Summary: The Hyperion Small Growth Companies Fund focuses on investing with a horizon of five to 10 years. The fund looks for companies with predictable growth and high return on capital. The four most senior investment team members have to approve all portfolio inclusions to protect against psychological misjudgements.
Key take out: Hyperion says the longer an investor’s time horizon, the greater percentage of their portfolio they can have in a fund such as this.
Key beneficiaries: General Investors. Category: Investment portfolio construction.
When someone tells you they manage a fund that has returned 13 per cent every year for five years your ears prick up, your eyes get a little brighter and you hang on their every word.
All the more so when you find out the fund manager – Joel Gray, portfolio manager for Hyperion Small Growth Companies Fund – has skin in the game and what’s more, he’s banned from buying stocks outside the fund.
The fund invests in businesses that fall outside the ASX100 (at time of investment). In our chat Gray lets us in on how the fund operates and talks about its disciplined investment process, which includes a vigorous selection of companies by committee.
Joel Gray, portfolio manager for Hyperion Small Growth Companies Fund
The success of Hyperion Small Growth Companies Fund comes down to a mix of passion and having an unwavering, ongoing faith in the team and its process.
Hyperion’s long-term investment success is the reason it has made it on to brightday’s Featured Fund list.
DD: The fund has returned 13% every year over 5 years. What do you think is a single factor that has driven this outperformance?
JG: It’s definitely our focus on investing with a 5-10 year horizon that is a differentiator. The market is a lot more short term than this.
We’ve never underperformed over rolling five-year periods or since inception and that’s because of the predictability of the earnings streams we are looking at.
Also, we are really disciplined. For us a company either passes our quality metrics and is in the portfolio – subject to valuation – or it’s not.
What are some of the things you might look for in a company that shows that five year predictability?
We look for businesses that are easy to understand, have strong customer value propositions and a track record of profitability. Quality businesses have sustainable competitive advantage, pricing power, fragmented customer base, no major acquisitions, stable industry and stable management teams.
Low gearing is also really important. Over half the small growth companies fund portfolio at the moment is in companies with no debt whatsoever, and the interest cover on the remaining shares is over 20 times (there are currently 21 stocks in the portfolio).
It’s not just growth we are looking for, it’s predictability around that growth, which is a bit of a differentiator for us compared to other fund managers.
We also think return on capital is a good proxy for quality in that it combines how much profit a business generates with the amount of capital required to generate the profit. It’s very easy to generate profit by just throwing a lot of capital at something, but it’s a lot harder to generate a high return on capital. It’s a signal that there’s maybe something special about the company.
Do you compare yourself to a particular benchmark when you talk about performance?
Yes, we compare the portfolio to the Small Ordinaries Accumulation index, but we think more in terms of absolute returns. We invest in predictable, high quality companies, which we say leads to predictable high quality outcomes for shareholders over the long term. So that’s really an absolute mentality rather than a relative benchmark.
You mentioned you have a very disciplined approach. How do you decide as a team what goes in the portfolio?
It’s a very automated bottom up portfolio construction process where the higher the five year internal risk adjusted return, the higher the weight in the portfolio.
In terms of decision making we think we have an unusual style compared to other fund managers. The four most senior investment team members at Hyperion have to approve all portfolio inclusions, which we think is really good protection against psychological misjudgements by an individual – like falling in love with a stock.
In most funds the analysts feed ideas up to a CIO who chooses the portfolio or you have analysts responsible for different aspects of the portfolio, but we don’t think you maximise the full benefits of a team by having that approach.
Is it true that one team member is allowed to veto a decision right at crunch time?
Our motto is: “if in doubt, stay out”. This leads to a more concentrated portfolio, because that approach can only lead to fewer stocks in a portfolio, not more. So you really have to do a lot of due diligence to make sure you can convince sceptical minds around the table who are going to challenge you on it, that it’s investment worthy.
Does market sentiment influence your decision? And does the actual share price matter on the day for when you buy a company?
We’re only looking at valuation when we’ve decided a business is of high enough quality.
Market sentiment always influences your decisions because what the market is saying is basically reflected in the share prices. Sentiment relates mainly to short termism. We are trying to take advantage of situations where there is a problem with a quality company, which we determine is only temporary, then we take advantage of that sentiment to buy these high quality businesses that have got great long term growth prospects, at lower prices than would otherwise be the case without that negative sentiment around them.
You’ve got personal money in Hyperion and are actually banned from investing anywhere else. Do you think this is a good policy?
Yes, you can’t invest in any companies that aren’t in the portfolio, so basically we can‘t buy any stocks that aren’t held by our clients. But you wouldn’t want to anyway.
It makes sense to be investing in our products because everyone here believes that high quality investing – providing you are not overpaying for businesses – will lead to superior returns long term. So because everyone is a passionate investor and believes fully in the process it makes sense they’d be invested in the process.
What percentage of a portfolio should you invest in a fund like the Small Growth Companies Fund?
The longer your time horizon the greater percentage you can have in a product like this. It is a concentrated portfolio. At the moment there are 21 companies in the portfolio, which is probably lower than more mainstream equity products. There will be short term volatility, but that’s only relevant if you’re thinking of taking that money out some stage over the short term.
We think the predictability focus really limits downside for a long term investor. People think of risk as pricing risk, whether you pay too much on a near term P/E basis. But we think the biggest risk is not getting those earning numbers roughly right, business risk we call it. We think that’s much more important in determining whether you are going to get a satisfactory long-term return.
Daniella D’Ambrosio is a writer at brightday. The Hyperion Small Growth Companies Fund is available on the brightday platform.