A look into the engine room of the Mellinckrodt fund shows the systematics of its success

Engine room

I. Engine room

The engine room of a ship is significant as speed and overhead are particularly important for its value. Taking a look into the engine room will give you an impression and facilitate the answers to questions about the aspects of speed and overhead.

For what types of drive are engines available? Are you still sailing or are you traveling with a galley propelled by muscle power? You can’t always tell right away from the outside.

The bridge—the place where decisions are made © RickDeacon/ Shutterstock

II. The bridge

If you want to see the engine room, you first have to go onto, then into the ship. The way to the engine room is at least as interesting as the engine room itself.

You should stay on the bridge for a while before proceeding to the engine room. It is the decision center for all major operational decisions concerning the ship. Captain and steerer, maps, navigation systems, echo sounder, radar and radio—you will all find them there.

In the modern stock exchange world, it is oftentimes difficult to identify the location of the bridge. However, it is very likely that you will—just like on the bridge of a ship—encounter the decision-makers between monitors and phones. At Mellinckrodt, these are the two initiators Daniel Flaig and Georg Oehm.

In the management of the Mellinckrodt fund, there are two important areas of decision-making that are independent of each other:

• Selection based on private-equity approach to achieve returns
• Risk management to protect the capital

III. Private-equity approach as performance machine 

The main task is to keep looking for companies that qualify as an investment for the fund.

Changes in the economic cycle, the politics of the Central Bank, the political development, and social trends constantly change the relative attractiveness of industries, topics, and companies. Active management reacts to this by adjusting the portfolio.

The process is always the same:

• Which industries are attractive today for a term of three to five years—from the perspective of investors who buy entire companies.
• Important trends are identified in the attractive industries. As a result, there are losers but also winners. For this purpose, concrete investment hypotheses are constructed. Stocks are sought with the goal to benefit from these hypotheses.
• Important investment hypotheses are described in our section “On Stocks.”
• Mellinckrodt is looking for “outperformers.” They can oftentimes be identified by their competent owners and managers.
Our own analyses on site, industry insiders and the network that we have built over decades form the basis for our information.
Analysis tools from the field of AI (Artificial Intelligence) complete our information gathering with signals that support our decision-making process.

However, selling is just as important as buying. For this purpose, too, we have a predetermined process that always follows the same pattern:

• Stocks that don’t rise as expected are not averaged down to make the purchase price cheaper but are rather decreased to protect the investors’ capital. We usually only buy additional shares of stocks that develop as expected and continue to hold enough potential.
• We sell stocks that have been in our portfolio for a while without showing a positive market trend.
Regardless of the market trend, the most common reason for selling is that the original investment hypothesis is no longer sustainable. Either because it has realized and the stock exchange has priced the respective potential in or because it is no longer expected that the hypothesis will realize.

© Creative-Material / Shutterstock

IV. Risk management

The key goal of risk management is to maintain the capital of our investors—especially for bigger corrections and in bear markets. It is particularly in these phases that the correlation of the investment increases and the protective effect of the diversification decreases. Stock picking alone doesn’t suffice for the maintenance of capital.

Three assumptions:

1. The most important task of risk management is to always be invested in stocks as little as possible when the overall situation for stocks is unfavorable.
2. It’s not possible to anticipate the future concretely based on a schedule.
3. The information available on a given day is enough to determine whether the market environment on this day is favorable or unfavorable for stocks.

Weather comes in many forms. Vola, vix, and monster waves have special significance in risk management.  © Michel Beno / Amanda Carden / Shutterstock

To stay with the example of seafaring: we can certainly distinguish whether it’s summer or winter, a recession or a storm. But we can’t know, of course, how strong exactly the wind will be in the course of the day and which wind-force can be expected at which hour. Not a groundbreaking insight. But definitely more than the disciples of passive investing believe possible.  For more details, read our article “Volatility, vix, and monster waves” in our section On Stocks.

Risk management is based on firm processes:

  • Daily market observation
    At the stock exchange it’s like on a ship. Calm sea, enough water under the keel, and a motivated crew don’t happen by themselves. If you’re not on site at seven o’clock in the morning, the mice will play, and the money disappears from the table—faster than you can look. When the futures exchange starts trading in Europe at 8:00 a.m., we have already formed our opinion about the state of the market and the resulting necessity for risk management. We don’t trade every day by far, but we always look.
  • Our own risk analysis system
    We, too, have built such a system to generate information regardless of reading and gut feeling on how the state of the market looks from a mathematical, statistical, and technological perspective. The development of the different currencies and industries that are important to us is key. Risks increase and decrease. Corrections come quickly. If there’s no constant analysis of the situation, we can neither decide quickly nor prepare adequately.
  • Perception studies
    This method from the area of Behavioral Finance is an important tool for risk analysis. Here, we analyze market evaluations and sentiments of a small circle of market participants. Because they are always the same people and they are active at the market, we gain valuable insights if relevant market changes are currently building up at the markets or not.

  • Implementation
    Our risk management follows a technical process that consists in dynamically reducing risks in phases of downturn to ensure that the fund price falls significantly less than the market. The low volatility achieved since the launch of our fund shows the success of our methodology.

We don’t like complex hedging strategies. Just like with our process for selecting stocks, we prefer concentrating on few but effective tools for hedging our capital.
We use various measures as tools for risk mitigation, depending on the situation. Selling stocks to increase the cash ratio and the tactical hedging through futures market positions are measures we use frequently. In addition, we shift the currency allocation toward the Swiss Franc in crisis situations and mitigate risks at a topic and industry level.

This way, we were able to significantly limit the decrease in prices in the second half of 2015, which had been triggered by concerns about a slower economic growth in China. The EU referendum in the UK in June 2016 (Brexit) and the election of the U.S. president in November 2016 were also situations that practically passed by the fund price without a trace.

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