NovaPort Smaller Companies Fund Update – October 2020
Alex Milton, NovaPort Principal and Co-Portfolio Manager
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- We just wanted to provide an update on the NovaPort Smaller Companies Fund touching on activity and performance primarily since late February which as we all know is the point where COVID hit global equities and has been the primary factor driving markets since.
- We wanted to re-affirm our investment process doesn’t change through various market cycles and has been consistently applied since the Smaller Companies Fund was established in late 2002, nearly 18 years ago.
- Also, our adherence to the process has been despite an awareness that significant recent monetary stimulus was driving valuations in popular tech and other growth stocks to levels we weren’t comfortable with and to not participate aggressively in the COVID rally would adversely impact our relative performance.
- Just on that, looking at our performance over the last 6 months the fund is up 21.30% (net of fees) versus the 30.93% for the Small Ordinaries Accumulation Index. Now, while we always take a longer-term perspective in investing as a low turnover, benchmark unaware fund we do want to understand where our returns are coming from and have an understanding at least of where the broader market sits.
- And on that, while we’re under index what has been pleasing is how the fund has performed on days where the market is down materially. We think outperformance generated on those days is attributable to avoiding some of the risk associated with aggressively chasing expensive growth stocks which have been a key driver of the smaller companies’ index but are prone to severe price declines on any sort of negative news.
- Drilling a bit deeper into that, by materially down days we mean days where the Small Ordinaries Index is down by more than 1%; and all up, there have been 40 days since the 24th of February where the index has declined by more than 1%, and if you simply add all the negative days the total is -114.5%. Now, looking at our fund over those days the total negatives add up to -94.83% which is a substantial 19.7% difference.
- So in simple terms, we can say the fund is good at preserving capital on the really tough days but the fact that overall we are below index over the COVID period tells us keeping up with the rally, especially on the strong up days, has been our challenge, not preserving capital.
- And the rally has been strong as we know with the key drivers largely attributable to
- some success to varying degrees flattening the infection curve and,
- the extraordinary level of monetary and fiscal stimulus unleashed globally.
- Now, while a flattening of the curve is no doubt positive from an investor’s risk perspective the bigger impetus to the rally in equities globally, as well as the small cap index here, has been the second factor.
- This is relevant because in fighting the COVID crisis central bankers clearly feel the playbook was written over the GFC and they were of the view back in March what this latest crisis needed is an even higher dose of the same monetary policy remedy. And by that what we mean is the mantra was to go even harder and go even earlier in bringing down interest rates and it’s as if they were saying if you think we worked hard to pump liquidity into markets post the GFC then watch what we’re about to do now to fight a global pandemic.
- So this dynamic is a continuation of what has been favourable conditions for growth stocks versus more value type exposures for a few years now because in short, the decline in interest rates since the GFC has supported longer duration growth stocks where losses or earnings volatility in early years are tolerated because the present value for the forecast longer term cashflows have been boosted by a declining discount rate.
- An outcome of this is that highly priced companies and in many cases stocks which even supporters acknowledged were expensive going into COVID have become even more expensive coming out of it. Now, while this is understandable, we’ve elected expected to avoid a lot of these high-priced stocks where we feel there’s a disproportionate focus on the upside risk relative to the downside thereby exposing investors to significant price declines if expectations aren’t met. I guess that goes back to the earlier point where the fund does especially well in preserving capital during periods of market weakness.
- So now we wanted to touch on how we’ve managed the fund with this macro background in mind. No doubt high levels of volatility since late February and the material change in outlook compared to early 2020 has presented some great opportunities and we’ve made more changes in the fund since March than has been the case in such a short period of time probably since the GFC.
- Just to touch on some of the new inclusions …
- Financial services provider Netwealth was added in late February and we believe is well positioned as a disruptor to grow FUM over time.
- IT services company, Data #3 has transitioned from an IT hardware reseller to a managed services business helping companies and public sector agencies migrate to the cloud, manage WFH environments from an IT perspective and address vital issues such as cyber security and data & analytics.
- CSR is another one we’ve added and as you would know it’s amanufacturer and supplier of building products across Australia and New Zealand. There’s net cash on the balance sheet with undrawn debt facilities and is well positioned to benefit from any stimulus support for housing related activity.
- Intellectual property and trademark services lawyers IPH is another new one. We like it because it’s a bureau type business and highly cash generative with very high market share in Australia and growth options across Asia. Also attractive is its digital capability to operate effectively in a WFH environment.
- Omni channel baby products retailer, Baby Bunting which is the last bricks and mortar network standing in Australia with a focus on baby products. They’ve been fine tuning the hybrid store and online model in competition with Amazon for a while now and we think it’s one of the retailers that will thrive in the current environment.
- We’ve also added Invocare which is a provider of funerals, cremations and memorial parks. Social distancing measures has reduced the spend on funerals and this has impacted earnings. However, its strong market positioning should see it withstand this period given it does have a solid balance to manage any liquidity issues.
- Lastly, Spark New Zealand was added to the fund recently and is New Zealand’s largest telco with a robust mobile position and is set to benefit from the completion of a 3 year transformational plan. We also like it for its strong cash generation and 5G growth opportunities.
- All up these new stocks now account for just under 20% of the fund.
- Overall, in terms of how we’ve positioned the fund, we believe now is the time for a diverse portfolio of safe/defensives as well as risk exposure for a recovery. What we’re not doing is chasing the tech sector or other high growth stocks which in many cases are trading on optimistic valuations (and being driven by liquidity) in order to protect performance relative to the index.
- So, before we take a closer look at particular stocks, we might make a quick comment on how we see the outlook for markets and the fund starting with how we see risk.
- As always, as managers we view risk as the risk the companies we own will not meet our expectations regarding issues such as earnings and balance sheet quality for example rather than not owning bigger small caps driving market returns. So, to that extent, where markets are driven by a relatively narrow range of companies where valuations are at levels where significant downside risk is evident should expectations not be met, we do expect to lag.
- That’s not to say we don’t like growth; we have growth in the portfolio, but as always, we manage our fund exposure to minimise this downside risk even if it’s at the expense of better relative performance.
- So on the question of growth vs value or COVID winners and losers, we’ve always been willing to invest in high PER growth stocks (where we can see a high degree of earnings certainty) as well low PER cyclicals. To minimise downside risk though we are mindful of the portfolio weightings of the higher PER companies we choose to own as their prices appreciate as well as drawing a line at stocks where sentiment and risk appetite have been stretched.
- Further to that, should we enter a new phase where virus eradication is accepted as unrealistic, but we’re are able to manage outbreaks effectively so as not to materially disrupt economic activity (ie, fighting the spot fires rather than large scale lockdowns), or if there is a vaccine then we will very likely see more attention paid to cyclical exposures that have been largely ignored in the COVID rally which we believe will benefit a number of the stocks in our fund that have lagged the risk on days over the last few months.
- The incredible amount of fiscal stimulus introduced since March and confirmed in the recent budget, which combined with an easing in restrictions, is also supportive of some of our recovery, or cyclical exposures we hold in the fund.
- Now turning to a few comments on stock performance, we’ll highlight some of the biggest positions in our fund and also look at our top contributors and detractors …
- Our top positions at the moment include medical devices company, Fisher & Paykel, insurance broker AUB Group (which used to be called Ausbrokers), mining and industrial services company Seven Group Holdings, two gold exposures in Saracen and Gold Roads, medical and pharmaceuticals distributor EBOS and travel and outdoor apparel retailer, Kathmandu. Combined these stocks account for 26.5% of the fund.
- As you’ll see there is a diverse exposure in high PER with Fisher & Paykel, through to industrial; cyclicals and consumer discretionary like Seven Group and Kathmandu.
- Finally, we’ll take a look at our top contributors and detractors over the last year to 30 September.
- While being our biggest positions, four of the stocks mentioned above are also our best contributors for the year. The remaining one of the top five is Netwealth which we’ve just highlighted was a new stock added in the last few months.
- Looking at the detractors, while share price performance has been disappointing there are none there that have gone out of business, or to use the expression blown up because of poor strategic decisions, badly executed offshore acquisitions or corporate malpractice.
- In hindsight, radio station group Southern Cross media was carrying too much debt prompting a highly dilutive raising but that was largely required because of extraordinary pandemic conditions which were unexpected to say the least at the start of the year.
- Similarly, for Credit Corp which is a very well managed debt purchasing and collections company it has been adversely impacted by COVID conditions. The other two major detractors were our exposure to aged care companies Estia Health and Regis Healthcare. We’ve been of the view that post the Royal Commission there will be an improvement in sentiment regarding the sector and the need for profitable companies to provide a service for an ageing demographic which the Federal government would be reluctant to fully fund itself but the COVID impact, which has been tragic in no uncertain terms, has buffeted their respective share prices in the short term.
- On a final stock comment we would just flag we continue to hold positions in all these detractors with a view the worst is priced in and in total, our fund exposure to aged care, Southern Cross and Credit Corp currently amounts to just under 8%.
This material has been prepared by NovaPort Capital Pty Limited (ABN 88 140 833 656, AFSL 385 329) (NovaPort), the investment manager of NovaPort Smaller Companies Fund and NovaPort Microcap Fund (Funds). Fidante Partners Limited ABN 94 002 835 592 AFSL 234668 (Fidante), 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 for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The PDS for the Funds, issued by Fidante, should be considered before deciding whether to acquire or hold units in the Funds. The PDS can be obtained by calling 13 51 53 or visiting www.fidante.com. Neither Fidante nor any of its respective related bodies corporate guarantees the performance of the Funds, any particular rate of return or return of capital. Past performance is not a reliable indicator of future performance. Any projections are based on assumptions which we believe are reasonable, but are subject to change and should not be relied upon. NovaPort and Fidante have entered into arrangements in connection with the distribution and administration of financial products to which this material relates. In connection with those arrangements, NovaPort and Fidante may receive remuneration or other benefits in respect of financial services provided by the parties.