As we approach the 10 year anniversary of our appointment as manager of the Nedgroup Investments Entrepreneur Fund (a fund that invests outside of the Top 40 largest shares in the All Share Index), it seemed appropriate to share a few thoughts on how the fund has evolved, as well as some of the investment lessons learned along the way.
In reflecting on the track record of the fund, we are delighted by the returns generated for investors (almost 25% per annum). We are also gratified that it ranks amongst the top performers when measured against its peer group as well as against some of the most recognised general equity funds of the industry. More importantly, we are pleased that these returns have been generated within acceptable levels of risk.
While the past is no guarantee of the future, we can guarantee that the stable team at Abax Investments remain as committed as we were when we first started managing the fund and that our investment approach remains unchanged. We described this as follows in our first monthly commentary in 2004 and I am happy that it can be repeated here:
- Proprietary research and stock picking
- A belief that earnings and dividend growth are the prime drivers of share price appreciation
- Investment in emerging growth companies
- Constant adjustment on a relative value basis to reduce risk and enhance performance
Conventional wisdom suggests that investing in a particular subset of the equity market (in this case the mid and small cap space) is likely to be a more volatile strategy than owning a more diversified portfolio of stocks. However, a study of the mid and small cap sectors shows that both have in fact demonstrated lower volatility than the All Share Index over almost all periods. The primary explanation for this is that the mid and small cap sectors have a lower exposure to the more volatile resource shares.
The investment approach we follow at Abax is also one that we believe will further reduce the risk of investing in smaller companies that may be less well established than their larger peers in the relevant industry. We have a tried and tested process that we apply to help us eliminate the likelihood of making a poor share selection. Some of the more important aspects of this include the following:
Attracted by “value” or repulsed by “expensiveness”
One of the most obvious mistakes is buying a share that you think has fallen to the point that it represents great value, only to see it collapse further as factors you had under-appreciated at the time of buying come to light. This can happen quite easily and as a consequence we are generally extremely reticent to acquire “speculative” investments in inherently low quality businesses that appear to offer substantial value. Another mistake is not being prepared to pay a premium for a business that appears expensive, but behind which there is substantial profit growth momentum that may have greater longevity than you think.
Earnings matched by cash flow
We have learnt through experience that it is cash flow that is the lifeblood of any smaller company. We always confirm that the operating profits reported in the income statement are fully matched in the cash flow statement. Any shortfall (especially in an economic downturn) results in our alarm bells ringing loudly.
Competent and trustworthy management
We are constantly surprised at what a difference a single individual in the capacity of CEO can have on the fortunes of even a very large business. This is especially true for smaller businesses and so we screen out management who:
- do not consider every decision from the perspective of a shareholder and delivering shareholder returns
- have a big ego or ambitions to build as big a business as possible regardless of the impact on profits and dividends
- have no or little shareholding in the business and / or are overly generously remunerated with a bonus scheme unaligned with shareholder returns
- don’t understand the difference between a public versus a private business and their accountability to minority shareholders
- have an executive management team exerting undue influence / effectively controlling a weak board of directors
Circumstances and business conditions for smaller businesses can change quickly so it is extremely important to be able to sell out of a position as quickly as you bought into it. We aim to ensure that we are able to exit a 2% position within two weeks if required (which given the current fund size does exclude very small businesses from our investment universe).
We have always managed the fund size very carefully and have previously closed the fund to additional flows when the opportunity set narrowed. We are committed to doing this again if required. This will ensure that existing investors always have full exposure to our best ideas.
These are just a few aspects of the investment approach we follow and its results are evidenced in the successful long term track record of the fund on both an absolute and risk-adjusted basis. We would like to thank investors for their loyal support over the last 10 years and assure you of our dedicated commitment to continue to deliver excellent results without exposing investors to undue risk.
Anthony Sedgwick is Investment Manager of the Nedgroup Investments Entrepreneur Fund