PR OFILE
Kernow’s average holding period for longs is anticipated to be about three years, Wood is not the sort of investor who will carry on holding positions through unlimited volatility. Running a hedge fund strategy reflects a defence threshold in terms of risk and loss tolerance, informed by years of experience. The risk process will tend to run winners and cut losses at a portfolio level. In March and April 2020, net exposure came down to as low as 20%. “When a crisis happens correlations spike to one and carrying a shield makes sense. In March 2020, we had one day down 8% and hit a drawdown of 12% after the market had dropped 34%. The instinct to batten down the hatches harks back to his personal investing history: “In bear markets I have always kept losses down to 15%. At a 10% drawdown I start cutting risk and can take time to reassess the market and earn back my risk premium. I lost 15% just after August 2007 and in hindsight I got out early, but I was also saved from being wiped out as the Great Financial Crisis swept the world. Capital preservation is key for long-term outperformance”.
Once the dust has settled however, Wood has the dry powder to come back: “After March 2020, we steadily rebuilt the book and had a stellar November 2020, up over 20%. Gross exposure, which rose towards 130%, and net past 70%”.
Market inefficiency The valuation of UK equities will ebb and flow – but the inefficiency of the market is a constant that Kernow expects to exploit throughout cycles. Wood argues that the UK equity market is dominated by short term quant traders, and closet trackers, each of which creates different sorts of inefficiencies: “The short-term quant traders are not buying companies. They are buying short-term assets and are trying to get ahead of other investors. Companies have no engagement with these agents. The closet indexers talk a good game but just follow the trend to keep their jobs. Both agents mean companies can have stock prices a long way from
their fundamental value. Trends and swings are exaggerated firstly by behavioural reasons and then extended by market participants’ business models. There are just not that many responsible owners out there so price discovery is uneven today. The efficiency of capital markets is also hampered. The reason for investment management is for financial markets to move money from those who have acquired wealth to those who have a productive use for it. If most of the intermediaries are not focused on this endeavor it will function less efficiently. We capture a small part of that inefficiency and the market pays us for fundamental price discovery over time”.
A repeatable process Kernow’s three-stage stock selection process is repeatable and robust: “We determine valuation, based on a football field approach using multiple metrics such as DCF, scenarios, comparable discounts, money multiples, buyout valuations, and margin analysis. We then monitor a watchlist for valuation gaps, and investigate reasons for discounts, which might relate to analyst coverage, shareholder registers or structural factors. We are seeking under-reactions or over-reactions and need to see a clear reason for mean reversion. An example would be a pub business priced to go bust in the pandemic that could double or triple investors’ money if the business model survives. The third ingredient is a catalyst for the mean reversion, which could include dividends, buybacks, re-capitalisations or M&A. Catalysts are partly time weighted so a near term catalyst one month away will be given a higher weighting than a catalyst one year away,” says Wood.
Some parts of the process are automated: “We make good use of technology and programming to support or refute fundamentally produced investment theses, monitor our existing investment portfolio and to generate new trade ideas. In the past when I was Head of Equity Research at a
boutique investment bank, some of these activities would have taken hours of my time, now they take just a few minutes,” says Hugo, who studied maths, AI, microsystems and nanotechnology. The research process also includes painstaking human input for management meetings, channel checks, and site visits where possible: “Away from the typical existing management contact, we also chat to corporate finance advisors, PRs, the last FD, last Chairman etc to get the real nuts and bolts of how the business is run. We research the shareholder register and sell side agenda. The full due diligence process adds up to hundreds of hours for each company and is ongoingly time consuming as catalysts and news-flow are constantly re-assessed,” says Wood.
Mid cap sweet spot Kernow can invest across all cap sizes above GBP100 million, in the LSE’s Main Market and AIM. In January 2021, the average long market cap was GBP4 billion, and shorts were smaller at GBP1 billion, but the size balance will move around opportunistically. The sweet spot for longs is often mid-caps: “They grow on average twice as fast as GDP, and often get taken over whereas for UK large caps the dividend yield has often been the main source of returns. Mid-caps also have scale, in terms of their operations, coupled with a low level of investment bank research,” says Wood. All sectors are covered, and Hugo has special expertise in alternative energy, agriculture, technology, metals and mining, and oil and gas sectors, which he covered in previous equity research roles.
As expected, Kernow has a somewhat non- consensus tilt to its sector exposure, born out of its fundamental analysis. Today, it is overweight retail and underweight technology, a few years ago it would have been overweight energy and underweight consumer staples. “We do not target specific sectors; the causality runs from bottom to top,” says Wood.
BECOMING A B CORP
ESG also applies to Kernow’s own CSR (corporate social responsibility). “We are becoming a B Corp, and we expect this will become like Fairtrade for coffee especially for newer funds and younger generations. It will become a default choice for firms thinking about ESG factors and is already very big in the US. In financial services it is more difficult to become a B Corp. We want to show our commitment. We believe that the B Corp requirements are more proactive than the quasi- regulatory UNPRI approach. They cover internal processes and policies, hiring, remuneration, supply chains, and self-assessment. Our shareholders, board, clients and prospects are all intrigued by it,” says Makris.
Long ideas In March 2021, Kernow is underweight of resources in general, though there are some exceptions, such as a Russian steelmaker. “It is a high quality, low- cost producer, with a well incentivised management team. It was under-priced because the City disliked the remuneration structure and there was uncertainty over the dividend,” says Wood.
General insurance appeals as a sector because Wood envisages a multi-year hardening of insurance premiums whereas the market is discounting only an ephemeral spike. He also ranks it as the cheapest sector in the market. Stock picks include a large cap
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