Getting caught in Blue Sky

This week’s fund manager interview is with Dean Fergie, Portfolio Manager and Co-Founder of Cyan Investment Management.

Cyan’s been going for four years and it’s had a good track record over those four years — roughly 24% performance since inception. However, it’s had a crook six months — it’s gone backwards in the past six months and the reason for that is largely because they got caught in Blue Sky. 

I spoke to Dean about why that happened, what he learnt out of it and what he’s got in his portfolio now. 

Here’s Dean Fergie, Co-Founder and Portfolio Manager of Cyan Investment Management.

Dean, you say on your website that your fund will close when it hits $100 million dollars.  How close are you to that now? 

The fund’s currently around $45m, so we’re about halfway.  But what we sort of find is, because the performance has probably been pretty strong to-date, we’ve been going for a little bit over four years, we’ve had a bit of an acceleration in funds.  My best guess, we’ll probably still be open for another 18 months, potentially two years, but I’d say given our current rate of inflows, which is $2-3 million bucks a month, probably should see us out in that time.

And what happens then, do you just keep running a $100 million dollar fund, is that right?

Yeah, I think one of the traps that investors, or that fund managers fall into especially when they’re looking at the small to micro-cap space, the funds become too big and they become a little bit unwieldy.  What that means is that they have trouble getting into stocks, they certainly have trouble getting out of the stocks and I think also when you run a lot of money there’s a tendency to potentially over-diversify, that you have too many stocks with lots of small weightings and you fail to get quite the quantum of returns you can achieve when you’re running smaller amounts of money. 

There’s plenty of kind of studies to show that once funds get big, they lose their ability to outperform.  We’re very conscious about not falling into that trap and we don’t want to be greedy, we just to provide good returns to our clients and manage a small amount of money.

As you say, you’ve had a good performance since inception in 2014, 23.6%; three-year performance, 23.9%; but this year it’s not been great.  Your six months performance is -1.1% versus small industrial accumulation of 9%, so what’s happened?

Unfortunately stocks don’t go up in a straight line completely, we’ve obviously been caught in a couple of positions that haven’t ended up that well.  Probably the most high profile we were in was Blue Sky Asset Management or Blue Sky Alternative Investments.  That harmed performance a little bit and there’s just been a little bit of volatility.  We’ve also seen a pullback in things like Experience Co, which is almost halved from its peak.  In hindsight, we would have been better to trim those things a little bit more than we had previously.

I’m surprised you got caught in Blue Sky, how did that happen?

That was a stock that we got into pretty early.  We invested into that at the end of 2014, when it was a couple of dollars and they had a number of upgrades, had very, very strong inflows.  The numbers look great and the stock performed incredibly well, it was one of our greatest contributors to performance and topped out at about $14 dollars.  I suppose when you have a very good experience with a stock, when the numbers that they’re reporting to market look pretty good and the stock price is performing well, I suppose you have a little bit of loyalty there, but we actually believed things were going a lot better than was actually happening underlying. 

I think what’s come out in hindsight is the numbers in terms of FUM and the management fees they were reporting were actually not correct, so there’s clearly a number of class actions pending that we’re considering with that business.  At the end of the day, we made some good money out of that stock.  We did sell most of our stock at sort $7 or $8 dollars, it’s now trading at, I think, $1.50.  Whilst over that sort of six month period that you’re referring to, the stock fell from $14 bucks to $8, we got in there at $2, we sold the majority at $7 or $8, we did pretty well.  But, we didn’t sell out at the very top. 

Did you learn things from that experience that will change the way you invest?

Yes and no.  I guess there’s one aspect that you always tend to want to be wary about businesses that are growing quite quickly.  But again, I think, one, has to rely on the numbers that management and board and auditors are signing off on and releasing to the market.  If those are proven to be misleading or indeed, incorrect, I don’t know that there’s much investors can do about that other than taking some sort of action after the fact.  I think looking back at the experience, we probably potentially fall into some of the same traps because I just think the information we were seeing wasn’t correct. 

But look, one of the views of what we do is that we tend to get on these stories very early rather than right at the end.  Over the course of any time period, we’re still able to do better than all the other investors that decide to jump on the bandwagon when things become common mainstream successes. 

Dean, tell us about how you invest.  How do you find the stocks to invest in and what are your screens?

We don’t have any specific screens as such.  There’s some sectors we tend to avoid.  We don’t do anything in resources or biotech, we just find both those sectors very volatile, very hard to predict and value and subject to a whole bunch of externalities that are very hard to control.  The other kind of stocks that we shy away from are anything that are yet to be commercially proven.  Businesses that aren’t generating any revenue whatsoever.  We’ll certainly invest in loss-making businesses but we want to see ones that are actually selling a product and generating some sort of revenue flow from that.  We also tend to obviously stay away from really highly geared companies, but that tends to not be such a factor at the smaller end of the market because businesses just aren’t able to achieve great levels of debt at the smaller end.

Probably most importantly for us and for your listeners is, we want to operate in the area of the market that’s very shallow, very shallowly covered.  We want to be finding companies that not a lot of people know about, there’s not a lot of research, there’s very inefficient pricing, and that tends to be in businesses that are kind of sub a market cap of about $200 million dollars.  That’s where analyst coverage kind of really drops off, you need to go out and see the companies, do a lot of legwork, and it’s essentially a case of turning over a lot of rocks, pretty much.  I don’t think there’s any secret kind of source where you can just punch the numbers into a spreadsheet and it will screen out all the bad ones and give you all the good ones. 

From over 20 years’ experience it’s just basically doing a lot of legwork, making a lot of phone calls and spending a lot of time in meetings that come to nothing.  One in twenty, we’ll find a good stock and you’ll do very, very well out of it.

I like the explanation of why you chose the name, ‘Cyan’, which is a subtractive primary colour, it’s produced when red light is removed from white.  Red, to you, is synonymous with losing money, so you remove the red – I like that.

Well, we try out best…

No, but I suppose what it reflects is you’re kind of cutting out stuff, you’re a subtractive investor in some ways. 

Look, I think that’s right.  I mean, I think sometimes investors need to think about the fact that a total return outcome, whether you’re someone like myself running a fund or whether you’re running your own personal portfolio of spot investments, your overall return is adding up all the investments that you do well in, you make money out of, and you subtract all the ones that you lose money from.  It’s a game where you’ve got to add up everything and people tend to want to look at all the stuff they’re going to make money out of it and don’t think about the negative, and I think it’s really important to go, “If I don’t make a decision to invest in something that ends up turning bad, that’s been a positive decision to make.”

If you go in there with that mindset, not about always having to do something, I think you end up with a very kind of risk averse strategy and we think over time, better long term returns.  Just to elaborate on that, we only run the 20 to 25 positions, so it’s a very select portfolio of stocks that we invest in, and we also can run a lot of cash in the portfolio.  Sometimes the cash level is up to 50%.  There’s a lot of decisions to not do things that we’re taking and I think that’s important and I think that’s helped generate that very strong risk/return outcome for our fund and our investors.

Can you tell us what’s in your portfolio at the moment roughly?  Well, the major positions?

Yes.  We still have a number of positions we’ve owned for quite a long period of time, things like Experience Co and Kelly Partners – I’ve probably spoken to you a lot about AMA Group as well, Afterpay Touch is another one.  We like to buy businesses.  We say to our investors, “You should think about investment in Cyan for at least three years.”  And so when we’re investing in businesses, we like to think about them growing at least over a sort of two to three or four year period.  Anything less than that we’d think is more kind of a short-term trading type mentality, which we don’t think is a great way to make long-term sustainable returns.  

What’s your minimum investment?

Our minimum investment is $100,000 dollars.

And what’s your fee?

1.5% per annum.

What’s your performance fee?

We charge a performance fee of 20% of any excess return over 10% per annum. 

I think, as I understand it, that performance fee is charged quarterly?

That’s correct.

And it’s 2.5% benchmark per quarter?

That’s correct, yes.  I think those fees are probably about average for a small cap fund domestically.  I mean, you might have other opinions, but I think they tend to range in that sort of 1 to 2% fee, the performance fees are sort of 10 to 20% with hurdles between cash or a small-ords index.  I don’t think we charge a lot, nor do we charge very little.

You’ve got a high watermark principle as well, how is that going to effect your fees after your negative six months?

Our high watermark was based back in December.  We are now around, I think, about 3 or 4% below that over the last sort of nine months.  Essentially, we won’t take any performance fees until we at least reach that hurdle and then exceed it.  So, essentially investors that are entering the fund now and have since we’ve been below that high watermark, will get positive performance without a performance fee until we reach that high watermark.

Where do you think your next 12 months’ performance is going to mostly come from?  What are the stocks that you like the most in your portfolio?  For example, do you think Experience Company is going to come back or what?

It’s been a little bit unusual because we tend to normally sell businesses that are going down and buy ones that are going up.  We tend to like to move with the momentum of stocks.  Certainly, Experience Co, even though it had halved, we hadn’t really bought any service stock this year and our fund, it was almost doubled in price, doubled in FUM over the last 12 months.  That position has been diluted down to about 2% of the portfolio and more recently we’ve actually been buying more stocks because we think there’s a couple of aspects that they’ve – they’ve had a pretty torrid time with a couple of skydiving deaths. 

I don’t think they’ve integrated a number of their acquisitions as well as they could have and I think the market’s just generally been pretty disappointed with what was a growth story and over the last 12 months was actually operated with a pretty flat result.  But I think they’ve actually got some really good strategic assets in terms of adventure tours and businesses over here.  There’s absolutely no doubt that the Australian Dollar sort of printing around 70 cents at the moment, that’s going to be very beneficial, the domestic tourist industry.  We see that, one, it’s a stock that’s fallen out of favour.  It’s got – we think, some very strong macro tailwinds. 

We think it’s good buying at the moment.  It’s sort of only trading around 12 times earnings.  For a business like that, we think it looks really attractive and there’s every chance that that could rise 50% or more the next year, easily I would suggest.

And what’s your biggest position?

Our biggest position at the moment is AMA Group, which is actually growing a little bit more recently.  Again, they had a takeover for the panel repair business that didn’t go through.  They’ve still got a very strong position in domestic panel repairs market and probably the main catalyst with AMA group at the moment is that Suncorp have a business called Capital Smart, which is about 40 panel repair businesses – and this is public information, they’re actually looking at selling those panel repair shops.  AMA Group own about 120 at the moment and they would definitely be in the box seat to acquire those.  Notwithstanding their current business is going very strong at the moment.  We think that is good business operating in a market that’s not incredibly high growth, but they’re able to expand their footprint of repair shops both through small acquisitions and greenfields and there’s potential upside in buying a big chunk of that market and having that very, very strong foothold there.  We think there’s some good upside there.

I guess, AMA’s one of those stocks that did well for you in the first couple of years after 2014, from 2014 to 2016, but it’s absolutely done nothing at all for two years?

Yes, you’re exactly right.  I mean, that has pretty much flatlined for the last…

Two years.

Yeah, look, even three.  You look at it back in October ’15, it was trading at $1 and it’s…  There’s obviously been dividends paid there, but that’s just one of those ones that – I almost think investing is a bit of a pie, you know, it will sort of ebb in and then it will come back a little bit, then it’ll come back in a bit, sometimes you’ve got to be patient and it’s very hard to time when these businesses are going to have a good run up in their share prices.  It’s not one that’s gone backwards but we could have made more money elsewhere, there’s no doubt. 

That was Dean Fergie, the Portfolio Manager and Co-Founder of Cyan Investment Management.