Summary: The Smallco Broadcap Fund has beat the ASX300 every year for the past five years by investing in smaller companies. The fund also has the flexibility to hold a high level of cash in uncertain times. Smallco looks for companies with a strong competitive advantage and a high return on funds employed.
Key take out: The fund charges a performance fee as much of its outperformance has come from overweighting small caps, which would be compromised if it had a higher level of funds under management.
Key beneficiaries: General Investors. Category: Investment portfolio construction.
A mandate that allows sizeable amounts to be invested in smaller companies and cash has proven to benefit the Smallco Broadcap Fund. The rules that govern the fund mean it is very different to other managed funds that must either be fully invested or substantially index focused.
The flexibility afforded to the fund has contributed to it returning 15 per cent more than the ASX300, every year for the past five years – and in this interview portfolio manager Andrew Hokin gives a pretty good justification for charging a performance fee.
Hokin goes on to tell us how Smallco determines good quality companies in the portfolio, what characteristics they avoid and when they would sell a stock.
Smallco Broadcap Fund portfolio manager Andrew Hokin. Source: Smallco.
Smallco’s long-term performance is the reason it has made it on to brightday’s Featured Fund list.
DD: The Smallco Broadcap Fund has a somewhat different set up to other funds. Can you tell us a bit about it and whether you compare yourself to a benchmark?
AH: We have a core of high quality, long-term growth companies that we think will deliver good returns for years to come. Then we wrap around that what we would define as shorter term opportunities – lower quality companies – which make up a maximum of a quarter of the fund.
The aim is to outperform the S&P/ASX300 accumulation index by 5 per cent per annum over rolling three-year periods after fees, which it has comfortably exceeded. But we deviate quite a lot from this and would describe it as substantially more index unaware than most funds.
Why did you choose a target return of 5 per cent?
It’s a number we felt was achievable given the style and flexibility we’ve put into the fund. Because it’s not a benchmark hugger it has the opportunity to beat the benchmark by more than what you’d call a typical outperformance.
There are two key drivers of this flexibility relative to your traditional big cap funds. Firstly is the fact that while the fund provides a broad market exposure it has the ability to invest up to 40 per cent of its assets outside the ASX100, in what we’d define as smaller companies.
Secondly, the fund isn’t required to be fully invested at all times like most funds are and can hold up to 50 per cent of its assets in cash if market valuations get silly, or earnings trends are generally negative, so this provides us with the opportunity to hopefully still achieve that target return, or at least not underperform the benchmark in a falling market – which is important because small caps typically will. So that ability to not be forced to be fully invested if we are not seeing enough attractive ideas is an important flexibility.
The fund’s cash position at the moment is in the low twenties and 32 per cent of the fund is in small caps. This is a little lower than what it tends to run and that combined with the cash weighting as well just reflects the difficulty of finding what I would call traditional value in the current market.
What kind of characteristics are you looking for of the companies that you invest in?
In defining quality we start out by looking for companies with a strong competitive advantage, or at the minimum at least the ability to hold their prices and not be dictated totally on price. We like companies to have a high return on funds employed and a low level of capital intensity which should mean cash flow generation is strong.
We have pretty detailed models where we aim to have a very good understanding of earnings drivers – for example we are very underweight in resources because nobody can possibly have strong confidence in the earnings forecast for those – and the aim of that is really seeking to avoid negative earnings surprises as much as possible.
With small caps it can be difficult to find where the opportunity lies because there’s less information typically available on them, they are less researched and to pick between them you have to do more of your own work. That is really what we seek to do and where we seek to add value. The further you get up the curve into the top 100 the less opportunities there are to find something that other people are missing.
What would you consider to be low quality?
Companies that are very much price takers, so most resource companies outside the top two, smaller retailers and most building material stocks. Price takers are companies which have no ability to control the price they charge. If I’m a retailer and I’m selling the same stuff as the guy next door and I don’t have any proprietary product well I can’t possibly know what my margin’s going to be next year with any degree of certainty – it depends entirely on the competitive environment. Also those that have little if any diversity in their business. A smaller miner with only a single mine would be regarded as having insufficient diversification, so it would be very low quality.
If companies have no profit history or history of generating positive operating cash flow we would generally put them in the low quality bucket simply because of the risk of them running out of money. We generally don’t invest in companies that don’t make earnings or in any unproven business models or concept stocks and we limit the value of the portfolio that can be invested in positions we consider to be below the market average on quality to less than 25 per cent.
You have a process that ensures if there are any signs that an investment is not going quite as expected you attempt to exit the entire position. Is that rule both for the core and the short-term parts of the portfolio? And what would make you sell?
For any of the short-term stocks which have a below market average quality rating, if a) it either hits the target price and there’s no reason to upgrade that target price or b) if something more than just moderately negative comes to pass that we weren’t expecting, then we’ll attempt to exit the position in full and quite quickly – simply because it’s lower quality and was something we would have only bought into on the basis of an expected relatively short term outcome driven by a pre-identified catalyst.
At the other end of the spectrum, which applies to the majority of the portfolio, what you tend to find is the very highest quality businesses with good long-term growth profiles – internet and healthcare companies are probably good examples of this – have more ability to consistently surprise you on the upside than lower quality companies.
So while we have prices at which we will look to reduce these core positions quite substantially, if they hit initial target prices then unless something is meaningfully different to what we expect – for example in terms of the earnings drivers or the competitive situation – what we are more likely to do is trim the position rather than exit it completely as we would still want some exposure to it.
Do you charge a performance fee for the fund?
Yes, the performance fee is 15 per cent of any excess returns above the S&P/ASX300, calculated daily and paid quarterly. One of the reasons we charge a performance fee is that we believe we aren’t in a position to provide the sorts of outperformance that we hope to achieve if we’ve got billions of dollars invested.
Quite simply a reasonable proportion of our outperformance has come from the ability to overweight the small caps and that would be severely compromised if we had traditional levels of FUM – well over a billion dollars or something like that. So we seek to offset that compromise with a view to remunerate partly on how the fund has performed relative to benchmark, which allows us to keep the fund smaller.
Daniella D’Ambrosio is a writer at brightday. The Smallco Broadcap Fund is available on the brightday platform.