Facing the Quest

The long/short UK equity fund from asset manager Collins Stewart passed its first birthday on 17 January, posting 8.22% returns over its first year in existence, according to the group.

The £10.5m fund concentrating on the UK largest 350 largest firms, has produced the returns against a FTSE 350 fall of 23.81%. The fund aims to produce absolute returns significantly above the risk-free rate.

Stocks that can go into the portfolio are chosen via a strict process using Collins Stewart's proprietary system called Quest, which ranks stocks according to five measures of value, quality and price momentum, and a technical view.

Neil Deacon, who manages the fund with Terry Smith, says while Quest's rankings are also available to external subscribers including hedge funds, Collins Stewart reconfigures its results to provide added value for Collins Stewart's funds. The group runs a European long/short as well asthe UK long/short.

'The first thing we look at is whether the company is one we would like to own or one we should be shorting. Then we ask is it cheap or expensive. Quest gives us a valuation. If a good company is cheap, we look at what markets think of it ' is it going up or down?'

For this final metric, Collins Stewart utilises five momentum indicators, overlaid with a technical view.

Neal Darke, responsible for Quest, which expanded its coverage of 1,030 European and UK stocks to a global remit in January, says Quest uses measurements including P/E ratios and enterprise value to sales, as well as cashflow return on investments (CFROI).

'CFROI grew out of a dissatisfaction with earnings based valuations. We are trying to move from an accounting-based framework to a cash-based one turning earnings-based numbers like EPS and net income into cash flow measures incorporating the amount of capital required to generate those cash flows.'

Using cash flows

The cash flows are then used to discover a net present value, which provides a spot valuation.

'Cash flows are easy to measure and all information is available from public accounts,' Darke says.

'Our definition of quality is cash flow returns, companies beating the cost of capital and with good free cash flow growth and growth expectations. Stocks we do not want are value destroyers at the wrong price. Technical analysis then suggests whether each firm's share price has further to go.'

Combining all this into a portfolio currently half way to holding 100 positions has produced eight positive months and maximum drawdown of 3.57% on 7% annualised volatility against the FTSE 350's 18.2%. The UK portfolio is currently 24% cash and has been market neutral for the last six weeks. Deacon expects to maintain neutrality until direction reasserts itself in the market.

Deacon explains it is the quality of data put into Quest that makes it valuable.

The UK hedge fund managers must go long stocks Quest rates nine or 10 on its 10-degree scale, and short those scoring one or two points.

During 2002 stocks earning nine or 10 points on 24 December 2001 outperformed the market by 14%. Those earning one or two on the scale underperformed it by 8%, according to the group.

Deacon says the system works providing there is not too much human overlay in the selection process. 'You must trust the system even if your instinct does not agree. Nine times out of 10 the system will get it right.'

However, when too few recommendations are generated to fill the portfolio the managers have the freedom to pick stocks themselves.

'This year we have been left with quite a lot of room for discretion because there have not been a lot of long market recommendations and we have had to step into the breach.'

The managers may buy stocks to balance sector exposures or make pairs trades, or may ignore some recommendations.

Deacon does not expect to repeat the profitable 48% net short position of last July ' which neared the maximum 50% net short exposure limit ' 'unless the market moves extremely again.'

The fund can have gross exposure up to 200% of equity, but would normally remain within 110%. No long position can exceed 10% of assets, nor can any short position exceed 5%. The maximum net long exposure is 150%, but typically the fund would be about 100% net long to 30% net short.

If any position moves 10% against the fund the managers must review it, referring to the documentation they prepare on every stock they buy or sell.

If a short goes 20% against the fund the managers close the position completely or buy back to their original position size.

Fundamentals

Fund: Collins Stewart No II Fund PCC

Ltd QUEST triAngle UK

Management company: Collins Stewart Fund

Management Limited

Fund size: £10m

Tel: + 44 (0) 20 7523 4565

Launch date: 22 January 2002

Fund objective: Capital growth

Is the fund still open for

new investors: Yes

Target returns: Significantly above the risk

free rate.

Domicile: Guernsey, Channel Islands

Listing: Guernsey, Channel islands

Administrator: Guernsey International Fund

Managers Limited

Prime broker: Goldman Sachs

Initial fee: Up to 5% of subscription price

Annual management

fee: 1.5% of NAV, payable monthly

in arrears

Performance fee: 20% of amount the fund

outperforms a hurdle based on

one month libor subject to

having made good any previous

underperformance

Denominations

of shares: Sterling

Minimum investment: £50,000, minimum

additional £5,000.

Lock-in for new

investors: No

Regularity of

redemption: Monthly

Notice required for

redemption: 30 days