes and have tended to demonstrate greater exposure to ESG controversies, according to the managers.

Individual Unicorn fund managers are responsible for exercising voting rights for companies held in their funds but their investment processes, which prioritise firms with high quality management teams, means they rarely feel the need to vote against them. Unicorn fund managers meet with company management teams regularly, although their engagement processes are a work in progress. We’re encouraged that Unicorn recently hired a dedicated ESG analyst who will support the firm’s ESG Officer, Alex Game, in engaging with the companies the firm invests in and continuing to develop the company’s overall ESG approach.

Within this fund, alongside their more traditional company research, the managers conduct an ESG review of all potential investments, with input from the firm’s Ethical Officer. If any company fails this review, it isn’t considered for the fund, or any other Unicorn fund.

Cost

This fund has an ongoing annual charge of 0.82%, but we've secured HL clients an ongoing saving of 0.35%. This means HL clients pay an ongoing charge of 0.47%. The fund discount is achieved through a loyalty bonus, which could be subject to tax if held outside of an ISA or SIPP. The HL platform fee of up to 0.45% per year also applies.

Performance

The fund's long-term performance has been impressive. It's significantly outperformed the broader UK stock market since launch in 2006. The managers' ability to select companies with great prospects, regardless of what size they are or industry they operate in boosted returns over this period, according to our analysis. Remember past performance is not a guide to the future.

The past two years have been weaker though. While the fund rose 14.32%*, it significantly underperformed the broader UK stock market, which rose 43.22%. This was partly down to the manager’s growth-focused investment style going out of favour. Instead, investors preferred businesses that are expected to do better during an economic recovery. Basic materials and oil & gas companies, for instance, performed extremely well over the period, and the fund’s lack of exposure held back performance. The managers’ stock picking also dragged on returns, according to our analysis.

There were also some company-specific issues. Marine engineering services provider James Fisher & Sons was one of the weakest performers because of several project delays and a drop in customer demand. It wasn’t all bad news though and a number of the fund’s investments performed well, including Tracsis, a company that provides technical solutions for companies in the rail and transport industry.

While recent performance has been disappointing overall, we're comfortable that the fund has performed in line with our expectations, given the managers' investment style. Overall, we think it's positive that the managers haven't changed their longstanding investment approach, and believe the fund still has the potential to perform well over the long term. Remember all investments fall as well as rise in value, so you could get back less than you invest.

Past performance isn't a guide to the future. Source: *Lipper IM 31/03/2022.

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