Asymmetric Opportunities Fund September 2022 Quarterly Letter
Dear Investment Partner,
For the month ended 30 September 2022 the Asymmetric Opportunities Fund (AOF) outperformed its benchmark by 2.0%. The AOF declined 8.9% (net of fees and expenses and assuming the reinvestment of distributions), while its benchmark, the S&P/ASX Small Industrials Accumulation Index, fell 10.9%.
As the table below shows, the Asymmetric Opportunities Fund has outperformed its benchmark over all time periods since inception.
| Returns to 30 September 2022 | 1 month | 3 Months | 1 year | 2 years (p.a) | 3 Years (p.a) | Since Inception 1 January 2019 (p.a) |
|---|---|---|---|---|---|---|
| Asymmetric Opportunities Fund (Net Return) | -8.9% | 6.3% | -20.9% | 6.7% | 6.1% | 9.0% |
| Benchmark* | -10.9% | -1.0% | -27.5% | -3.3% | -3.7% | 2.6% |
| Value Add (Net) | 2.0% | 7.3% | 6.6% | 10.0% | 9.8% | 6.4% |
*S&P/ASX Small Industrials Accumulation Index (XSIAI); All AOF performance figures are calculated net of fees & assume reinvestment of income distributions.
Portfolio Update
At September end the portfolio held 15 stocks (up 1 on the prior month) plus a position in an Exchange Traded Fund (ETF) that provided exposure to the broader stock market.
Equities comprised 87% of the portfolio with the balance (13%) in cash and dividends due.
The median market capitalisation of a portfolio company was $434 million.
We have recently identified some new investment opportunities and we were poised to add other new companies to the portfolio during the month; given the downward trajectory of markets in September however, we ultimately ‘held our fire’.
PORTFOLIO HOLDINGS BY MARKET CAPITALISATION
Overall, we were comfortable with how the portfolio was positioned and how it performed during the month given the souring mood across global markets. The standout performer for the fund was electrical components supplier IPD Group, which saw its share price grind higher over September, resulting in IPD Group becoming the largest position in the fund. Amongst other positives, we view IPD Group as well positioned to benefit from the continued evolution of renewable energy transmission and growth in electric vehicle take up.
| Portfolio Characteristics Snapshot | AOF | Small industrials* | AOF Attributes |
|---|---|---|---|
| Return on Equity | 13.1% | 12.7% | High Quality |
| Net Debt/EBITDA | 37% | 80% | High Quality |
| Revenue Growth | 6.2% | 10.5% | Solid Growth |
| Earnings Per Share (EPS) Growth | 5.3% | 1.8% | Solid Growth |
| Price to Earnings (PE) ratio | 9.1x | 16.5x | Attractively Priced |
| Dividend Yield | 4.9% | 3.2% | Attractively Priced |
Source: Thomson Reuters, Asymmetric Asset Management; Median of 1 year forward analyst consensus forecasts; *Small industrials comparison is ASX Small Industrials Index excluding real Estate and Biotechnology companies
The largest detractor was outsourcing provider Link Administration with the negative attribution from this position twice that of the fund’s second biggest detractor during the month.
What made the return from Link particularly disappointing was that its place in the fund was premised on a takeover offer hence it was categorised as a Special Situation. One of the reasons the fund invests in Special Situations is that (in theory) there is inherent downside protection which can be particularly valuable and useful when the market falls like it did in September. Unfortunately, that “protection” didn’t result in this instance.
The Special Situation that wasn’t
To begin our review of the Link Administration position we’d like readers to understand the starting point we take with all Special Situations.
Before initiating a Special Situation a company must first meet our criterion that the price we’re paying is a price at which we’d be comfortable owning the stock longer term should we have to. In other words, with every Special Situation we don’t just consider the expected return and the probability of deal completion rather we also consider the underlying investment metrics and value.
This has a few ramifications. Firstly, we pass on most takeovers in the market as they don’t get over this first hurdle.
Secondly, it gives us optionality if the takeover offer doesn’t complete. Whereas owning a company that we don’t like or that we don’t believe has valuation support would generally force us to sell immediately upon a failed takeover, owning a company such as Link Administration still leaves us with ways to win.
Indeed, Link has numerous favorable investment characteristics. The company has recurring, defensive revenue streams with global growth opportunities. This can be seen in the recently reaffirmed FY23 earnings guidance which is impressive considering the macro backdrop.
The attractiveness of Link’s business units is also evident from the new buyout offer for parts of the group just days after the whole of company buyout offer fell over.
While Link’s UK business, Link Fund Services, is clearly facing some significant obstacles emanating from the Woodford Fund turmoil, until recently these were hard to quantify and even now the outcome remains unclear. The Independent Experts Report, accompanying the prior takeover offer, was also unable to quantify the potential exposure to the Woodford matter.
Allowing for the most recent information and the fall in share price we still see value today and the continued corporate interest suggests others see value too.
"I realized the great investment arbitrage – the biggest source of alpha of all – was time horizon. The longer-term time horizon you have, the more probability you'll have of success if you have a framework that is true and robust and realistic. Those two things married together just shift the balance of probabilities in your favor."
Raoul Pal
Compounding long term equity returns
Given the market ructions of the past year we thought readers may appreciate the results of our following research.
Firstly, we lay out an explanation of why the Asymmetric Opportunities Fund is focused on investing in smaller, rather than large, industrial companies.
Secondly, we remind readers why it can be so beneficial to wealth creation to not “settle” for an index-level return.
The chart below breaks down the S&P/ASX Small Ordinaries into its two component parts: the S&P/ASX Small Industrials index and the S&P/ASX Small Resources index.
Source: Refinitiv Eikon; AAM; data to 30 June 2022
What we glean from the above chart is the drag which investing in resources can have on portfolio returns. Obviously, it’s been a very helpful tailwind over the past five years; however longer term the benefit of simply avoiding this sector altogether is stark.
So, the exclusion of resources from the Asymmetric Opportunities Fund, we believe, puts the fund at a distinct advantage to produce superior relative returns over the long term.
By the same token, we have chosen the S&P/ASX Small Industrials Accumulation index to benchmark the fund against. Not only is this ‘true to form’ but as can be seen in the bar graphs above, in the long term it also creates a higher hurdle rate which benefits unitholders more than if we had chosen the broader small ordinaries index, as many small cap managers do.
The foregoing explains our focus on industrial companies (or rather exclusion of resource companies) but it doesn’t explain our focus on smaller companies as opposed to larger ones.
While the returns of the ‘Big Cap’ indices have been superior, by ~2% per annum over the past 30 years, to their ‘Small Cap’ peers, there is another critically important factor for investors to consider as the chart below highlights.
Source: Lonsec Research Pty Ltd, AAM; data to 30 June 2022
Pricing inefficiencies amongst smaller companies appear to create a very real opportunity for a small cap investor to outperform. As the chart above shows, the median large cap manager has a persistently poor record (shown here over 5, 7 and 10 year timeframes) of performance against the large cap index.
By contrast, over the same time periods, the median small cap manager has consistently added value (after fees). This explains our focus on smaller companies. We believe this space offers the best potential to outperform.
The beauty of compounding returns and the difference outperformance can make
The 30-year Compound Average Growth Rate (CAGR) of the S&P/ASX Small Industrials Accumulation index has been a respectable 7.2% per annum (p.a).
Assuming one had made a $100,000 investment in a replica of the S&P/ASX Small Industrials Index (and had no fees or taxes to pay) back in 1992, thirty years later (including the reinvestment of dividends) compounded at 7.2% pa that initial investment would have grown to $812,000.
That’s a return many investors would be happy with however the evidence suggests investors in small caps can do even better. The data set utilised in the chart above stretches back 10 years and shows the median small cap fund manager outperformed the small cap benchmark by 3% p.a.
By way of example, if we were to add that 3% p.a outperformance to the 7.2% p.a index return and assume it could be sustained for 30 years then an initial $100,000 would compound to $1.8 million.
It goes to show just how valuable every extra percentage point is to growing one’s wealth.
Outlook
With interest rates moving higher, discount rates are moving higher and the near-term outlook for most asset prices remains poor. Our job is to find mispriced assets and while the outlook for economies is far from rosy or pleasant, these higher levels of uncertainty and volatility increase the chances of mispricing.
To that end we’ll continue implementing our investment process and doing our best to position the fund to benefit from asymmetric mispricing opportunities.
We take our role as stewards of our investment partners’ capital very seriously and express our sincere appreciation to you for investing alongside us.
Kind regards,
Tim McArthur & Pierre Prentice
Co-Portfolio Managers
Disclaimer: The information contained in this document is general information only and does not constitute investment or other advice. The contents of this document do not constitute an offer or solicitation to subscribe for units in the Asymmetric Opportunities Fund. Asymmetric Asset Management accepts no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information.