The Sceptre UK fund was up 7.6% in December (6.1% after performance fees) versus an FT All Share return of 3.9%. Over the final Quarter the Sceptre UK Fund was up 9.3% (7.8% after performance fees) versus an FT All Share return of 3.7% over the same period.

The outperformance was spread across the portfolio of 14 stocks (reduced from 16 at end of November) with 11 stocks gaining (+4% to +16%) and 3 stocks falling (-2% to -4%). We sold 2 stocks in the month as they reached our price targets and increased the weighting of 2 core holdings that have underperformed over the Quarter – these changes were our only real trading activity during the month.

The fund ended the month with the top 5 stocks making up 54% of the portfolio and the top 10 stocks making up 84% - so we continue to run a very concentrated and focussed fund. We believe that we hold a very balanced portfolio of highly cash generative businesses which are undervalued by the market and are not closely correlated to each other.

Our Stock Valuation Method

Our focus for stock valuation and portfolio construction at Sceptre is on expected “free cash flow”, expected growth and our current valuation of these factors – stock weightings are allocated according to the “best upside” opportunity and then adjusted to compensate for the added risk of stock liquidity, “certainty of expectations” and time horizons.

Free Cash Flow is defined as cash available after payment of interest, tax and all maintenance capital expenditure but before expansion capital expenditure, dividend payments or any stock buy backs – ie the cash that the business generates in a “steady state”. Our estimates are drawn up conservatively and we will frequently use different scenarios which lead to different cash flows so that we can test our assumptions.

Expected Growth is based on a qualitative review of management plans (both current and historic) overlaid with expectations for industry growth, market share and historic trends. Often our growth expectations are reduced to flat or GDP+ to give us a “worst case” valuation of a stock.

Our top 2 holdings are both trading at about 7x our expected free cash flow and we have assumed no real growth in this cashflow – ie we are expecting at least a 14% return on these investments over the medium term. Our 3rd largest holding has had the same senior management in place for over 15 years and has averaged 5%+ organic growth and 10%+ total growth over the past 5 years. It is the European market leader and is continuing to add capacity as competitors fail and sell their manufacturing operations for book value (or less). Whilst we expect growth in cashflow to be around 10% pa for the foreseeable future we have assumed only 5% growth in our valuation. When we bought this stock it was trading at about 10x free cash flow and is growing at about 5% pa. – ie we have a 10% cash “yield” on our initial investment which we expect to grow at about 5%+ pa.

We hold an insurance stock in the portfolio (a Lloyds Underwriter), which is a good example of a ‘highly undervalued’ stock that is held with a lower weighting than its ranked valuation would have given it, on account of our assumptions of stock specific risks. Whilst the stock is trading at about 5x expected free cash flow and is growing at about 5% pa there continues to be limited visibility on the “quality” of the underwriting, vulnerability to significant disasters (both natural and terrorist), stock liquidity (market cap. <£200m) and an overall reliance on the current senior management to allocate capital astutely. So, instead of this being a 15% to 20% weighting it is a 6% weighting and our only insurance stock in the 14 stock portfolio.

We hope that this short summary gives some further insight into our approach – if you would like more detail please let us know.

All the best wishes for a healthy and profitable 2006.

Chris Broadhurst
CEO