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Blue Whale Update: How Blue Whale views and manages risk

Stephen Yiu - Blue Whale Fund Manager Stephen Yiu is the Chief Investment Officer at Blue Whale Capital and Lead Manager of the Blue Whale Growth Fund.
Stephen co-founded Blue Whale Capital with Peter Hargreaves, co-founder of Hargreaves Lansdown, in 2016. The Blue Whale Growth Fund was launched in September 2017 and is a long-only global equity fund focusing on developed markets.
Stephen adopts a high conviction, active approach based on bottom-up, fundamental research.

When Odysseus, a hero of the Trojan War, sailed home through the Strait of Messina, he was warned to do so with great caution, for on both sides of the strait lay danger – a six-headed man-eating monster on one and a giant whirlpool on the other. Odysseus navigated the passage cautiously through the middle and delivered the ship and crew closer to home and safety.

We find this to be an apt metaphor for managing a portfolio of 25-35 holdings in the stormy seas of global equity markets. There are many risks and dangers that lurk around a surging market rally. Therefore, to deliver consistent significant outperformance successfully, we must navigate the choppy waters with hard work and discipline.

What is risk?

Volatility is not risk

Many professional investors take volatility as an indicator of risk; our view is quite different.

Firstly, share price volatility is hardly ever an indicator of company quality. As owners of Adobe and PayPal, if we had managed risk by simply looking at volatility then we would have established only small positions in these high quality businesses or sold out of them long ago – to the detriment of our investors.

Secondly, volatility can be a good thing, providing opportunities to buy high quality companies during short-term depressions in price.

Lastly, in the pursuit of limiting volatility via diversification, one often ends up with returns no better than a passive index fund.

How Blue Whale views risk

Quite simply, we define risk as a permanent loss of capital.

A permanent loss of capital can occur at the company level (bankruptcies, fraud, mismanagement etc.), industry level (technological/creative disruption) and at the market and macro levels through critical changes in economic output and political interference.

By viewing risk as the danger to outperformance from an irreversible loss of capital, we can better focus on how to manage and mitigate it.

How Blue Whale manages risk

We start by accepting, like in the Serenity Prayer, that there are things we cannot change.

Throughout the history of markets, there have always been testing periods when share prices went sideways or down. We accept that we cannot predict or control these years of lean market performance. If an investor sold their holdings during these times, they could well recognise a permanent loss of capital.

However, as long term investors, we believe that staying invested is the best way to ride out any storm. Although we cannot guarantee positive performance forever, we have developed a risk management framework to help us through turbulent times.

The North Star of our framework is our understanding of risks and their likelihoods. For risks where outcomes are clearer, we manage our exposure through our in-house fundamental research and our strict valuation discipline:

By investing in only high-quality businesses, many company-level risks are simply eliminated through our in-house research process: we do not invest in companies and industries that are getting disrupted (conversely we like the companies doing the “disrupting”) or experiencing weakening competitive position; we do not invest in companies with high debt or potential cash flow problems; nor do we invest in companies that are weak on corporate governance and where there is little or no alignment between management and shareholders. This means that high quality companies, even if they have highly volatile share prices, are actually less risky.

For macro-level risks, we are not in the business of second-guessing the Bank of England or the US Fed so we focus on what is within our control, namely: stress testing our companies’ balance sheets and cash flows through recessions and adverse scenarios; speaking with company representatives to ascertain the impact of geopolitical events. In short, we develop a thorough understanding of the impact of macro risks on our portfolio holdings and we act accordingly.

For market-level risks, we exercise a strict valuation discipline. We do so by assiduously monitoring industry and market developments with the aim of ensuring that market prices do not run significantly ahead of company fundamentals. When we see a company’s valuation getting frothy, we will reduce the holding and channel capital into other, less expensive, high quality businesses. If the market itself becomes frothy, we are not averse to increasing our cash holding.

For risks where there is more uncertainty, we can choose to either eliminate, accept or reduce our exposure. For example:

  • We decided to eliminate our COVID risk exposure through IHG because the return to revenue and cashflow growth in the business was highly uncertain.
  • On the other hand, in the case of Mastercard and Visa, we decided to accept the COVID risk coming from reduced cross-border travel spend as this would be partly mitigated by an acceleration in online and digital card payments.
  • We decided to reduce our exposure to market risk in the case of Amazon, which had rallied significantly on the back of strong eCommerce revenues during the pandemic. We exercised our strict valuation discipline and took the company out of our top 10 holdings in Q3 2020.

Our risk management framework, like our research process, is straightforward but not easy. It is, however, absolutely necessary if we are to continue charting a course to delivering consistent significant outperformance for our investors.

Dealing with Uncertainty through 2021 and beyond

The classical scholars out there will be quick to point out that Odysseus didn’t get past the dangers completely unscathed – he’d lost six of his crew to the six-headed monster perching on one side of the cliffs in the Strait of Messina. However, therein lies the lesson in risk management: the rest of his four-dozen men and the entire ship sailed through, achieving Odysseus’s primary objective.

Though young, many in our team have experienced multiple market cycles, and we therefore accept that not all our holdings will be perennial outperformers. We are aware of the risks and uncertainties out there. However, we prefer to be decisive in the face of uncertainty rather than be paralysed by it. We accept the risks, and we take action to manage, monitor and mitigate them with all the tools we have available to us. That’s what active investing is all about.

2020 has certainly been a year full of risks and dangers but we are glad to report on successfully delivering outperformance for our investors. In 2021 we will take the example of Odysseus with us – cautiously navigating the route ahead of us, remaining vigilant and with the aim of continuing to deliver consistent significant outperformance for our investors.

LF Blue Whale Growth Fund is manufactured by Blue Whale Capital LLP and represented in Malta by MeDirect Bank (Malta) plc.

Blue Whale Key Risks & Disclaimers:

The opinions, data, and analyses presented herein is issued for information only by Blue Whale Capital LLP (“Blue Whale”) which is a limited liability partnership incorporated in England and Wales under number OC414255. Blue Whale is authorised and regulated by the Financial Conduct Authority (“FCA”).

The contents presented herein are based upon sources of information believed to be reliable, however, save to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to its accuracy or completeness and, Blue Whale, its members, officers and employees do not accept any liability or responsibility in respect of the information or any views expressed herein. All data is sourced from Blue Whale unless otherwise stated.

The contents herein may include or may refer to documents that include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. The views we express on holdings do not constitute Investment Recommendations and must not be viewed as such.

There are significant risks associated with investment in the Fund referred to herein. Investment in the Fund is intended for investors who understand and can accept the risks associated with such an investment including potentially a substantial or complete loss of their investment.

Past performance is not a guide to future performance. The value of investments and any income derived from them can go down as well as up and the value of your investment may be volatile and be subject to sudden and substantial falls.

Investment in a Fund with exposure to emerging markets involves risk factors and special considerations which may not be typically associated with investing in more developed markets. Political or economic change and instability may be more likely to occur and have a greater effect on the economies and markets of emerging countries. Adverse government policies, taxation, restrictions on foreign investment and on currency convertibility and repatriation, currency fluctuations and other developments in the laws and regulations of emerging countries in which investment may be made, including expropriation, nationalisation or other confiscation could result in loss to the Fund.

Income from investments may fluctuate. Changes in rates of exchange may have an adverse effect on the value, price or income of investments. Fund charges may be applied in whole or part to capital, which may result in capital erosion. The Authorised Corporate Director may apply a dilution adjustment as detailed in the Prospectus. The Fund is not traded on an exchange or recognised market.

The foregoing list of risk factors is not complete, and reference should be made to the Fund’s Prospectus, KIID and application form.

MeDirect Disclaimers:

This information has been accurately reproduced, as received from Blue Whale Capital LLP. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

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