Not a Good Month for Goldilocks

– David Wanis, November 2020

We build portfolios for the long term based upon balance. Good quality and proven businesses. Balance sheets geared appropriately for uncertainty. Management teams that allocate capital judiciously. Companies whose valuations that are not excessive. November was an amazing month for equity returns globally and in Australia – however the strongest returns were found at the extremes. Balance was not rewarded as highly.

In some ways it makes complete sense. The market has been of a view for some time there are a group of stocks which cannot ever be considered expensive, and another group that appears cheap but can only get cheaper. This approach violates a fundamental tenant of investing – but of course no-one knows when this will break. It snapped in November.

When we look under the hood at what drove such strong small cap returns, and why our portfolio failed to keep up, there were some interesting results.

Yes value (as defined by the MSCI small cap style indices) outperformed growth; +12% vs +6%. However, we also saw that the lowest quality business also outperformed higher quality businesses by +19% vs +6%. Higher financial leverage companies outperformed lower leverage companies by +12% vs +9%.

So the ideal place to be in small caps during November – in highly levered, low quality value stocks – was not the place to have been either in the past 20 years nor would we suspect over the next 5 years. This looks like a healthy catch up. A reminder that markets cannot go one way forever and that a properly functioning market is a discounting not momentum machine.

Governance in life and investing

October and November have been a big couple of months for democracy – of both nations (United States) and companies (annual proxy voting season here in Australia). Having taken for granted the trust in the process, many citizens and shareholders are seeing for the first time some of the vested interests at work. Seeing how the sausage is made is never pleasant, but ultimately preferable to being disenfranchised by representatives who fail to perform their duty.

What is the role of a representative? There are two commonly accepted models;

  1. Delegate model: the delegates act as a conduit for the wishes of their constituency with no autonomy,
  2. Trustee model: the trustee acts with autonomy using their knowledge, experience, and judgement to make decisions in the interest of the constituency even if this is counter to explicit constituent opinion and direction at the time.

A third model, that the representative uses their position to personal advantage, potentially in conflict to the interest of their constituency, hasn’t been formalised but appears to be commonly observable – both in politics and corporate life. There is no need to alarm ourselves this is a modern invention. We can trace such behaviour of representative self interest back to Greek and Roman democracies. As individuals and shareholders we can use our awareness of the reality of human nature to best protect the interests of our vote and our capital.

Observations from 2020 proxy voting

We view board governance as a marker of quality. The process of reviewing annual reports for disclosure and approach on issues such as remuneration, representation, sustainability and equitable shareholder alignment of management incentives illuminates where quality shines and where it is lacking.

We picked up a number of governance issues through this years’ review, research, engagement and voting. These directly influenced our views on the quality and value of business as well as resulting in changes to the portfolio to reduce exposure to lower quality, higher risk behaviours we believe the market has not yet accounted. Timing is always uncertain. The current issues disclosed by Freedom Foods shows many years of poor governance and low quality accounting can be overlooked by the market due to a soaring share price. We cannot guess what the market will notice or overlook and when. We will detail more of our observations on proxy voting in our next bi-annual Proxy Voting Report in January 2021.

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