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Profile: Cerno Capital on avoiding the allure of index hugging

Profile: Cerno Capital on avoiding the allure of index hugging
The credit crunch held little fear for Cerno Capital managing partner James Spence.

As the former head of BNP Paribas’ Indonesian brokerage business, he had already experienced first-hand the devastation of the Asian financial crash in 1998, which saw equity valuations fall for external investors by twice as much as they did in 2008.

‘I had a front-row seat for what was the most devastating crash the world had ever seen. The Indonesian stock market fell by more than 90% in dollar terms,’ Spence recalls.

‘I had responsibility for the office, the profit and loss account and the team, trying to advise very nervous investors. There was a lot of political upheaval and it was a very bracing experience, but also very shaping.

‘All crises are different, but when the financial crisis came along in 2007-08, we had the background of having worked through crises before and our decision making was calm and not panicked. It was a bit like being in a fire with a room full of smoke – you need to know the way out.’

Spence speaks fondly of his time spent working abroad, and the contacts he made there ultimately laid the foundations for the launch of Cerno.

After graduating in philosophy and logic from St Andrew’s University, he went on to train as a chartered accountant, working in the City through the Big Bang.


Later, armed with the qualification, he worked briefly in Australia before joining brokerage WI Carr in 1991 as an analyst in its Hong Kong office.

‘There were a lot of outstanding minds and characters at the firm and I learnt equity investing from my colleagues. It was a time when institutional investors from all around the world were putting money to work in Asia and I was working with a lot of managers from long-only to hedge,’ he says.

‘Working in Asia, your exposure was probably higher than it would have been in London. You got a lot of responsibility early and there were great opportunities for advancement.’

The 16 years Spence spent in south east Asia took in a variety of senior roles, including stints at both HSBC and UBS. He moved back to the UK in 2007 where Sloane Robinson co-founder George Robinson put him back in touch with Nick Hornby. Spence had known Hornby in Asia, when he worked at CLSA.

The pair went on to found Cerno in 2008 and after making the switch from the sell-side to the buy-side, they had strong convictions about the type of business they wanted to run.

‘We both wanted to create a firm focused on multi-asset investing with a very strong service ethos at the heart of it. We were keen to work in an unconstrained manner in a world of benchmark huggers,’ he says.


‘Our approach from the very beginning was to appeal to a broad section of the investment community and not address any part of it exclusively.’

Spence said they took a ‘conscious decision’ to invest in external funds, both long-only and hedge, alongside passives and direct equities on a case-by–case basis. They are supported by a team of three analysts and use a decision tree methodology to identify the best way to execute their views.

‘We justify our exposures relative to expectations of future returns on a three-year forward basis. Forecasting the future is very difficult, but it doesn’t mean we shouldn’t try,’ he says.

‘This means as investors we are much more strategic than tactical.

‘We never consider ourselves underweight or overweight because we don’t feel the need to hold something for the sake of it.

‘We are very diverse. As long as liquidity permits and the rationale is good, we’ll go there. We are the antithesis of the firm that has UK,
US and emerging market silos.

‘There is a certain logic in thinking geographically, but you need to challenge that and see if there is a better way of doing it, not being subject to sovereign borders or MSCI components.’


The firm runs three funds. They comprise: TM Cerno Select, its flagship product, which acts as the model for its private client portfolios, alongside EF Unconstrained, an offshore sister fund and EF Pacific & Emerging. This taps into the firm’s specialist knowledge of the region.

The Select fund was launched in September 2013, but the strategy has been running since October 2007 and has delivered just over 10% annualised returns over the last three years. Its capital preservation qualities are evident, as it managed to cap losses at -4.1% in 2008, the year when several global indices slumped by 40%.

‘All our investors have expectations of returns. We try to deliver a positive return that meets their needs but also protects against the downside,’ Spence says.

‘Over the last three years it has returned 10.1% net of fees per year but with downside capture of under 50%.’

Although still a relatively small boutique with £352 million of assets under management, Cerno has built up a diverse client bank, which includes two of the colleges at Oxford University, family offices, charities and endowments, intermediated funds, as well as Sipp and ISA money.

When launched, the firm attracted considerable interest from several high profile investors, several of whom are shareholders and sit on its external investment advisory committee as non-executive partners.


‘When we formed the business it attracted some capital from a number of people interested in what we were doing and more critically, they lent us their reputations,’ Spence says.

He describes the committee as a ‘contextual sounding board’, which brings together ‘managers of different stripes’. The members comprise high-profile fund picker and Oldfield Partners executive chairman Richard Oldfield, Sloane Robinson co-founder Hugh Sloane, Jupiter fund manager Miles Geldard and Russell Napier, the well-known stock market historian and global equity strategist.

At the same time, Cerno set up an advisory board that focuses on business development and the company was able to attract a number of luminaries, ranging from Robinson  of Sloane Robinson, venture capital expert Nicholas Morland and Sian Hansen, the latest recruit, who is an executive director of the think-tank the Legatum Institute.

In many ways it is unsurprising that Cerno has piqued the interest of such a diverse range of impressive intellects. Spence speaks with an authority when explaining his current conviction and a quick scan of the company’s client investment letters reveals a wit and eloquence when explaining their positioning.

Underlining the flexibility of the core product, Spence said his current net equity exposure is 55%, having ranged from 10% to 90% historically, while underlying sterling exposure has been anywhere from 40%-90%.


His single largest exposure is to Japan, which has been a conviction play since 2012, but he recently rotated out of active to passive exposure, tracking the JPX 400 index. He brands it a ‘self-referencing’ index that incorporates quality and governance when choosing its components, so providing the beta exposure he wants at a lower cost.

‘We have reduced our US exposure because the current valuations reflect the fact that forward expectations are not as good as they have been for the last few years,’ he says.

‘We are invested in the US financial sector which is a late cycle play and two merger arbitrage specialists. Our UK balance is lower than it has been because we are genuinely concerned about the political prospects.’

Elsewhere, the fund has little exposure to emerging markets. Spence says that despite the time he and Hornby spent there, this has not resulted in a ‘pronounced bias’ in the way they invest.

‘It also gives you a level of scepticism,’ he adds.

A growing portion of Cerno’s core Select fund is held in its ‘global leaders strategy’, which identifies the best companies in each sector globally.

‘It is an important part of everything we do,’ Spence says. ‘We have a thesis that companies with a strong market position, which could be a duopoly, and positive margins will on average sustain those margins longer than economic theory might suggest.’


The team has developed a screening process, which excludes both deep cyclicals, such as miners and energy stocks, and highly leveraged companies, ruling out banks. By setting a five-year average earnings per share growth target of over 5% per year, the screen actually whittles down a universe of 744,000 to a more manageable 808, where qualitative screens can be used.

The goal is that the strategy will own the top 20 of these names. It currently holds 13 and comprises 13% of the Select portfolio, but this will rise as the number of so-called ‘leader stocks’ goes up. ‘Once we get to 20, it will be one in one out,’ Spence says.

Demonstrating the merits of the approach and the kind of companies it has identified, he notes that the average return on equity of the global leaders stocks currently held is 24% compared with an average 9.5% for the MSCI AC World index. And on valuation terms, they are trading on an average price-to-earnings ratio of 20.8x versus 17.4% for the index.

‘If you can find an attractive entry point, then it is a good way to get derisked growth,’ he says. ‘You are paying 15% more for more than double the returns, so you can access quality for a very low premium.’

Examples of companies held include Novo Nordisk and Visa with Spence stressing it is not about brands, but about ‘what makes companies good’.


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