Monthly Report

The Longwave Australian Small Companies Fund increased by 1.9% during August 2022, outperforming the 0.6% increase in the S&P/ASX Small Ordinaries Accumulation Index benchmark by 1.3% over the month.

FUND PERFORMANCE TO 31 AUGUST 2022

1Return net of 0.89% p.a. management fee. 2S&P/ASX Small Ordinaries Accumulation Index. 3Inception date: 31 Oct, 2019. aStrategy inception date: 1 Feb, 2019, gross performance shown. Past performance is not a reliable indicator of future performance, p.a. performance is annualised.

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 26th 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.

 

Portfolio Positioning and Performance

Overall, the portfolio investments performed well during August reflecting the decent results reported and once again it was the last speculative pocket (non-producing lithium stocks) responsible for most of our detractors. Despite getting a brief respite in July, August saw the continued underperformance of the cash burning speculative stocks within the index, mostly contained within technology, healthcare, consumer sectors.

There were some results which are prompting activity across the portfolio – adding to or reducing from names we already hold, as well as some new names that look likely to be added to the portfolio in the coming weeks based upon the fundamental performance we observed in their full year results.

TOP 10 HOLDINGS
FUND AND BENCHMARK SECTOR WEIGHT (%)
STOCK ATTRIBUTION (ALPHABETICAL)
INVESTMENT OBJECTIVE

The Fund aims to outperform the S&P/ASX Small Ordinaries Accumulation Index over the long term.

The Fund aims to provide long term capital growth through investment in a diversified portfolio of highquality Australasian small companies (outside S&P/ASX 100 Index at time of investment or expected to be within six months).

INVESTMENT STYLE

Longwave’s investment philosophy is underpinned by the belief that the stocks of high-quality small companies outperform the benchmark over time, and as such, an active approach to investing in high-quality stocks provides value to investors who might otherwise have invested passively.

Longwave believes in the value of a deep and fundamental understanding of the securities in which we invest.

Disclaimer

This communication is prepared by Longwave Capital Partners (‘Longwave’) (ABN 17 629 034 902), a corporate authorised representative (No. 1269404) of Pinnacle Investment Management Limited (‘PIML’) (ABN 66 109 659 109, AFSL 322140) as the investment manager of Longwave Australian Small Companies Fund (ARSN 630 979 449) (‘the Fund’). Pinnacle Fund Services Limited (‘PFSL’) (ABN 29 082 494 362, AFSL 238371)  is the product issuer of the Fund. PFSL is not licensed to provide financial product advice. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited (‘Pinnacle’) (ABN 22 100 325 184). The Product Disclosure Statement (‘PDS’) and Target Market Determination (‘TMD’) of the Fund are available via the links below. Any potential investor should consider the PDS and TMD before deciding whether to acquire, or continue to hold units in, the Fund.
Link to the Product Disclosure Statement: WHT9368AU
Link to the Target Market Determination: WHT9368AU
For historic TMD’s please contact Pinnacle client service Phone 1300 010 311 or Email service@pinnacleinvestment.com
This communication is for general information only. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.
Whilst Longwave, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Longwave, PFSL and Pinnacle disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information. This disclaimer extends to any entity that may distribute this communication.
Any opinions and forecasts reflect the judgment and assumptions of Longwave and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future. Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information contained in this communication is prohibited without obtaining prior written permission from Longwave. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication. This may contain the trade names or trademarks of various third parties, and if so, any such use is solely for illustrative purposes only. All product and company names are trademarks™ or registered® trademarks of their respective holders. Use of them does not imply any affiliation with, endorsement by, or association of any kind between them and Longwave.
Lonsec Disclaimer:
The Lonsec Ratings (assigned as follows: Longwave Australian Small Companies Fund – assigned October 2021) presented in this document are published by Lonsec Research Pty Ltd (‘Lonsec’) (ABN 11 151 658 561, AFSL 421445). The Ratings are limited to “General Advice” (as defined in the Corporations Act 2001 (Cth)) and based solely on consideration of the investment merits of the financial products. Past performance information is for illustrative purposes only and is not indicative of future performance. They are not a recommendation to purchase, sell or hold Longwave Capital Partners Pty Ltd products, and you should seek independent financial advice before investing in these products. The Ratings are subject to change without notice and Lonsec assumes no obligation to update the relevant documents following publication. Lonsec receives a fee from the Fund Manager for researching the products using comprehensive and objective criteria. For further information regarding Lonsec’s Ratings methodology, please refer to Lonsec’s website at https://www.lonsec.com.au/investment-product-ratings/.
Zenith Disclaimer:
The Zenith Investment Partners (‘Zenith’) (ABN 27 103 132 672, AFSL 226872) rating (assigned Longwave Australian Small Companies Fund – February 2022) referred to in this piece is limited to “General Advice” (s766B Corporations Act 2001) for Wholesale clients only. This advice has been prepared without taking into account the objectives, financial situation or needs of any individual, including target markets of financial products, where applicable, and is subject to change at any time without prior notice. It is not a specific recommendation to purchase, sell or hold the relevant product(s). Investors should seek independent financial advice before making an investment decision and should consider the appropriateness of this advice in light of their own objectives, financial situation and needs. Investors should obtain a copy of, and consider the PDS or offer document before making any decision and refer to the full Zenith Product Assessment available on the Zenith website. Past performance is not an indication of future performance. Zenith usually charges the product issuer, fund manager or related party to conduct Product Assessments. Full details regarding Zenith’s methodology, ratings definitions and regulatory compliance are available on our Product Assessments and at Fund Research Regulatory Guidelines.

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