Australian Small Companies Fund

Monthly Report

The Longwave Australian Small Companies Fund increased by 0.1% during April 2022, outperforming the 1.5% decrease in the S&P/ASX Small Ordinaries Accumulation Index benchmark by 1.6% over the month.

FUND PERFORMANCE TO 30 APRIL 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.

Surviving Hope Mountain

There is a very good reason why 99% of people who have climbed Everest have done so with supplementary oxygen. Above 8,200 metres (the summit is almost 8,900m) the lack of oxygen in the air starts to effect both the body and the brain. A lack of oxygen starts to impair thinking, cloud judgement, cause hallucinations or result in people taking risks they shouldn’t. Like climbers need for oxygen, we think investors need to remember when judgement may become clouded and avoid unnecessary risk. Focusing on quality within small caps is like investing with a supplementary oxygen bottle.
If bull markets climb a wall of worry, bubbles scale a mountain of hope
In more normal markets investors focus on the grounded fundamentals of company performance – balance sheets and current cash flows. As share prices rise, the focus moves more to earnings far in the future. Prices march higher and earnings either disappear or fail to explain the current share price – so we move to “valuation”. We use quotation marks here, because the valuation methods deployed have almost nothing in common with what we learned in textbooks (given we left balance sheets and cashflow behind a long time ago). Investors start to talk more about sales multiples or LTV to CAC or simply saying the words “we think the stock is cheap” with no evidence at all can sometimes justify the investment case.
Higher still and in the absence of oxygen, hallucinations and unwise risk-taking grips the investor. All we have left is hope.

Quality is the Oxygen Protecting Investors During a Bubble

Hope comes in the form of Themes (like SaaS or Electrification or Artificial Intelligence). Hope comes in the form of a huge Total Addressable Market (TAM). Hope comes in the form of an amazing product, a unique person, or a compelling idea.
In combination with sound fundamentals, strong tailwinds from a theme, a large addressable market and amazing products and people can result in incredible investment outcomes. But if hope is all there is, investing feels weightless. If you feel like “nothing more than a single narrow gasping lung, floating over the mists and summits” you probably need oxygen (quality) before you lose all your money.
We know how the story ends. Turns out this time is not different. Over the past few months hope based investing has come crashing down to earth.
One of the primary culprits of this collapse was slowing liquidity growth – which will soon turn to a full-blown liquidity contraction as interest rates rise and central bank balance sheets reduce. For companies and investment processes to be sound and deliver through the cycle, they must be able to withstand this withdrawal of liquidity.
What can we do as small cap investors? Can we generate positive returns when a bubble bursts?
Many people point to the tech bubble in 2000 and its aftermath as an analogy of investing during a bursting bubble and lessons for investors in 2022. And it is a good one to look at. But for Australian small cap investors, we have another example that is more recent and happened in our investment universe.
The commodity bubble that ended in Dec 2010.

Quality is how we Outperform a Bursting Speculative Bubble

After the 2010 commodity bubble burst, the Small Ords total return index went sideways for six years. Six years with zero return to show for it. Inside the market it was a different story. Small resources declined by almost 70% and small industrials returned a positive 60% over the same period.
We believe you can deliver positive returns in a bursting bubble – but to do so requires a solid grounding in fundamental value. You are also unlikely to find positive returns in the very stocks that led the bubble. Like resources in 2010, the best thing to do is avoid recent bubble champions as much as possible.
Quality stocks grounded by solid fundamentals and can deliver positive returns even if speculative small caps collapse. The first requirement is the quality of the businesses. We need commercially proven businesses generating profits and cashflows and a solid return on equity. Secondly, we don’t need to believe in made up valuation metrics to justify their current pricing. A simple earnings multiple should give us a pretty good idea of value. Thirdly, the balance sheets need to be strong – either net cash or a very comfortable level of debt. Finally, cash flows must be real, positive and provide support to the valuation through either dividends or buybacks.
By building a portfolio invested in great businesses – with better ROEs and less debt than the market at reasonable prices (and today arguably cheap given the lingering distraction of speculation) should allow investors to continue to capture the long-term capital growth that quality small companies have delivered for decades.
“A manager that has become overconfident by using a bad process is like somebody who plays Russian roulette three times in a row without the gun going off and thinks they’re great at Russian roulette. The fourth time, they blow their brains out.” — Daniel Loeb, October 2011.
The Longwave investment process has been developed and improved over more than 15 years – tracing back to one of our founders’ earliest fund in 2006 – and is built from investment first principles that work over the long run. We found the immediate post COVID environment difficult as the market rewarded those investors taking maximum risk, ignoring all the red flags of history and betting it all on this time being different. We wrote at the time it seemed obvious much of what was happening was a speculative bubble and unsustainable but rational analysis holds little sway in the face of unbridled animal spirits.
The adjustment back to reality has been painful for many stocks and we are not convinced the market has finished re-pricing them to the new higher inflation, higher interest rate regime. At the individual company level, share price falls from recent highs of 50%, 70 or even 90% would suggest value is now compelling but for many names the over-valuation was so extreme this is not the case. We are actively researching select opportunities found among this group.

Portfolio Positioning and Performance

Significant outperformance in April and over the past few months has come from owning attractively priced quality businesses and avoiding the big losers. Megaport (-38%), Liontown Resources (-22%), AVZ Minerals (-20%), EML Payments (-47%) and Life 360 (-32%) were the biggest contributors we didn’t own in April. What we did own that did well during the month included Viva Energy (+20%), Whitehaven (+19%), SSR Mining (+9%) and Corporate Travel (+11%).
Detractors came from holding no position in Sayona Mining (+33%), Flight Centre (+15%), Graincorp (+22%) and NIB Holdings (+11%) as well as underperformance from our positions in Newscorp (-6%), HT&E (-11%) and Janus Henderson (-5%).
A good long-term process is worthless without the behavioural discipline to stick to it when it isn’t working in the short term. We know there will be other short-term periods when animal spirits grip markets and Russian roulette again becomes the investors favoured process. Through these periods, our performance may seem pedestrian compared to highfliers – but taken over a longer horizon, once a full cycle is accounted for, we expect discipline will deliver compelling investment returns.

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 (ABN 17 629 034 902) (‘Longwave’), a corporate authorised representative (No. 1269404) of Pinnacle Investment Management Limited (ABN 66 109 659 109, AFSL 322140) (‘Pinnacle’) as the investment manager of Longwave Australian Small Companies Fund (ARSN 630 979 449) (‘the Fund’). Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371 (‘PFSL’) 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.lonsecresearch.com.au/research-solutions/our-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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