Are Concentrated Small Cap Portfolios Superior?

“In May of 1977, I took over the Fidelity Magellan fund. Fidelity Magellan had $20 million in assets. There were only 40 stocks in the portfolio, and Ned Johnson, Fidelity’s head man, recommended that I reduce the number to 25. I listened politely and then went out and raised the number to 60 stocks, six months later to 100 stocks, and soon after that, to 150 stocks.” – Peter Lynch, One Up on Wall Street, 1989.

Between 1977 and 1990 the Fidelity Magellan fund averaged over a 29% p.a return, making Magellan the best performing mutual fund in the world. To outperform the market, sometimes you need to take the path less travelled.

Many people say to us they want their small cap manager to be concentrated. To hold few stocks and have large positions in the best ideas. Portfolio concentration sounds like something that should work – after all, who wants to invest in their 26^th best idea? Is this belief true, or are we telling ourselves a story unsupported by the data?

Active small cap portfolio concentration and subsequent performance is an easily testable idea. Interestingly we found little evidence it has been tested in the most direct way possible – by looking at the performance track records of concentrated and diversified active small cap managers over a long period of time.

We studied over 630 US small cap funds (longer history, bigger sample size than Australia) with at least three years of performance in the Morningstar database from December 1999 to July 2022. We sorted the funds into four groups, from most concentrated to most diversified defined by the percentage of the total portfolio held in the largest 10 positions. The results show that median returns between the most and least diversified funds aren’t all that different. On the single dimension of returns, in this study there is no evidence to support the desire for more concentrated small cap funds. On other dimensions there are differences which may or may not matter to clients – we think they mostly matter. Relative to more diversified strategies, the most concentrated funds deliver the highest variance in manager returns, the worst draw-down experiences to clients (by a large margin), the highest tracking error and the highest fees. It is true, the single highest returning fund was found in this most concentrated group, however there was only one fund out of 632 that was higher than the best performers in the more diversified groups.

The direct translation of this study to Australia is difficult for a few reasons: i) there are far fewer active small cap managers – usually less than 50 in the past 22 years, ii) there is little difference in approach with 80-90% of Australian managers running concentrated small cap portfolios and iii) the diversified managers are mostly purely quantitative or factor-based investors which means any study may confound diversification differences with a quantitative vs fundamental investment approach.

Although we use technology and quantitative methods to enhance our process, Longwave is philosophically a fundamental investment manager. Our portfolio managers have very successfully managed concentrated small cap portfolios and we are agnostic to stock numbers, however to deliver more consistent alpha at lower fees, something we believe our investors want with limited choices available, a more diversified portfolio is more likely to reach this goal.

There are no shortcuts to finding alpha or finding a manager who can deliver it. Whether following Warren Buffett in concentrating or Peter Lynch in diversifying it is skill and process, not an arbitrary number of stocks that matters the most.

Reporting Season Results

Reporting season is always volatile as reality and expectations meet and August was no different. Given the uncertainty around the impact of inflation and interest rates over the next 12 months many companies elected to withhold guidance.

Industrial companies are now our largest sector overweight and one in which we find plenty of diversification given the disparate company exposures. We saw strong results from many holdings such as IPH Pty Ltd (boosted by an accretive acquisition), McMillan Shakespeare and Austal as well as mining services companies. SmartGroup did not fare as well due to a lack of availability of new cars.

Mining services bucked the trend of vague outlook commentary. Monadelphous and NRW Holdings both posted clean results with solid margins and strong cash conversion, belying the labour issues both companies have been dealing with since the pandemic began. Both companies provided strong outlook statements. Tender pipelines have grown in the last 12 months, and all industry players we speak to are consistently messaging that margins for both construction and mining contracts will rise. Monadelphous alluded to being selective in their bidding, a sure sign of emerging tightness in the sector. In addition to posting 41% NPAT growth, Imdex also provided further details on their move into the bulk-commodity drill and blast production market. Imdex have moved to commercialization in-field trials of the technology and are standing up the global business unit to see it through to full commercialization. Success in the drill-and-blast sensor technology they have been developing has the potential to double the business again.

Quite a few of our retail holdings reported results that were in-line or ahead of expectations, including their post June 30 trading updates, such as Super Retail Group, Lovisa, Baby Bunting and Beacon Lighting. A few found conditions more challenging during F2022 including Accent Group and Adairs. With concerns about rising interest rates and inflation crimping household budgets the market is in no mood to look favourably on any of these names – with the exception of Lovisa.

A slow recovery in travel activity due to supply constraints and on-going Covid-19 restrictions in certain regions. Airlines have cut overrides in some markets and transitioned to transaction-based incentives. Based on IATA’s forecasts, full travel recovery won’t be until FY2024. Recovery in corporate travel activity is ongoing and Corporate Travel Ltd has continued to win clients which will grow revenue during later years as travel recovers and should continue to gain share.

Technology stocks were mixed, as companies focused on growing the top line with little regard for profits were again punished (we own none of these), a reminder of the reality that this growth can’t be externally funded indefinitely. Against a backdrop of generally negative sentiment, some companies are quietly going about their business of growing profitable revenue streams organically. RPM Global, Objective Corp, and Codan are good examples.

Stocks that we do not own that performed well included Lithium explorers and developers, Nearmap (received a takeover bid), Tyro and Bega. On the other side, we avoided the downside from the cash burners across sectors such as PPK Group, Red Bubble, Fineos, Kogan, Megaport, Polynovo, Dubber, Siteminder, Betmakers, Telix, Zip, Brainchip, Pointsbet and, Mesoblast, as well as over-leveraged companies such as Pact Group and TPG Telecom.