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Differentiating a small cap fund

By Newsdesk
  • November 02 2023
  • Share

Resources

Differentiating a small cap fund

By Newsdesk
November 02 2023

In this episode of Relative Return, hosts Charbel Kadib and Laura Dew speak to Simon Brown, co-portfolio manager at Tribeca, about small cap performance and how he differentiates his fund.

Differentiating a small cap fund

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By Newsdesk
  • November 02 2023
  • Share

In this episode of Relative Return, hosts Charbel Kadib and Laura Dew speak to Simon Brown, co-portfolio manager at Tribeca, about small cap performance and how he differentiates his fund.

Differentiating a small cap fund

Listen as they discuss:

How the fund has achieved outperformance in an underperforming asset class.
The “survivorship bias” in the fund’s 22-year tenure.
The Tribeca Australian Smaller Companies Fund’s allocations.
What he enjoys about working as a fund manager.
Opportunities the fund is seeing in the energy transition.

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Differentiating a small cap fund

Transcript

 

Welcome to Relative Return, get closer to the people, products and strategies shaping Australia's financial services industry.

Hello and welcome to the Relative Return podcast. I'm your host today, Charbel Kadib, hosting for my debut appearance on the Relative Return podcast. I'm the leading editor, financial services here at Momentum Media. And I'm joined by my colleague, editor of money management and super review, Laura Dew. Welcome, Laura.

Hi. And we have a special guest today, we have Simon Brown from Tribeca, he's the co-portfolio manager of the smaller companies strategy at the firm. Thanks for joining us, Simon.

Great to be here. Great to have you.

Okay, Simon, thanks for coming on today. Do you just want to start by talking about what your role is at Tribeca and sort of how long you've been with the firm?

Well, I'm a co-portfolio manager of the smaller companies fund here at Tribeca Investment Partners. I've been here for around 18 years, which is quite a long time, I guess I'm not that old, but I certainly cut my teeth in the, very much cut my teeth in the industry here at Tribeca. I started as the trader over 18 years ago with very little experience. I had an interest in stocks and effectively used the sort of trade and roll at Tribeca as a sort of platform to further myself. And they sort of, Tribeca had a sort of process and some really smart people around that could sort of help me do that. So I became an analyst in my own right, I always had an interest in stocks and I wanted to be sort of an analyst and invest money. So I managed to become an analyst in my own right and after a bit of success, the founder of our firm, sort of David Arwood invited me to co-portfolio manage the smaller companies fund with him.

So my day-to-day role, I'm still an analyst across a number of sectors, so I still present stock ideas to the rest of the team here in the process of how we sort of present, we get stocks into the, included into the fund. I work across the rest of the team, along with David, sort of on their own idea generation. We'd like to sort of have a second set of eyes for a lot of things and another opinion there to keep challenging each other. I also work closely with David on portfolio construction, which we believe is sort of very important. We like to know where the risks are emanating out of our portfolio and whether we're comfortable with taking those risks. And outside of that, we're regularly interacting with clients and marketing the fund into retail advising networks and the like. So that's pretty much a quick summation of the job.

Great. Sounds like quite a varied role. What would be the main thing that you enjoy?

Look, I think why David asked me to be co-portfolio manager was he saw my eagerness and willingness to get out and find ideas. And it's very much like that in smaller companies, you tend to have a lot less sort of focus, a lot less coverage in small caps. So there is a lot more legwork that's required in getting out and sort of finding out about ideas. And I really love that. I enjoy interacting with people, interacting with management teams, interacting with sort of customer suppliers, going and seeing sites. It's great, which you probably get a little bit, you know, in larger caps, you're probably tied to the desk a little bit more. There is a lot more sort of information and analysis is kind of done by the sort of sell side broken community in that space.

It's a very interesting time to be working in the space at the moment. I want to get your take on sort of the broader macro environment. There's a lot of sort of uncertainty plaguing the market, of course, characterized by high inflation, aggressive monetary policy tightening. And we had some surprise data, inflation data last week, suggesting that perhaps we might get some more rate hikes in the next few months. I think most analysts are expecting another hike for November. And of course, hikes typically affect equities markets pretty heavily. And we've seen bond yields go up as well. And that's brought equities prices down a little bit. Just I guess, what's your take on the market? How have you navigated through those complexities and through that uncertainty?

Yeah, look, it's part of the challenge has been sort of maybe some of the excesses that built up over a reasonably long period of the last decade or so of sort of extraordinary monetary policy, if you like, sort of with a lot of multiple QE's being announced sort of in the US market. We ended up seeing QE's sort of employed here and obviously in Europe and very low interest rates effectively look to sort of supplement sort of the lack of sort of real growth that we were seeing in a lot of those economies as they recovered from the GFC.

So the pandemic sort of came around and sort of a lot of central banks laid on a lot more sort of extraordinary sort of monetary policy to sort of offset that. And then we saw sort of a very much a tightening up of sort of supply chains and also a huge sort of spike in inflation, I guess so. Monetary policies had to be normalized to a huge degree from a very low base, which can often be quite painful. I guess the rate of change of some of those interest rate rises and the speed at which they were conducted was always going to take a lot to be dealt with. So it has created a fair bit of volatility in markets and obviously sort of markets, volatility is not sort of an investor's friend. So I think it's pushed to be reasonably cautious.

Now, where do we sit today? We are probably a reasonably large way through normalization, I would believe at this point in time. We have rates up towards a more normal level and a lot of people may not remember what normal levels are, but sort of go back to sort of 2007 and beyond, sort of rates between sort of four and 5% aren't anything particularly abnormal. As I said, it has come from a relatively low base. So I think sort of inflation is coming down gradually. Maybe there is a little bit more work to do in regards to tamping that back down to sort of their 2% target. Maybe there is one more rate hike there, but I think there are sort of reasonable lags associated with monetary policy and implementation of that over such a short period of time means that we may not have completely felt, I guess, the pain from sort of higher rates just yet. So I think they will be relatively cautious. Jawboning is one technique they use to try and sort of get the market sort of to move their way without actually moving interest rates. So I think that has brought a greater degree of focus on, obviously, you sort of have a bit of business cycle there, sort of tightening sort of credit availability and the banks are sort of restricted lending to some degree and require a higher rate of return. So there is looking to sort of slow that growth. That's not always great for equities in terms of sort of growth revision sort of coming down. Stock prices tend to like to follow sort of earnings growth. And I think it's obviously refocused to the markets on valuations firstly, and then sort of potentially unsustainable business models that were being supported off relatively sort of low hurdle rates as a result of sort of the low cost of money, the depressed cost of money.

So I think what we've seen in the last sort of 18 months to two years is a bit of a washout in that space that sort of couldn't necessarily support themselves by their earnings and we're relying on sort of consistent capital raises to get through. And also sort of some of the higher sort of valuations that were imputed by the market while sort of hurdle rates were low, those have looked to sort of normalise as sort of cost of capital, the like have sort of normalised to more normal levels.

Yeah, you touched on a bit there, but I just wanted to get some more of your take on sort of how the small cap market has performed relative to other asset classes, particularly large caps over the past year. Have there been any surprises since sort of the market turned off the back of aggressive red hikes?

Well, not too much. I mean, small caps have performed poorly and particularly compared to large caps across the past 18 months. But small caps have historically struggled during hiking cycles. This one sort of more so than recent history. I mean, small caps tend to be more cyclical. They're made up of sort of the makeup of the actual small cap market tends, particularly this time is overweight some of the more cyclical parts of the economy. I mean, if you think about that, it's discretionary consumer exposed, building materials, technology, non-bank financials, all areas which are going to become more challenged as sort of the cost of debt and goes up and liquidity is retrenched. So arguably, you've got more sort of domestically exposed earning streams in small caps. They have and with regards to large caps, often have a lot more offshore earnings exposure that can benefit from current, you know, currency transition, particularly when the Aussie dollar depreciates like it has recently.

And lastly, I'll probably add small caps and another trait is that they often have less access to debt capital markets, and they're more reliant on equity markets for their funding. And that's just the nature of the fact that they're smaller, they're less sophisticated. Maybe their sort of business models are less developed and banks aren't sort of always there for them. Yeah, it's been a tougher time, but that's nothing unusual with regards to sort of small caps during periods like this.

Is that harder as an asset manager if you're trying to sort of market a fund and manage a fund that is in a sort of negative sentiment?

Yes and no. I think sort of volatility and the smaller end of the market is more volatile. We argue sort of on the counterbalance that you tend to find more sort of interesting growth opportunities and it grows faster. With those higher growth opportunities, you're always going to have more volatility. I don't think there's anything structural that's happened in this cycle to say to us that the small cap opportunity is diminished. We think actually there's more opportunity now. I think looking back at 2022, that was the, I think it was the second worst year in the last 20 years for small caps versus large caps and not too much has improved in 2023.

But when we look at it, some of the wins in the face of smaller cap stocks, such as sort of inflation, when you think about sort of smaller caps versus larger caps, a lot of businesses across the economy have been trying to pass through higher costs, right? And when you think about larger caps, they tend to be more mature businesses in far more consolidated sectors where they've got a lot more pricing power and been able to pass through price increases far better than we've seen in small caps where you tend to sort of be maybe more competitive, more disaggregated sort of industries. And you've seen that in the margins where small cap margins have been hit far more than large cap margins, resulting in sort of more earnings downgrades. And as we know, I said sort of a little bit earlier that sort of stock prices tend to like to follow sort of the trajectory of earnings. So they're parts of the reasons why we've seen that small cap underperformance. But I think it's largely cyclical. I don't think anything structurally changed within the small cap market to suggest that sort of inflation sort of peaks, rates sort of peak, sort of inflation comes down. We've got some additional sort of aggregate demand, sort of opportunities in the domestic economy by the return of immigration, where there's going to have to be sort of capacity added sort of across the economy to handle an influx of additional people and a larger population. And we think that should largely support sort of domestic growth sort of as we sort of come out the other side of this cycle and into sort of better and in terms of into a better period of growth going forward.

And I just want to talk about the fund itself now, I guess. How has the fund differentiated itself from some of its, from other similar funds? And sort of what's been the strategy underpinning some of your recent success? I saw some of the figures earlier and of course, all funds, small cap funds have been affected by market conditions in the sort of the past few months. But over the longer term, the funds delivered some strong returns, I think, since inception over 7 percent. So what would you attribute that to and what are some of the strategies underpinning the fund?

We've always maintained that we're style neutral, and I think that sort of helps take a lot of a lot of the debate away sort of in terms of whether you might have a style that sort of that's consistent with the market or not, and whether that is suited or it doesn't suit. We effectively aim to deliver sort of alpha in all market conditions. So I think that that's one sort of potential differentiator from other stocks in the market. I think we have a process, a lot of people have a process. So, you know, arguably it's not a huge differentiator, but we think it's important when combined with very experienced people from the that have got a lot of experience in the market, which is what we we have here at Tribeca and we've always had it's we've always had a very solid team in terms of our capability. We also think it's important to know what you want to achieve, like what are you effectively sort of offering clients, and our target of sort of 5% to 7% of alpha per annum gross return over the benchmark is effectively what we started the fund with, and that's ultimately what we've achieved sort of since the fund was started back in 1999.

So we effectively can tailor the risks that we take in investing towards achieving that outcome, and that helps us take the risks that we need to take to make 5% to 7% because of course making 5% to 7% of the benchmark, you're not going to be able to do it without taking some risk. But there's also risks that we think we don't need to take that might sort of make that task of achieving those returns a little bit more problematic or more challenging. And one of those ones is we tend to exclude sort of parts of the market. We have sort of a process where we run through sort of businesses such as mining explorers and early stage biotech companies that actually don't have any earnings that we can value tend to be sort of screened out, they tend to be a bit too binary for us. In terms of liquidity is another one, and size of companies that they're too small and we can't get the available liquidity or we can't sort of move in and out of names, they might be excluded. So that all goes into a bit of a mix and then our process sort of processes a lot of that information into sort of price targets with a degree of sort of standardization around this numerical outcomes there. So we think that works very well together to provide a usability experience for clients. We want to have a consistency about our alpha sort of year in, year out without sort of too many large drawdowns where investors can't handle sort of the volatility or may need to sort of exit at some stage to realize their investment. And your performance may not be at a point where you've kind of delivered those returns that you sort of said that you would to investors. So I think our process via its sort of history, it's a long sort of history of being in the market, delivering those returns, has also shown a consistency of returns that we take a lot of pride in and that we sort of think that the customers of ours are very appreciative of.

Okay. And small companies' funds tend to sort of hold lots of holdings at smaller weightings. Sort of how many companies would you be holding at any one time and what criteria do you have for when you want to sell one?

We usually hold between 45 and 55 names, and that's just a function of how the fund was developed. David, when he started the fund, David Alwood determined that sort of achieving that sort of consistent 5% to 7% alpha was best done with around that sort of average of 50 stocks. We will, as I touched on our process in terms of sort of what is available sort of for analysis and consideration for the fund is done via a sort of a very bottom up sort of fundamental sort of research process. And we screen some out, as I said, on the initial stages, but then everything that sort of runs through our recess process is available for sort of consideration at the end of the day. And that's largely done via sort of valuations or sort of price targets, upsides that we determine we think that to the current sort of price that's trading in the market. And then sort of, I guess our top sort of 50 ideas will come together within a portfolio, which we run some portfolio risk metrics over the top of just to ensure that those 50 stocks coming together don't sort of present risks that A, we don't know about and B, that we aren't comfortable in taking. And that's sort of, I guess, how it works.

I just want to pick your brains a little bit, Simon, on sort of how you go about picking stocks. How do you look at the fund? It's very diverse in the industries that you're investing in from sort of commodities and energy to employment management and family safety. So how do you go about determining which sectors you want to buy into? What forms part of that thinking?

Look, it very much is on a stock by stock basis. We are sort of truly sort of bottom up sort of fundamental. So I think a lot of the time that sectoral sort of viewpoint will come towards the end of the process and be borne out in sort of risks associated with the fund. So I guess I could possibly use an example, a recent example of maybe sort of technology. I guess if we look back over the last 10 years, there's been some extraordinary gains made in technology stocks. And then the last sort of 18 months, there's been sort of some extraordinary losses probably made in the sector. But we will have a lot of individual stocks coming through by all the analysts. But that will be, we'll have to overlay some risk metrics at the portfolio level to try and achieve to what the 5% to 7% we're trying to deliver to our unit holders. If we're going to sort of invest too much into, we wouldn't necessarily have a whole bunch in sort of technology because that may at that point in time present unacceptable risks to achieving our 5% to 7% alpha if technology was to, as we saw sort of 18 months ago, have a really terrible period of time in the market. So I don't know if that gives you a little bit of insight into sort of how we sort of across sort of sectors, oil and gas and sort of materials is an area that we've done reasonably well in over the past sort of 18 to 24 months. At the end of the day, if a company has a stream of cash flows that we can value, then it's generally sort of considered sort of an option sort of for investment in our fund, I guess. And energy and sort of miners are no different to sort of retailers and sort of power providers and sort of manufacturers and sort of service providers, I guess. And you mentioned the fund was set up in 1999. Is that correct? Yeah, that's like an impressive amount of time. It's time when like funds are opening and closing all the time. What do you think has contributed to that success? Again, look, there's probably a survivorship bias there in the market. I think sort of when David started, there wouldn't have been more than a handful of sort of small cap funds. And I think you can probably see through the service today that there's quite a lot, but there's also a lot that have probably gone by the wayside during that period as well. So I just think it's, again, I think we've largely said what we were going to do. And I think people sort of like that when you sort of have a narrative and you can kind of back that up. I think that the experience has been, again, I'll probably go back to the usability of experience. I think sort of we've delivered sort of a lot, you know, largely delivered a consistency of alpha that sort of people like. And I think there's obviously an opportunity set in small caps that is rich for delivering sort of alpha. We feel that there are a lot of opportunities in small caps. And to the extent that those opportunities are still there after sort of what is it sort of 25 years we've been going, some of the fundamentals of why David started the fund back in the day haven't necessarily changed, such as, you know, this focus on smaller companies from sort of large bold bracket brokers isn't sort of terribly different to what it was back then. There isn't a huge amount of coverage there. There are a lot of emerging companies that come through the index. You know, I'll use an example such as a lot of the major lithium companies today that you see sort of as key sort of parts of the market have all sort of emerged pre and sort of through the small ordinaries. And so there's consistently an index that's replenishing itself with sort of new sort of differentiated and growing businesses that sort of require sort of fundamental analysis to sort of be able to understand them and value them and determine whether there are opportunities for investments and can they grow in the future. Yeah.

And finally, Simon, I guess looking ahead, what are you bullish about? What are you bearish about? And I guess where do you see the fund going? How would you describe its sort of short, medium, long term objectives? Yeah, look, I think, as I said, through a little bit earlier, I think there's a fantastic opportunity for normalisation in small cap markets as conditions start to improve. There has been a large amount of underperformance historically, in a historic sense, sort of versus large caps. And I think sort of ultimately sort of we are in a cycle and that cycle will normalise and that will mean conditions for sort of the broader sort of small cap index will become more favourable sort of at current valuations. We think that that is increasingly an opportunity sort of for investors. As we look out for the outlook for the fund, we are caught to sort of the opportunities in consumer facing areas. The consumer has been put under a fair bit of pressure sort of by interest rate rises. They have withstood that sort of very well thus far, largely sort of pretty well. There has been sort of balls in the consumer facing stocks, but earnings haven't been overly impacted. So we're fishing around there, which is an area where we've been underweight sort of since the end of the, you know, post the sort of pandemic sort of induced spending sprees, present some opportunities there in business models that we really like. We've been a big supporter of energy transition for quite some time. See our returns in the materials space probably as evident of that, where we've supported a number of sort of key lithium sort of stocks through the small odds and into their progression in the large cap space. We still think there's opportunities there in probably places that aren't as sort of popular right now, so such as Green Steel. And look, even in technology, which has come under a bit of pressure lately, we think there are names that are sort of reasonably fairly valued with good growth, with good forecast growth ahead, potentially probably ahead of what markets kind of largely expecting or pricing the stocks for at the moment. And then sort of on that energy transition side, there's sort of some of the legacy oil and gas names that sort of have looked reasonable value that will probably be needing sort of oil and gas for a bit longer than maybe people originally thought or priced into those stocks. And then sort of some more recent gains we sort of made in uranium names where we feel like that might be a commodity that becomes key in this sort of energy transition to a less carbon intensive energy source. Awesome. And I guess for investors, financial advisors, wealth professionals looking to learn more about your fund, where can they find you guys? You can find us at, via our website, it's sort of tribecaip.com.au, and we are on a number of platforms, which our investor relations team can provide you with, or our marketing partners, distribution partners at GSFM. Awesome.

Thank you so much for your time, Simon. We really appreciate all your insights today. It was a very informative podcast, and I'm sure the audience took a lot out of it. So I really appreciate your time, Simon. Nice.

Thank you very much. And Laura, as well, on your debut appearance, appreciate your time.

Thanks for tuning in, everybody. Have a great day and until next time.

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