Quality is in the eye of the beholder

Investors must be endlessly frustrated by managers whose philosophy is labelled ‘Quality’. Value and growth are relatively standardised, supported by observable metrics and investors can quickly spot managers in those camps deviating from their stated goal. Quality, however, can be used to justify almost any investment a manager chooses to make, which risks rendering the term meaningless. We have seen junk small caps held by quality managers on the basis that in their view, at some point in the future, the business will demonstrate all the characteristics of a quality company.

This is a wonderful development. What makes a value or growth manager’s job in adding genuine value so hard is that once a style becomes easily defined, it can be algorithmically replicated. A true measure of a value manager’s alpha is not really relative to the broad market benchmark, it is more relevant to the naïve value index capturing much of their style bias. Part of why value investing perhaps used to work better was the behavioural fortitude required to invest against the crowd. A computer has no such reticence and will happily buy beat up, cheap stocks all day.

Quality being harder to define and pin down makes it less competitive and having a unique view on quality can be an advantage. Which brings us to resources. Many quality managers exclude commodity industries due to their inherent lack of pricing power. Taken to extremes, some quality investment processes become so narrow they resemble single sector funds, as the manager believes quality only exists in one or two places – like consumer or technology. Overall portfolio performance ends up dominated by sector influences and sacrifices a lot of diversification benefits. We think this is too narrow, and happily include resource stocks in our investment universe and quality resource stocks if we can find them, in our portfolio.

We can understand why many small cap investors exclude resources stock en-mass. A study we performed in late 2020 demonstrated over more than 15 years (from 2003 to 2020) the S&P/ASX Small Resource TR Index (small resources) underperformed the S&P/ASX Small Ordinaries TR Index (small ords) by 1.2% p.a. Simply by excluding resources and holding the S&P/ASX Small Industrials TR Index (small industrials) you could outperform the small ords by 0.6% p.a. More than this, not only did small resources drag returns, but the volatility was also horrendous: 29% p.a (vs 18% p.a for the small ords and 17% p.a for small industrials) and max drawdown was 20% greater as well. Seems like an open and shut case to exclude these stocks entirely.

Except the resources junk hides some gems. Quality businesses which can earn their place in the portfolio. Our research showed that quality small resources (our definition, applied consistently over time) outperformed the small ords handily (by more than 5% per annum) – although the high volatility and drawdown remained. Returns and volatility are one aspect of a stock’s role in a portfolio, but the other first principle consideration (often overlooked) is the correlation with the rest of the portfolio. This is where small resources shine.

When quality small resource stocks perform is sometimes exactly at the time other stocks are not working. Like in 2022. Having many different and uncorrelated sources of alpha from which to construct a portfolio gives us a fighting chance to deliver consistent performance.

Source: Factset, Company Accounts, Longwave Capital Partners

A decade ago, the picture for small cap gold companies was not encouraging. The A$ gold price had declined from a peak of around A$1,700 in late 2012 to under A$1,400 by mid 2014. It wasn’t only the commodity pricing environment that was bleak; balance sheets for most small cap gold miners were loaded with debt, and poor profitability was, if anything, overstated when using inconsistent management cash cost disclosure. In early 2014 the introduction of All-In Sustaining Cost (AISC) adopted across industry highlighted an even worse reality. Many companies were in the perilous position of carrying too much debt and delivering real cash losses.

Stock specific risk of failure was heightened across many names. From 2014 to 2016, companies focused on getting their true operating costs (AISC) to more sustainable levels and were fortunate enough to have a strong tail wind in the form of gold prices increasing from A$1,400 to A$1,600 over that period. Strong cash flow was used to pay down debt and many gold companies quickly got to net cash balance sheet positions. These fitter, better capitalised businesses then had the ongoing good fortune of seeing the A$ gold price continue to rise another 25% and set a record of A$2,000 / oz by June 2019 (rising US$ gold boosted by a falling AUDUSD exchange rate), driving margins, profits, cash flow and net cash even higher.

Despite continuing to operate during the pandemic, labour and travel restrictions saw average AISC across small-cap gold stocks rise from A$1300/oz to A$1500/oz in in the space of 2 quarters.  A global flight to safety in assets, however saw AISC margins (the difference between $A/oz gold price and $A/oz AISC) rise to record levels by December of 2020.  From a cash perspective, the stocks had become a relative gold-mine.  A sharp rise in oil prices brought AISC margins back to A$650/oz but these have been on the rise again as the gold price has made new highs and All-in-sustaining costs have stabilized.  ASIC margins for the small-cap gold stocks as a whole are now some 200% above where they were in 2015.  These record ASIC margins should continue to generate cashflow for businesses that already have healthy balance sheets.  The next phase for small cap gold companies will be interesting to watch, but we believe management teams are likely to remember the lessons of the early 2010’s and shareholders will continue to see the benefits of the discipline learned during that era.

Source: Factset, Company Accounts, Longwave Capital Partners