Simple but not easy

Investing is simple but not easy. We largely know what to do, what to ignore, the right time horizon to focus on for superior long-term results, but we seem to not be able to get out of our own way. And by we, I mean pretty much all human decision makers, investors, allocators and stock pickers.

In simple terms, actively managed Australian small caps out-perform large caps (active or passive) over the long term. This outperformance is not linear nor consistent every year, which means the path to superior long run performance is marked with periods of underperformance. This underperformance has been the story of 2023 (and 2022!) but the long term remains intact.

In 2023 we covered much of what investors need to know about the whys and hows of long-term small cap outperformance:

• Long term Australian small cap outperformance: Active Australian Small Caps have been one of the best performing places to invest over the past three decades.

Source: Morningstar, Longwave Capital. Index returns are gross of fees, fund returns are net of fees.

• Why Small Caps are different: Investors often forget that small caps are younger and more fragile than their large cap brethren. They are also less well covered and more dynamic businesses.

Source: Aswath Damodaran, Longwave Capital Partners

• Why active management works in small caps: Active management is under pressure in many parts of the market – and for good reason as the delivered performance hasn’t justified the fees. Small caps continue to be a part of the market where it really does pay to be active, and there are structural reasons why this will continue.

Source: Morningstar, Longwave Capital. Index returns are gross of fees.

• The importance of quality: Quality is a common term with a multitude of ways to be defined. This is a feature, not a bug.
• Human Behaviour and decision making: Artificial Intelligence (AI) captured the imagination of the world in 2023. Experience in the Chess world gives some clues how investors may best respond and integrate technology into fundamental investing.
• Mythbusting our way to higher long term returns with lower risk: The myths we specifically highlighted were:
  • More concentrated portfolios deliver better returns. This is one of the most persistent myths in funds management and it is just not true,

Source: Morningstar. U.S Database. Dec 1999 to July 2022. 632 total funds. Concentration measured by % of portfolio in 10 largest positions.

• • High conviction is about low stock numbers,

Source: ASX Indices, Longwave Capital Partners

• • Small Cap alpha only comes from Information Edge,
  • Value, or Growth, is the factor that works best in Small Caps,
  • Thematic investing is a short cut to high alpha in Small Caps.

The worthwhile goal of active investment in Australian Small Caps is the superior long-term compounding of wealth that can be achieved. Activity for the sake of looking busy is one thing that feels like it should help but does not improve investment returns.

As a quality investor, looking to buy and hold companies that can compound value over the long term, our portfolio turnover is relatively low. Given we have not previously discussed this, we thought some numbers may illustrate what this looks like.

Our portfolio turnover in 2023 was 38% and while this was low by the standards of active small cap managers (average around 60%, with many above 80% per annum), it is also inflated by some factors outside our control. Every year we sell companies due to external factors that ordinarily (based upon the performance of the business) we would continue to hold. In 2023, 8.5% of our turnover was due to index changes (we are not allowed to own ASX100 stocks) and the delisting of the Janus Henderson CDI (forcing us to sell). 1.6% of our portfolio turned over from companies we own that were the subject of takeovers. We also have some portfolio turnover driven by changes in weight between companies in the portfolio due to changes in relative valuation appeal.

It is also worth noting that the underlying small cap index turnover is around 25% per annum, far higher than the 1-2% p.a turnover seen in an ASX300 ETF.

Name turnover – how many companies enter and exit the portfolio in a given year – was 26% in 2023, which was slightly higher than prior years, when it had averaged closer to 15-20%.