Beware the allure of a discount

Investors in the Acorn Capital Investment Fund know that from little things, big things don’t always grow… at least not right away.

Summary: Small and micro-cap manager Acorn Capital Investment Fund admits shareholder engagement could have been better after listing, while the timing of the fund’s listing was also less than ideal. The fund’s market neutral strategy means it must have exposure to each sector in the S&P/ASX Small Ords index, which has also hit performance.

Key take-out: While it is essential to look at the NTA of an LIC when making a buy or sell decision, the key driver of returns will always be the manager and the fundamentals.

Key beneficiaries: General investors. Category: LICs.

In the stock market there are value investors everywhere: People who want to buy things for less than the sum of their parts but of course not fall for value traps. The LIC space is the same. Years ago when I first started looking at LICs I looked for an investment approach I liked and for discounts to their net tangible assets (NTA). I thought it was an easy game. Buy at a discount to NTA and sell at a premium.

The more I look at LICs now the less I pay attention to premiums and discounts unless they are significant. Why? Even the managers behind the LICs can’t work out why their stock trades at a premium at times and a discount at others. Generally speaking as long as they are within a few percent either side of the NTA the managers are happy. And I am happy to buy with a long-term view in mind.

I do pay attention to discounts and premiums at extremes and this always makes me cautious. Australian Leaders Fund (ALF) is a good case in point of a premium that is material. Mid-2014 the share price steadily climbed above the NTA until it reached a 30 per cent premium. Performance then weakened. Every fund manager will go through tougher times but it’s exceptionally painful when you are trading at a 30 per cent premium. The share price fell in line with NTA and then some; on all accounts the AGM that year was a little tense.

On the inverse a deep discount should be treated with suspicion too. LICs will trade at a material discount for a number of reasons: poor shareholder engagement, the hangover of outstanding options, negative sentiment if involved in a specific sector or, most commonly, poor performance.

Small and micro-cap manager Acorn Capital Investment Fund (ACQ) comes close to ticking all of the above boxes. By their own admission shareholder engagement since listing could have been better, there are options outstanding (and very unlikely to be exercised at this point) and performance has gone south since inception.

ACQ comes from one of the largest small/micro-cap fund managers in the country, Acorn Capital, which was founded by Barry Fairley in 1998. At the time of ACQ listing the manager had approximately $1.1 billion of funds under management. The bulk of these funds are institutional mandates. For those institutional clients who run a micro-cap/unlisted strategy with Acorn they do so in their own separate unit trusts. There is a reason for this. The manager cannot have unit holders coming and going. You cannot rebalance a portfolio of unlisted companies. When rolling out a mass offering with this strategy the only real way they could do it was in a closed-ended structure. That is the one benefit of this fund being an LIC.

The downfall for managers of LICs is the transparency – although this is positive for investors. Investors who are used to traditional small cap LICs can see what the sum of the parts is and can easily track the underlying shares on the market. The value can easily be assessed. Unlisted companies are not regularly revalued and generally it is not until the investment is realised. This could provide for a surprising sugar hit to underlying value or potentially the opposite. Regardless of what it does there is a good chance it won’t do it for some time. This means communication is critical to keep investors informed of the progress of these investments and this is something Acorn’s head of private markets Robert Routley admits they could have done better from the start.

“We spent a lot of time getting our portfolio set and I think our shareholder engagement was probably lacking,” he says. “The June quarter we made a concerted effort to get out there and this quarter we’ve opened it up for individual shareholder updates.”

ACQ has also announced a series of shareholder briefings to take place in October around the country – expect to see more of them taking place.

The timing of ACQ’s listing wasn’t great and that cannot be helped. The LIC listed into a market that was sharply climbing. But what could be helped was their approach to getting invested to the mandate. From the outset the portfolio was to be fully invested or very close to within three months. After three months the portfolio was 72 per cent invested with the funds going into a market management thought was overpriced.

“During the portfolio construction phase the market ran hard and we missed out some of the performance and we were holding so much cash from the July/August period last year. And then November through to January our energy portfolio in particular underperformed which represents about 8-10 per cent of the overall portfolio weight,” Routley says.

Consider this strategy compared to Perpetual Equity Investment Company Limited (PIC) which is held in the Eureka Report LIC model portfolio. PIC had similar instructions. The manager was given six months to get the portfolio to the mandate. Six months passed and the manager was not prepared to deploy capital into his targeted stocks at the prices of the time. The manager requested an extension of a further six months and the patience paid off for shareholders.

Both managers use a bottom up stock selection process driven by value. In ACQ’s defence management have stated numerous times they are stock pickers and not market timers. Nevertheless this has impacted shareholder returns.

Impacting the performance of ACQ has been the portfolio’s market neutral strategy. The fund by its mandate follows the sector weightings of the S&P/ASX Small Ords index. Being market neutral means it does not have to hold the stocks in this index but must hold stocks within each sector. It is up to the investment team to use their fundamental stock picking to select the best stocks to make up the sector weight. This is theoretically where the fund will add alpha and outperform on a relative basis.

This strategy ties the hands of the manager. They must have exposure to the good, the bad and the ugly and this too has hit their performance. Routley says: “The energy and IT sector have not performed well and our stock selection in those sectors as well. We are confident in the asset values and part of the reason why the board has initiated the buyback program that is ongoing. We do believe in what we are doing. We can only really fix this over time and I think performance is going to be the critical aspect.”

In the quarterly updates and the prospectus for ACQ it has been highlighted micro caps have underperformed the All Ords by 54 per cent over the past four years. The team at Acorn puts this down to the search for yield driving up the large cap stocks mostly dominated by the banks and an aversion to the resource sector. For this reason Acorn argues on relative terms the micro-cap space is compelling value.

As well as the apparent attraction of the micro-cap space, one broking company has put its weight behind ACQ. Most analysts in the LIC space have listed ACQ as an underperform but ever since the LIC listed one broker has seen compelling value. According to the broker, there was compelling value at $1 and now there is compelling value at $0.73 for those with a medium to long term view.

Another issue hurting ACQ at the present time is its own lack of yield. Management has specifically stated it is a growth orientated portfolio but we are in a time of dividend hungry SMSFs. Management can say the investment horizon is a five to seven year view but unfortunately in a world of full transparency with monthly and quarterly updates investors want to see returns at least in line with the index. Unfortunately that has not come through and ACQ now finds itself at a 15.14 per cent discount to NTA.

Looking at a few examples, with all the good will in the world it is difficult to close the gap to NTA when it widens that much. Hunter Hall Global Value, AMP Capital China Growth, Contango Microcap, Clime Capital and Templeton Global Growth are a handful of names that have found it incredibly difficult to close the NTA gap. AMP Capital China Growth has found itself under attack from activist shareholders for never once beating its benchmark and trading at a significant discount.

Lessons to be learnt? While it is essential to look at the NTA of an LIC when making a buy or sell decision the key driver of returns will always be the manager and the fundamentals. Just like any stock the underlying business and management's ability to carry out the strategy will eventually drive the growth. Perhaps you could consider the discount/premium as the technicals.

Can ACQ make investors returns from this point? There is every chance. Their historical track record with institutional funds is proven. Yes the micro-cap space is showing relative value on basic terms.

But will this get my money? Not right now. I am happy to let close to a 20 per cent discount go. I am happy to miss out on the upside when they do close the gap. As Tom Millner of BKI told me when I asked him what he thought of the new, smaller LICs: “Just give them time. Give them time to grow and prove themselves. There’s no harm in that.”  

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