Surviving Hope Mountain
– David Wanis, May 2022
There is a very good reason why 99% of people who have climbed Everest have done so with supplementary oxygen. Above 8,200 metres (the summit is almost 8,900m) the lack of oxygen in the air starts to effect both the body and the brain. A lack of oxygen starts to impair thinking, cloud judgement, cause hallucinations or result in people taking risks they shouldn’t. Like climbers need for oxygen, we think investors need to remember when judgement may become clouded and avoid unnecessary risk. Focusing on quality within small caps is like investing with a supplementary oxygen bottle.
If bull markets climb a wall of worry, bubbles scale a mountain of hope
In more normal markets investors focus on the grounded fundamentals of company performance – balance sheets and current cash flows. As share prices rise, the focus moves more to earnings far in the future. Prices march higher and earnings either disappear or fail to explain the current share price – so we move to “valuation”. We use quotation marks here, because the valuation methods deployed have almost nothing in common with what we learned in textbooks (given we left balance sheets and cashflow behind a long time ago). Investors start to talk more about sales multiples or LTV to CAC or simply saying the words “we think the stock is cheap” with no evidence at all can sometimes justify the investment case.
Higher still and in the absence of oxygen, hallucinations and unwise risk-taking grips the investor. All we have left is hope.
Quality is the Oxygen Protecting Investors During a Bubble
Hope comes in the form of Themes (like SaaS or Electrification or Artificial Intelligence). Hope comes in the form of a huge Total Addressable Market (TAM). Hope comes in the form of an amazing product, a unique person, or a compelling idea.
In combination with sound fundamentals, strong tailwinds from a theme, a large addressable market and amazing products and people can result in incredible investment outcomes. But if hope is all there is, investing feels weightless. If you feel like “nothing more than a single narrow gasping lung, floating over the mists and summits” you probably need oxygen (quality) before you lose all your money.
We know how the story ends. Turns out this time is not different. Over the past few months hope based investing has come crashing down to earth.
One of the primary culprits of this collapse was slowing liquidity growth – which will soon turn to a full-blown liquidity contraction as interest rates rise and central bank balance sheets reduce. For companies and investment processes to be sound and deliver through the cycle, they must be able to withstand this withdrawal of liquidity.
What can we do as small cap investors? Can we generate positive returns when a bubble bursts?
Many people point to the tech bubble in 2000 and its aftermath as an analogy of investing during a bursting bubble and lessons for investors in 2022. And it is a good one to look at. But for Australian small cap investors, we have another example that is more recent and happened in our investment universe.
The commodity bubble that ended in Dec 2010.
Quality is how we Outperform a Bursting Speculative Bubble
After the 2010 commodity bubble burst, the Small Ords total return index went sideways for six years. Six years with zero return to show for it. Inside the market it was a different story. Small resources declined by almost 70% and small industrials returned a positive 60% over the same period.
We believe you can deliver positive returns in a bursting bubble – but to do so requires a solid grounding in fundamental value. You are also unlikely to find positive returns in the very stocks that led the bubble. Like resources in 2010, the best thing to do is avoid recent bubble champions as much as possible.
Quality stocks grounded by solid fundamentals and can deliver positive returns even if speculative small caps collapse. The first requirement is the quality of the businesses. We need commercially proven businesses generating profits and cashflows and a solid return on equity. Secondly, we don’t need to believe in made up valuation metrics to justify their current pricing. A simple earnings multiple should give us a pretty good idea of value. Thirdly, the balance sheets need to be strong – either net cash or a very comfortable level of debt. Finally, cash flows must be real, positive and provide support to the valuation through either dividends or buybacks.
By building a portfolio invested in great businesses – with better ROEs and less debt than the market at reasonable prices (and today arguably cheap given the lingering distraction of speculation) should allow investors to continue to capture the long-term capital growth that quality small companies have delivered for decades.
“A manager that has become overconfident by using a bad process is like somebody who plays Russian roulette three times in a row without the gun going off and thinks they’re great at Russian roulette. The fourth time, they blow their brains out.” — Daniel Loeb, October 2011.
The Longwave investment process has been developed and improved over more than 15 years – tracing back to one of our founders’ earliest fund in 2006 – and is built from investment first principles that work over the long run. We found the immediate post COVID environment difficult as the market rewarded those investors taking maximum risk, ignoring all the red flags of history and betting it all on this time being different. We wrote at the time it seemed obvious much of what was happening was a speculative bubble and unsustainable but rational analysis holds little sway in the face of unbridled animal spirits.
The adjustment back to reality has been painful for many stocks and we are not convinced the market has finished re-pricing them to the new higher inflation, higher interest rate regime. At the individual company level, share price falls from recent highs of 50%, 70 or even 90% would suggest value is now compelling but for many names the over-valuation was so extreme this is not the case. We are actively researching select opportunities found among this group.
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.
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