PORTFOLIO POINT: Hyperion has been able to generate good returns since its launch, with a 9.2% total return for last financial year.
Searching for the main reasons for the under-performance of large cap stocks in global markets, inevitably leads to analysis of the “weight of money” in markets.
It’s easy to see why stocks in economies which are struggling will themselves be lagging, but what about stocks in growing economies like Australia? When institutional investors allocate to global markets they do so typically into major indices and their components, reflecting the liquidity of the large indices and their ingredients.
In this era of “risk on and risk off,” any negative macro signals lead swiftly to a withdrawal of money from blue-chip stocks. This is part of the reason for a lack of any meaningful equity risk premium in Aussie large and mid cap stocks, and has the by-product that smaller cap stocks are (more than ever) trading under the radar of the ebbs and flows of large institutional investors.
Small cap stocks have less liquidity than blue chips – leading to small cap investing being more “buy and hold” – and aren’t widely researched or understood. Eureka readers will know of the solid returns to be enjoyed in this sector and today we review one of the leading small cap fund managers, the Hyperion Small Growth Companies Fund: www.hyperionam.com.au
What looks like a tautology in the name (are we investing in a fund that only promises “small growth”?) shows the clear focus of the fund – to invest in small companies with a growth bias – with at least a medium-term investment timeframe.
Therein lies the risk of the small cap sector, not only through the lack of liquidity but also from the need to hold stocks for several years to allow their growth potential to be realised. Small cap investing isn’t for the fainthearted – hence the merit of accessing a skilled manager with a proven track record in the space.
Growth investing is typified by stocks where the valuation (easily understood through the P/E ratio) is in excess of the current cash flow being produced by the company. High P/E multiples are a fact of life in growth investing, where the story isn’t just about what the company is doing today but what it is going to do tomorrow.
Investors in the failed ABC Learning group will know of the risk of the “gonna” style of investing, especially when the current cash flow of the company doesn’t support the current share price.
Successful growth investing therefore tends to try to locate companies with emerging technologies or business systems, and innovation in products/services and management style drive the forward growth in the company’s fortunes and share price. Stocks like Microsoft and Apple are classic examples of growth stocks, especially in their early days; although now that they have proven their business models and established quasi monopolistic positions they may also now be seen as defensive stocks (with resilient and maintainable earnings).
Therein lies the deeper attraction of small cap growth stocks – in this era of rapid business and social change, seeking out innovative companies with the potential to become as profitable as a Microsoft has to be a part of all investor portfolios.
The problem for most investors is that research on small cap stocks isn’t readily available. Lack of liquidity means that stockbrokers can’t generate meaningful revenues from share turnover at the small end of the market. This means that the “boots on the ground” approach used by good fund managers provides them with the potential to access stocks which aren’t widely understood, in turn highlighting the importance of good analytical skills as well as a good understanding of the strategic settings within the industry sector or market niche that the target company occupies.
Hyperion describes itself as a “deep growth” investor – an interesting play on the usual mantra of “deep value” – both styles seek to buy stocks at a cheap valuation, with Hyperion explicitly stating that the price they pay for a stock is one of the main drivers of the ultimate returns available from the stock. So the Hyperion style may perhaps be seen as an enhanced version of the GARP (“growth at a reasonable price”) style – with an emphasis on market timing and therefore the strategic activity within the niche the company occupies.
Compared to some managers, Hyperion doesn’t provide as much information regarding its key investment metrics as investors may wish for. No doubt that reflects the proprietary IP behind its approach, and the relatively small amount of available information describes (but doesn’t give great detail) around its longer-term “buy and hold” approach.
For example, Hyperion explicitly states that it is benchmark unaware – a positive investment theme that we have described in detail in this column – and that it holds a concentrated portfolio of stocks to generate alpha “over the whole business cycle.” Unlike larger cap investors where a “top-down” approach is used to target optimal sectors, prior to stock specific or “bottom up” analysis being undertaken, Hyperion states that it is focused on a bottom-up approach … no doubt reflective that it looks for growth in stocks wherever it can find it.
Being sector agnostic can bring its own set of risks, as innovation in products and services at the firm level can be difficult to use to extract superior returns in industries and sectors that are lagging: the problems with investment in the troubled financial planning and wealth management sector is a clear example that most investors would understand and appreciate in the current climate.
Hyperion states that it uses a proprietary five-year valuation methodology with a focus on the predictability and maintainability of earnings over that period. This seems to be to overcome the problem of buying a company based on what its “gonna” do over the period; obviously good earnings show that any innovations in products, services or business systems are actually working to generate positive cash flow.
A good indication of the outcome of the Hyperion stock selection methodology can be seen from the list of its top 10 holdings, which it publishes in its regular market and fund reports (known as the “Satellite” report – because Hyperion is one of the orbiting moons of Saturn).
Source: Hyperion Asset Management
Using this approach has been working successfully for Hyperion over the before/during and after GFC approach.
With the benefit of a stable investment team during the period, Hyperion has been able to generate good returns with moderate capital stability: the unit price of $1.68 prior to the GFC (on August 31, 2006) fell to a low of $1.19 immediately after the bottom of the GFC (on January 31, 2009) and has risen consistently since then to the current price of $2.19.
Total returns have been good during the period, with a 9.2% total return for last financial year following a 4.3% pa return for the prior year, and a superb 28.2% pa return for 2010.
Hyperion uses a performance-based fee structure with the base management fee of 1.25% pa plus 15% of any outperformance above the S&P/ASX Small Companies Index (with a highwater mark applicable). The Hyperion Small Growth Fund is a good performer with a slight lack of transparency about its process (entirely explicable given the space it works in) a relatively small negative.
Given the illiquidity in the sector, investors should carefully consider the relative size of any investment, noting the minimum investment amount of $20,000.
The score: Hyperion Small Growth Companies Fund – 3.5 stars
0.5 Ease of understanding/transparency
0.5 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks