Active Management of Small Caps
Sinclair Currie and Alex Milton, Principals, and Co-Portfolio Managers at NovaPort Capital
Paradigm shifts, in this case the emergence of high inflation for the first time in more than 30 years, is an enemy of passive investing, and a friend of active investing.
Passive investing isn’t the one-way bet that it was post the global financial crisis, because there is an economic cycle. And in cycles there’s ups and downs, so capital preservation becomes more important.
Fund managers, and financial planners, are paid to manage risk, though often this translates in client conversations as being paid to take risks.
It took rising interest rates and a change in the macroeconomic environment for many investors to pay more attention to capital preservation. Keep in mind index tracking exchange traded funds mirror the market, or a section of the market, and have no incentive to preserve capital.
Similarly passive investing backs the index. Stock selection is almost irrelevant outside weightings.
At some point, valuation itself becomes a risk in passive investing. And it’s a risk that passive investing is blind to because it is based on the market always being right.
We saw this most recently during the COVID “risk on”/FOMO/TINA1 rally where unprofitable buy now pay later companies and cash burning tech stocks with unproven business models (in many cases reliant on continued lockdown conditions to grow revenues) had an inordinate impact on index returns. Similarly, situations where either the cost of growth was ignored or deemed a non-issue thanks to negative interest rates.
The point of active management is to ignore these drivers. That’s something passive investing can’t do.
While many of the COVID winners gave back all of their gains and more last year to the detriment of index returns, some of our investments with economic cycles and inflation in mind fared well including Spark New Zealand (a quality defensive as the dominant telco in the NZ market), EBOS Group (well managed and diversified exposure to the healthcare and pharmacy sectors via its marketing, wholesaling and product distribution divisions) and Data#3 (a technology company with a long track record of cashflow generation, dividends, cloud beneficiary and a fundamental basis for its valuation).
If you take a passive style, you’re saying the market adapts to change and recognises that change very efficiently. But that’s illogical.
Passive investing does not reflect a view of what’s changing and what that means for the future. Our job at NovaPort is to identify change and invest where we see that change occurring.
A current example for us includes Estia Healthcare where improved funding outlook for the sector, excessive COVID costs rolling off and a much more demanding operational environment to the detriment of less well capitalised companies is not yet reflected by the market.
The passive versus active debate introduces the notion of market efficiency. Markets provide an efficient signal of the demand for and supply of a security, but not necessarily its value or outlook.
An important part of active investing is looking beyond the current share price. There’s much more to it than deciding whether a small cap is a buy or sell when its trading on a price to earnings multiple of 15 times earnings, or 20 times earnings.
More fundamentally is it a viable and sustainable business?
A lot has changed in eighteen months when a good portion of the Small Ordinaries benchmark was made up of unproven companies. Maybe they were cheap. Maybe they weren’t in the long run. No-one really knew.
What we found out is that ultimately investing is about valuation and business models and shouldn’t be about short term directional share price moves driven by market thematics rather than fundamentals. This was tenable when there’s plenty of liquidity. Its relatively easy to buy an index.
However, with escalating interest rates and lower liquidity it isn’t as easy for managers to enact top-down strategies via indices. The top-down strategy starts to fray at the edges.
Active management is about more than valuation as implied by the current price and its likely direction in the short term. It’s about knowing if a company will be around five years from now, by virtue of their management, their products, the industry structure, and a range of other factors.
Put simply: is it a good business or not?
Important Information
1 TINA refers to ‘there is no alternative’ and FOMO refers to ‘fear of missing out’.
This material has been prepared by NovaPort Capital Pty Limited (ABN 88 140 833 656 AFSL 385 329) (NovaPort), the investment manager of the NovaPort Smaller Companies Fund and the NovaPort Microcap Fund (Funds).
Fidante Partners Limited ABN 94 002 835 592 AFSL 234668 (Fidante) is a member of the Challenger Limited group of companies (Challenger Group) and is the responsible entity of the Funds. Other than information which is identified as sourced from Fidante in relation to the Funds, Fidante is not responsible for the information in this material, including any statements of opinion.
It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable to your circumstances. The Fund’s Target Market Determination and Product Disclosure Statement (PDS) available at www.fidante.com should be considered before making a decision about whether to buy or hold units in the Funds. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.
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