Investment Idea: Nutshell Growth Fund

 

Many moons ago—the late 1990s, to be exact—I got a tad obsessed with stock screening. I’d spend hours assembling a vast list of screens and then unleashing them on the market. These screens varied in nature; some were value-driven, others momentum and growth. Each had myriad metrics embedded within them, and I’d spend many happy hours (!?!) updating these via systems such as Sharepad (or Sharescope, as it was then known).

 

This unhealthy obsession even found its way into print via the Investors Chronicle, where we launched a dedicated Stock Screening Newsletter for slightly nerdy types like myself. God, it even ended up in a book for the Financial Times which, at one point, allegedly cost hundreds of pounds to buy second-hand (Smarter Stock screening was the name of this magnum opus).

 

Now, reflecting on my earlier obsessions, I’ve begun to see a link all the way through to my more recent interest in exchange-traded funds or ETFs. What interested me all those decades ago was the idea that one could be

 

1) Systematic in stock selection

 

2) There were some screens that worked better in different markets than others i.e. there is no magic, one-size-fits-all all route to investing success

 

3) You were removing the emotion from investing and

 

4) You weren’t over-reliant on analysts’ reports and forecasts

 

Scratch away the veneer of quantitative reasoning, and I think I was already articulating an inherent suspicion of what one can call idiosyncratic stock selection risk. In simple language, I was deeply worried by the way that active fund managers took all sorts of weird risks based on hunches, projections, and guesses. This drew me to stock screening and its ruthlessly numerical or quantitative way of looking at markets.

 

If one used the language of economics, what interested me was quantitative investing and factor-based investing, i.e., picking out factor metrics to screen through a market. Over time, this idea of factor investing emerged into the mainstream of investing via exchange-traded funds or ETFs. The first iteration was smart beta – ETFs that screened a market using either single factors (value, momentum) or multiple factors. Whole fund management firms such as Research Affiliates/RAFI and Ossiam emerged to champion these fundamental factor ETFs.

 

But smart beta never really took off with mainstream private investors – they remain popular with big institutions – because there was something missing in the mix: the human sitting at the centre of the quantitative machine. Yes, it’s great to remove emotion and subjective forecasts from the process of selecting stocks, but you still need humans to do three vitally important things:

 

1) To manage top-down risk

 

2) To make sure that the models and systems still have relevance and don’t need tweaking and, finally

 

3) To trade the positions efficiently and cheaply

 

Most smart beta ETFs have faded away or have very little money invested in them because many mainstream investors worry about this lack of humans in the machine. But factor-based investing is still a great idea—it removes emotion, lets the numbers speak, and helps reduce costs by not overpaying for an active fund manager and their company sports car.

 

What’s emerged is a middle ground, usually run by hedge fund managers. They employ systematic factor models but build in human-controlled risk management systems and then overlay human-based trading capability (knowing how to size trades) to implement the strategy. These strategies come in all shapes and sizes, with the most common being relative value investing. It works and makes many hedge funds a great deal of money, but it’s mostly not available to private investors.

 

Back in the less rarified world of funds aimed at private investors, a version of this systematic investing has emerged in what I call the School of Quality. Well-known fund managers such as Terry Smith or Nick Train run big funds that are fairly systematic in their approach to finding what they perceive to be quality stocks with real growth potential at reasonable prices. Some call this the quality factor, though others think that quality is too undefined to qualify as a factor (there are quality ETFs, by the way). Jamie Ward over at Sharepad has a great article critiquing many quality approaches – you can read it HERE.

 

Quality as a factor is much debated, but in reality, you’re probably looking at a combination of the following metrics:

 

- High operating margins and highly profitable

 

- Decent balance sheet- Positive share price momentum

 

- Reasonable valuation metrics given the growth potential

 

- Some moat of competitive advantage

 

- Probably, the need for a liquid stock and decent visibility of finances pushes you towards more mid to large-cap stocks

 

Cynics will mutter that this sounds a bit like cakeism for investors: a bit of value here, a bit of growth there, add a bit of momentum, and they’d probably be right. Some economists, as I have already noted, doubt that quality investing is a factor, while plenty of commentators have noted that quality investing is so elastic that it can include huge swathes of the market.

 

Nevertheless, the intrinsic underlying appeal of quality doesn’t need explaining. Who doesn’t like great world-class businesses whose shares aren’t overvalued? At this point, my old concerns about idiosyncratic bias and emotion creep back in. I worry about the lack of rigour and the degree to which emotion and attachment to stocks come into play, and I hanker after the cold, unsentimentality of the hedge fund versions that aim to be rigorously systematic.

 

Cue an interesting, relatively new boutique manager called Mark Ellis and his Nutshell Growth fund. Mark’s background is a classic mix of banking prop desk trading - 25yr+ NatWest Markets and Citibank – plus long stints at fund managers such as Symmetry Investments. But Mark has also fallen hook, line and sinker for the school of quantitative systematic investing and drunk deeply from the fountain of factor investing, even penning his academic paper on the subject while doing a post-grad degree in quant finance. 

 

In a rather unusual move, Mark abandoned hedge fund land and is now offering his systematic process to retail investors with some help from a City grandee – his new Growth fund was seeded & supported by the Family Office of Lord Michael Spencer, the founder of ICAP. The strategy was incepted in January 2019 & over three years, has consistently outperformed global Quality/Growth peers – it is classic quality factor investing with a bias towards growth stocks but with a rigorous top-down risk control process overlayed.

 

Nutshell Growth : Process

 

Mark’s approach is to avoid the behavioural biases of traditional fund managers. Inside his black box, he has built a proprietary model that includes 30 different factors based on his original research published back in 2004. These measures include classic quality growth metrics such as high return on equity (RoE), high Profit Margin and strong share price Momentum, and valuation measures such as P/E, Free Cash Flow Yield, and Expected IRR. In the technical language of factor investing, Nutshell Growth is biased towards Size, credit strength, quality and profitability and slightly biased to momentum.

 

To manage risk, Ellis has a series of metrics based on capital preservation, including something called minus beta, which measures how companies perform relative to the index on down days. There’s also an in-house, proprietary Recession Indicator.

 

As for implanting these metrics, the Nutshell approach starts with over 10,000 stocks, uses classic metrics to win them down to 600 stocks and then uses the factor model to end up with a shortlist of 200 stocks, which are closely monitored over many years. This shortlist is also subject to various exclusions such as China risk (see next idea) and, more obviously, a detailed ESG screen. Mark is a big fan of ESG screens, me less so – so the less said on this score, the better!

 

The last element is what’s called agile rebalancing i.e the portfolio is actively traded (turnover on an annual basis is well over 100%). This sizing of bought-in positions and managing selling stocks marks this fund out from investors such as Nick Train, who historically sit tight in their positions for long periods of time. This could sound an alarm bell for many investors in terms of extra trading cost but Ellis says his trading background means that only a few basis percentage points are added to costs. He also points out that the historical beta of the fund has “been considerably lower than indices and most peers – we have run with less risk”.

 

So, in simple language, you’re buying into a systematic, quality, and growth global equities fund that is very active in stock selection and managing downside risk, with an additional ESG overlay if that’s your thing.

 

It's more expensive in terms of fees than a quality ETF, but you have much more active manager involvement than an ETF, and the newish fund has built up a more than decent track record in comparison to its actively managed peers such as Fundsmith and Lindsell Train. The high turnover also distinguishes this fund from many of its quality peers, such as Fundsmith and Lindsell Train (who manage vastly bigger sums of capital). But I would argue that the Nutshell strategy is vastly less idiosyncratic and personalised!

 

Fund details: Nutshell Growth Fund

 

· Description: A concentrated portfolio of exceptional companies at reasonable valuations

 

· Top ten holdings (end July) at 60% of portfolio: Alpha Group International, Arista Networks, Alphabet, AutoZone, Fortinet, Fortnox, Hermes, Meta Platforms, MSCI, and Nvidia

 

· Launched 18/5/2020

 

· Current portfolio: 60% US, 10% UK, Consumer discretionary 29.7%, IT 29.4%, Financials 21.9%

 

· Portfolio characteristics: PE 21.6, free cashflow yield 3.7%, Return on equity 42%, average beta 1.08

 

· Fees: Institutional Founder (0.85%), Institutional (1.00%), Retail (1.15%)

 

The graphic below lists companies that found their way in to the Nutshell screens over time.

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