Generating the Highest Returns with the Greatest Probability

– David Wanis, April 2022

Common wisdom says that a concentrated portfolio is superior to a more diversified approach in delivering high returns. This may be true in large and mega caps but after six years of running a diversified portfolio in the small cap market we have demonstrated there is alternative path to superior long-term returns.

To generate high returns investors need exposure to the highest returning stocks. Globally these are found in the micro to midcap universe – which also contains some of the biggest wealth destroyers hiding amongst the compounders. The challenge is to hold the big winners and limit exposure to the big losers. This is the market in which Longwave invests.

High returns with a wide range of outcomes: Portfolios with high concentration in a few big winners in this market may give investors the potential for truly life-changing returns. Unfortunately, it may also give investors the prospect of significant wealth destruction if the portfolio ends up with too many losers. The underperformance can be so great that funds end up closing, creating a picture – almost entirely through survivor bias – that the best surviving concentrated strategies have a higher success rate than investors should really expect. The median portfolio may be very good, but an investors’ ability to achieve the median with high confidence is low. You will probably end up with something a lot better or a lot worse.

High returns with a narrower range of outcomes: Our process aims to limit exposure to losers, capture the benefits of big winners and use diversification to deliver a more consistent outcome. As we noted in December the stronger long-term performance of quality small companies comes almost entirely from their ability to generate superior long-term EPS growth. This is a useful measure of whether quality is being delivered to shareholders over time.

Our proprietary quality process is designed to be robust. We observe many quality definitions used by investors tend to become tighter and tighter over time – narrowing down the number of companies that fit the desired attributes. Often to what has worked most recently. You may observe this when portfolios start to become overly concentrated in one business type or financial metric (consumer franchises or software are recent examples, unsustainably high ROIC or sales growth rates may be another). This process may work if the future looks like the past, but it doesn’t map well to real world uncertainty and change becomes an Achilles heel.

Quality as a philosophy can be more susceptible to over-fitting as it contains a lot of subjective judgement. The very fact that investors do not agree on a quality definition is exactly what makes it so hard to be replicated by statistical algorithms. It is also why judgement and experience matter. Other investment styles like value, growth, momentum, and low volatility are built heavily from price, not business fundamentals.

Highly concentrated, tightly defined quality processes can become fragile over time.

How Longwave Target High Returns with Consistency

Two features of our investment process – our proprietary quality models and our more diversified portfolio approach – are the differences investors most often notice.

These are not bugs.

They are deliberate process features that allow us to generate the highest return with the narrowest range around this return over the long term. The robustness of our models to uncertainty will likely mean there are always alternative strategies at a point in time generating superior short term returns as their concentrated portfolios and tight fit processes map perfectly to the current market. The fragility of these models only becomes apparent when the inevitable surprises arrive, and markets change. And change is inevitable.

Our investment strategy using our quality model in a diversified portfolio has now reached six years of real money investment performance – at our prior firm where we managed over A$100m using this approach from April 2016 and continued at Longwave from February 2019. If we applied our highest unit class fee (A Class, 89 bps) to the gross returns over this period, the strategy has generated a net return of 14% per annum.  3.1% per annum higher than the Small Ords index and 3% higher than the ASX300. So far, the net returns from our approach stand up well to our objectives, all passive and most active alternatives.

We note that our return goal considers fees and taxes because this is what our investors – including the Longwave team investments in the fund – receive. This is why we have a comparatively low management fee, and our strategy is tax efficient by being long term in nature – limiting trading costs and taxes from turnover. Portfolio turnover should average less than 50% in most years.

Quality Investing in Resource Companies

We wrote some time ago how Longwave consider resource companies in the context of our quality process. The quick recap is we believe quality resource companies can absolutely meet our criteria and we strongly favour producing companies over earlier stage exploration and development names. As seen through the recent tech bubble our unwillingness to be too early can cost us returns in the short term (we miss out on the hottest stocks) but holds us in good stead over the long term in achieving our highest return with the greatest probability goal. We are seeing this now with resource companies where we don’t own the hottest stocks – exploration and development lithium – by a country mile – but have enough exposure to quality producers to capture long term resource stock returns.

Beyond single stock consideration there are also real portfolio diversification benefits from owning resources. Their cashflow and earnings drivers can be very different to those of technology or consumer or financial services business. As we have also seen in recent months the inflation diversification benefits resources provide are not available in many other parts of the market.

We don’t lower our quality hurdles to own resources companies, but we don’t exclude them for failing a narrow definition of what quality means.


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 (‘Pinnacle’) (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

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.
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