Summary: The Arnhem Core Australian Equity Fund focuses on quality ASX200 companies with better than average long-term growth prospects. The manager focuses on micro industries, rather than looking at broadly defined industries such as healthcare that could include a device manufacturer and a hospital operator that don’t compete with each other. The fund has a number of international earners given their greater growth potential and also likes companies taking advantage of the move from bricks and mortar activities to online.
Key take-out: The fund’s performance has just fallen short of its benchmark after fees over five years as the market has favoured yield stocks over almost everything else. But the manager runs a low turnover portfolio to minimise the realised capital gains tax and is focused on achieving alpha over the long term.
Key beneficiaries: General investors. Category: Shares.
Arnhem Investment Management invests in core Australian equities with a view to finding growth stocks – and it has a bit of a different approach to other fund managers.
As portfolio manager Neil Boyd-Clark explains, as a way to seek out those companies with the most potential for growth, it breaks industries down and looks at those companies competing directly with each other for the same pool of revenue.
The online classifieds market is an example of what Arnhem considers a micro industry. On issues such as barriers to entry, concentration of the industry and value chain analysis it will assess a number of competitors like Carsales.com, CarsGuide (part of News Corp, publisher of Eureka Report), Gumtree (part of eBay) and Drive (part of Fairfax) and then make an assessment of the best investment opportunity (in this case it prefers Carsales).
Because of stronger growth potential internationally, it has meant there is a propensity for the Arnhem Core Australian Equity Fund to hold a number of companies with offshore exposure, which helps at times, like present, when the Australian dollar is depreciating.
Because of investors’ propensity to prefer high yield stocks over growth, Neil says the past 18 months have been challenging – the fund has underperformed its benchmark the S&P/ASX200. In fact, the fund has returned 9.16 per cent pa over the last five years, 0.53 per cent pa below the index. However, the focus is definitely on achieving alpha over the long term.
Portfolio Manager, Arnhem Investment Management, Neil Boyd-Clark. Source: Arnhem.
DD: What does the Core Fund invest in?
NB: Our focus in the Arnhem Core Australian Fund is on good quality companies that have better than average long-term growth prospects and are typically operating in well-structured micro industries where they have better than average pricing power for their goods and services. We typically own between 30 and 40 stocks in the portfolio, at the moment we have 32, and we confine ourselves to investing in ASX200 listed companies.
What do you mean by micro industries?
For us, industries don’t correspond with global industry classification standard or GICS industries most investors think of. We define our own industries or “micro industries” because we are interested in identifying the companies that are competing for a pool of revenue or profits – so companies that are competing directly with each other.
For example, we don’t think of a company that operates in the hospitals industry as competing with a medical device manufacturer, despite the fact both of those companies might exist in the same healthcare GICS sector. So we define our own micro industries and we then go about analysing the dynamics of the micro industry that we define internally. Over time we monitor things like industry structure changes across the value chain. And we make investment decisions based on our assessment about the prospects for an industry and if it’s likely to see consolidation or fragmentation and whether that’s going to translate into improving or deteriorating negotiating power for the participants. If you think of companies that operate in concentrated industries – for example, exchanges, casinos and this type of micro industry – these are the industries that you’ll find well represented in our portfolios.
Financials are the largest holding in your portfolio at 38 per cent. Are you worried about commentary suggesting a recession or whether slowing economic growth might affect their probability?
It is true that we have a large position in the financials but we are actually holding an underweight position to the financial sector. We have investments in the large, diversified banks because we think that they offer relatively attractive micro industry exposures in mortgages, deposit taking and wealth management which will allow the banks to generate above average returns over the medium to long term.
We do think the growth we’ve seen over the last 10 to 15 years in the banks is likely to slow, but we recognise the banks in Australia have strong pricing power, that they are in a very strong capital position relative to their global peers, and we expect that they can extract cost efficiencies which will maintain earnings per share growth for several years to come.
When you say you’re underweight financials, with the construction of a portfolio like this are you trying to mirror the benchmark a little bit?
We do not mirror the benchmark, but we are benchmark aware. We have a very sound and disciplined portfolio risk framework which allows us to take active positions in companies and industries where we think there is attractive potential. But the size of our positions is well-managed from a risk perspective and part of that risk management framework incorporates the benchmark in terms of the weightings across the portfolio.
Quite a number of the companies you invest in have large offshore exposures – for example, CSL and ResMed and Brambles. Should retail investors consider this when choosing you in their allocation to Australian equities?
It’s not a top down process where we decide that we’re going to expose ourselves to international earners per se. It’s more that when we’re looking for attractively structured growth industries as a starting point a number of international companies emerge from that. It’s because they have greater growth potential because of the size of the markets that they’re operating in than those companies that are constrained to the Australian economy only.
It is something important for investors to recognise that our portfolio would normally have a bias towards international earning companies. That’s a positive thing in an environment where the currency is depreciating because earnings that are generated offshore, when translated into Australian dollars, are higher after the Australian dollar has depreciated.
What companies at the moment excite you and why?
We like companies that are taking advantage of the move from, say, bricks and mortar activities to online activities and are growing a presence online that may ultimately prove to be global in nature. Companies like, for example, REA, Carsales and Trade Me we think have got good growth potential over the medium to long term and have gone through a phase of investment to keep their businesses competitive. And in the case of Carsales and REA they are now looking to capture a greater share of wallet in adjacent markets or expanding overseas. So we think the value that’s on offer in those companies, relative to the rest of the market, is very appealing at current levels.
What’s the reason you are underweight property?
The property sector tends to be an area that we find quite challenging in terms of identifying appealing investments because the vast majority of property trusts do not offer underlying earnings growth and effectively are paying out all of their earnings in the form of dividends every year. This essentially means their ability to grow earnings or grow profitability over the long term is highly constrained and largely based on their ability to leverage up the business through borrowing or raising capital from shareholders. So, for us, the vast majority of property trusts do not offer the kind of long-term, sustainable earnings growth that we are searching for in our portfolios. And hence, we have a natural predisposition against property trusts in the portfolio.
Your benchmark is the ASX200 and every year for five years you’ve just fallen short after fees by about half a per cent. Do you have a return goal in mind? When retail investors are considering investing, why would they choose a fund like this over say an ETF that tracks the index?
We’re taking positions against the benchmark to try and deliver performance that’s different to the benchmark. We’re targeting performance that’s going to add value over and above this for mum and dad investors.
I think one needs to be cognisant of the time period that you’re choosing. Our performance has shown that we can deliver greater alpha over the long term. In fact, since inception we’re looking at about one and a half per cent of alpha per annum [before fees]. It’s fair to say that over the last 18 months we’ve had a significant headwind in terms of performance where we’ve seen markets favour high yield stocks over almost everything else.
One of the other things to note with regard to our approach is that our portfolio is a low turnover portfolio, so we only turn over about one third of the portfolio in any given year. So we are minimising the realised capital gains tax in the portfolio by reducing turnover and we are aware of dividend payment dates and will manage the portfolio to be as tax effective as we can for our investors.
Daniella D’Ambrosio is a writer at brightday. The Arnhem Core Australian Equity Fund is available on the brightday platform, which allows a minimum investment of $1,000 in managed funds.