Longwave Australian Small Companies Fund – Our first 12 months
– David Wanis, January 2020
Our experience in successfully investing in small caps over many years has shaped our view that quality is a key driver of delivering long-term outperformance of small cap portfolios against both the small cap index and the large cap alternative. Our philosophy applies fundamental and quantitative insights in the pursuit of a risk- controlled portfolio of high-quality small companies. For longer-term investors concerned with minimising both underperformance and excessive turnover, higher- quality companies held in a reasonably valued diversified portfolio can deliver superior long-term returns.
Our investment process
Implementing a philosophy in a disciplined and repeatable manner is easy to say, but harder to do when faced with the perpetual uncertainty within markets and the biases that make us all human. The first systematic stage of our investment process is deliberately designed to help achieve one simple goal: the more ways we see quality in a company the greater the weight in the portfolio, so long as a minimum threshold is met. In our first 12 months we remained unwavering in the application of our quality assessment process.
The second stage of our process is recognising the limitations to simply looking at what is known and acknowledging the need to account for a wide range of potential outcomes for each company, such as industry trends, company value drivers, management performance, strategic objectives, regulation, competition, sustainable financial performance (including ESG) and risk factors. In order to arrive at an estimate of fair value, we must appropriately judge the likely range of future probabilities. Quality companies can become mispriced just like any security, and the goal of our fundamental research process is to identify instances where we have the highest confidence that a quality company is either under or overpriced by the market. To identify the 30-40 names that we believed were significantly mispriced, we completed dozens of in-depth company models during the year, supported by fundamental research.
From the combination of our systematic and fundamental research, we constructed a portfolio of around 100 quality businesses that we believed had the highest probability of achieving our investment objectives. As we discussed during the year, diversification is a key part of our investment strategy to capture the winners that emerge from the very broad ‘small company universe’.
Performance over the first 12 months
During the first 12 months we held an average of ~100 stocks in the portfolio. Although quality and value are assessed at the individual company level, our portfolio can have meaningful sector exposures depending upon where we find opportunity. During the period, our largest portfolio exposures were in the Consumer Discretionary, Materials and Financial sectors. These were also our largest relative to benchmark exposures and the source of much of our excess return. Our smallest relative exposures were to A-REIT, Industrials and Healthcare sectors – and in each case we would have done better had we had a greater exposure; our stock selection was good, we just didn’t have enough (particularly healthcare).
Our net total return for the 12 months was 23.1%, 3.9% ahead of the 19.2% return of the benchmark. 75-80% of our excess return came from our systematic quality process and 20-25% came from our fundamental valuation positions. This is roughly the expected relative contribution of these components through time – however, the surprise was the performance of the fundamental value positions in a period when a) the market went up 20% and b) value in general had a tough time. We would normally expect the fundamental value component of the portfolio to perform in less ebullient market conditions and to struggle in markets such as this.
Which is a good time to note when our approach to small cap investing will struggle. If our objective is to build a quality small cap portfolio with deliberate exposure to value, then market environments where low quality outperforms, or where growth (ie. not value) outperforms are unlikely to provide much joy when looking at strategy excess returns. These past 12 months had elements of both such market environments, with lots of market cap added to companies that are not yet self- funding (which is a fairly low bar for quality) and valuation multiples that would have been considered outrageous only 3-5 years ago becoming normalised by investors.
In order to outperform we need to be different and right
Our approach is different to other investors in the Australian small cap market. We believe our differences provide us advantages that underpin the long-term investment performance of this fund. Some of those differences include:
- An investment team that has many years’ experience in equities, credit and multi asset class investing
- A long outperformance track record investing in Australian small companies and understanding the drivers of success and failure in this part of the market
- Proprietary quantitative models which capture many of our fundamental insights, provide behavioural discipline and which have successful real money track records in outperforming index benchmarks
- Proprietary and differentiated fundamental equity research and valuation frameworks to help identify small cap mispricing opportunities
- A robust process which captures our unique blend of quantitative and fundamental insights into a high-quality, risk-aware small cap equity portfolio
One year is a very short investing milestone, but round numbers are often useful when pausing to remind ourselves and our investors how we are travelling on a much longer journey.
During January, Longwave Capital Partners became signatories to the UN Principles for Responsible Investment and we will discuss more about our ESG approach and process to Australian small cap investing in an upcoming monthly report.