The Sceptre UK Fund was down by 0.7% in August which compares to a fall of 0.9% in the FT All Share index. In the last two months the index has fallen by 4.2% whilst the Sceptre UK Fund is down only 0.2% – this is further confirmation of our robust, value based approach of investment which leads us to construct a concentrated portfolio of well managed companies that generate solid cashflows from real (tangible) assets. The strict adherence to investing with a “margin of safety” means we buy companies that comfortably generate enough cash to cover interest on (conservative) debt, have scope for share buybacks, have defendable margins (through brands or technology) and keeps our portfolio away from expensive companies.

August has been an unusually busy month for us with the market volatility allowing the investment of 6% of our cash weighting during the period, with additions of 1% to each of 3 existing holdings (on price weakness) and the establishment of a new holding with a 3% initial investment. We have also been busy revising our buying targets for companies that have been on the “buy list” for some time but whose prices have been too “expensive” for us. Whilst many valuations have become much more realistic, in our opinion, there are still a very limited number of “cheap” stocks available and we remain very comfortable with the current cash holding of 19% in the fund. This is not a target or limit and we will be very happy to invest all this cash as soon as we identify more companies that meet our investment criteria, or indeed should there be further weakness in existing holdings within the fund.

You probably know that we do not invest based on macroeconomic issues or normally give our opinions on them but, given the extraordinary market activity and volatility of the last two months, we would like to make a few observations on its likely impact on the equity market and our investments.

John Kenneth Galbraith wrote: “Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”

It is clear that all structured notes are (eventually) secured on a real asset but it is the fact that many of these have been leveraged by a factor of 10x that has helped create a bubble in the financial markets that we are starting to see unwind. Since the world economy bottomed in late 2002 we have seen a flow of borrowed capital into the markets that has taken equities (in many markets) and commodities to record levels and led many investors to believe that leveraged beta is really value adding alpha. The fall in volatility (and hence potential returns) has encouraged further leverage and quantitative funds to grow to massive sizes so that they can magnify small movements into acceptable returns for investors. This quest for profits has encouraged pension funds to now hold assets and asset classes that they would not have held 5 years ago and for some to sell many “real” assets to invest in structured notes, swaps and hedge funds in order to reduce pension fund volatility by Liability Driven Investment (LDI). The search for the much needed alpha has required yield enhancement on fixed income holdings and driven demand for more structured products that has led to “black boxes” producing higher yields for investors in instruments with the same credit ratings – a “free lunch” that went unquestioned by many but now is starting to raise questions of the credit rating agencies.

August has seen bailouts for many leveraged funds from blue-chip companies such as Bear Stearns, Goldman Sachs, HBOS and Barclays and more will probably follow as short term financing for these leveraged funds is more and more difficult to put in place (mainly due to the questionable longer term holdings within the funds). There is now a back log of $500bn in IPO’s, corporate bond deals and junk bond financing and a contracting US housing market that will doubtless lead to slower US economic growth and the consequential impact on world economic growth. This slowing economy together with the less accommodative capital markets may well lead to similar problems in the credit card loan and car loan markets with mirrored problems in their associated CDO structured products.

Many of our companies have net cash on their balance sheets and the others have a conservative (tax efficient) level of debt and interest payments that are well covered by real free cashflow. It is almost a year ago that it started to be more difficult to find candidates for the fund and it is exciting to think that some long awaited bargains may become available. At present there is not too much on offer but further volatility over the next few weeks and months could hopefully allow us to put the 19% cash to work and become fully invested.

As always, if you have any questions on our approach or performance, please let us know.

Chris Broadhurst
CEO