For BMO Capital & Income Investment Trust, we have always said we pick our stocks and manage our portfolios on the basis of our micro, stock-relevant assumptions and not with regard to broad-brush, macroeconomic assumptions, believing these are most often either inaccurate or just irrelevant to individual stock performance. If we had known at the start of last year what we know now, we would definitely have had a different balance in the portfolio, yet I think many of the companies we invest in would have remained the same.
Let me explain
Our assessment of companies is across three dimensions: quality, management and price. Taking these characteristics in turn, by quality, we look to judge (amongst other things) the returns a company has made in the past, the variation of those returns, the predictability of future returns and how the returns are converted into cash.
We assess the management of the company: are they operating in shareholders’ best interests, are they well aligned financially with shareholders by existing equity holdings and the incentive structure, are they proven allocators of capital? Although the crisis has been profound, with the roll-out of the vaccines, we can be certain it is finite and therefore, for the majority of companies, the assessment of these first two characteristics will be largely unchanged.
What did change during the crisis, however, was the third component: price. The wild swings we saw in share prices allowed us to make a number of changes to our holdings that have been very profitable. This is best shown by the example of our two largest investments, OneSavings Bank and Intermediate Capital.
OneSavings Bank is a niche lender, primarily of Buy to Let mortgages. It has consistently generated returns on equity of over 20% – multiples of those achieved by the UK’s mainstream banks. It has not achieved these by taking excess risk; its mortgage defaults have historically been very low, and the average mortgage loan to value ratio has been less than 70%. Despite the worst economic collapse in 300 years, the housing market has again defied bearish predictions. The quality is good and we like management; its move to merge with Charter Court helps to diversify the business and will bring cost reductions, which will improve future returns. OSB’s share price at around 420p is little changed on a year ago, having fallen dramatically in the first quarter of the year and subsequently recovered. The confidence we had in the quality of the business and the management team led us to buy a further 600,000 shares at less than 240p / share in late March.
Intermediate Capital is a long-standing investment in the portfolio, going back to 2009. Over this time, the management teams have progressively transformed it from an interesting, specialist proprietary investor to a much higher quality, better balanced, less geared and faster growing business through the development of its third-party investment management operations. We initially built our holding as the company came out of the Global Financial Crisis, and with the knowledge of how resilient its operations had been then, we had the confidence to add a further 200,000 shares to our investment in March 2020 at an average price of 710p / share compared to its share price at the start of 2020 of 1640p. The subsequent strong recovery in the share price led it to finish 2020 at 1726.
Test and retest
Importantly, for all companies in the portfolio and our watch list of potential purchases, we regularly test and retest our assessments of their quality and management and re-run our valuation models. But for both OneSavings Bank and Intermediate Capital, we believe the test of last year will show they are companies of extraordinarily high quality with strong management, and furthermore we believe they are still considerably undervalued.