Can you describe your investment style?
We are active, fundamental investors, who run a concentrated portfolio focused on small cap companies outside the S&P/ASX 100 Index. We are looking for sustainable businesses that can grow through the cycle. So, we look for factors that we think can deliver that, such as compounding free cash flow streams, healthy balance sheets, high return on invested capital and a few other intangible things. We tend to gravitate towards founder/manager led businesses; a good chunk of our portfolio is with companies where the management team has a long-term interest in the business.
Why do you particularly like founder/manager businesses?
Because there’s skin in the game; they have to own their own decisions. If something goes wrong in the business, they are still there to manage through that. Elsewhere, in those circumstances, the manager typically gets changed out and there’s upheaval in the business. Having a founder/manager helps with the sustainability of the business model.
Are there any particular sectors that you like or do you invest across the board?
The nature of our process means that we tend to be consistently overweight certain industry sectors and underweight others. We typically have exposure to the consumer space, services businesses and IT businesses, whereas we tend to be underweight extractive businesses, whether that’s energy, metals or gold.
Small-to-mid cap companies were out of favour throughout last year, as investors became more risk averse. How do you think that will play out in 2023? Will there be a swing back towards small caps?
I am constantly amazed at how myopically short-term the market’s focus is. If you look at short-term track records, they can be vastly different from year to year, so we don’t tend to focus on what’s in favour or what’s out of favour. For us, the main game is about executing good entry points and good exit points to our positions in companies that we have chosen through our long-term, fundamental investment process.
When it comes to mid-caps, the space is filled with what you would call long duration growth type stocks, so the past 12 months have not been great for them. We think this year could be quite different. There is emerging evidence that inflation has peaked. You can see that in terms of longer-term rates settings, which have drifted over the second half of last year and into this year. So yes, I think it’ll be a very different environment and we are a lot more optimistic about that part of the market. We are already starting to see a little bit of a swing back towards mid-caps. The only question is whether that’s sustainable.
What’s your general market outlook?
Certainly for the next 12-18 months, we are cautious. The main reason for that is because we think we still haven’t seen the full effects of the recent rapid interest rate increases on consumers. As a big chunk of fixed rate mortgage settings start to come off and reset to much higher rates, you’re going to see an ongoing impact to the consumer in the latter half of this year. So, we are cautious. As a result, our portfolio is stacked with defensive growth stocks, many of them being in services businesses that are largely unaffected by the cycle.
What do you think the major trends of 2023 are likely to be?
I think we’ll start to see some deflation emerging in terms of the cost of goods out of China. We have already seen shipping rates come down, so there is going to be an unwinding of inventory cycles compared to the elevated levels that we saw in 2022. That’s not going to be great for China’s manufacturing base.
In terms of other 2023 themes, it’s difficult to predict because a lot will depend on geopolitics, particularly how long the Ukraine war plays out. But, generally, our view is that the rates cycle will start to ease in the second quarter this year. We are starting to “anniversarise” a lot of the big impacts of commodity prices. Gas and energy prices were very elevated in the first half of last year, and we’re now cycling past that, so I think the inflation picture will look quite different in the second half of this year.
What sectors do you expect to benefit from this new cycle?
I think the focus is going to be a lot more on earnings and companies that can deliver longer term earnings growth. We don’t believe that the market can continue to underperform in long duration growth companies when you need growth to offset the inflation impact. To use a simple case in point, if inflation is running at 7% and you’re going forward in real time, you need to have growth rates and an earnings line that are higher than that. There aren’t a lot of companies that are delivering that at the moment! So I think the focus now is going to be very much on companies that can deliver earnings growth in a far more difficult environment, where consumers are going to be impacted in the next six to 12 months.
So you’ll be looking at things on a company-by-company basis, rather than by sectors?
Absolutely. We’re unashamedly bottom-up in our outlook. We’ve got 27 companies in the portfolio at the moment, across a variety of industry sectors, but we think they all have what it takes to deliver longer term performance.
Why do you think this bottom-up approach works for you?
I think the investment process has to suit the personality of the manager. I have an accounting background so, for me, an investment is all about cash flow and the simple mathematical equation of compounding over the long term. Even when you’re looking at your portfolio concentration, you’ve got to take an approach that suits your mentality and the mentality of your investor base. Obviously, the more concentrated you are, the better you will do if you manage to pick the right stocks. But there is a balance to that, in terms of volatility and tracking error. So you’ve got to find an approach that suits you and allows you to sleep at night.
What returns do you think it’s reasonable for investors to expect this year?
Well, the simple mathematical equation is that you’ve got a 10-year bond rate at 4%. Equities typically deliver a premium of 5% or so above that, so you’d be wanting a pre-tax return of around 9%.
Is that achievable?
Yes, absolutely. Especially since we’ve had a deweighting of the market over the past four months.
Are we close to the bottom of the market?
We’re still not market bulls. The market downturn is just a consequence of long-term rates going from 1% to 3.5%. The market has had to digest that and that’s the impact we’ve seen over the past four months.
Sitting where we are today, we’d say the market as a whole is fair value, if not slightly overvalued. But again, we don’t tend to think top-down about the market as a whole. We focus on companies that can deliver on our earnings expectations, irrespective of the wider market.
Obviously, it’s been a tough couple of years for everyone. How has your fund fared?
We have suffered over the past 12 months.
We are now in our sixth year at QVG Capital, and prior to that Chris (Prunty, co-founder of QVG Capital) and I ran the Ausbil Micro Cap Fund for seven years. Over those 13 years, we have delivered returns almost three times above the market. But over the past 12 months, we have underperformed and that’s because we have been in those long duration growth companies, while there’s been a gravitation towards commodity plays. But, like I said earlier, we think the market’s shifting again.
What have been some of the notable contributors to your long-term performance?
Probably the best two attribution companies that we’ve had are Uniti Group, a telecommunications infrastructure business that got taken out last year, and Johns Lyng (ASX: JLG), a building services company. It’s a very good example of a business with a high return on funds employed that can deliver irrespective of the cycle.
When you outperform the market for so long, and then you have a year like last year, how psychologically difficult is it for you to stay the course and keep backing your strategy?
That’s a great question. And the answer is to have patience and conviction in what you’re about.
The market has changed significantly in terms of its composition. There is a lot less active money in day-to-day trading and the market is currently dominated by passive money, whether that’s ETFs, index funds or quantitative type strategies. As a result, you end up with significant short-term momentum washing through different sectors, depending on what the short-term drivers dictate. And that means that you need to have a lot more patience and to be really convinced by your strategy.
How does ESG inform your investment decisions?
We’re not an ESG specific fund, but it is very important to us. We’re all about sustainable returns and investing in sustainable companies, so they need to have an ESG imperative. In today’s environment, if they don’t have that, then there’s a significant question about the longevity of the business.
What are the two key lessons you’ve learned during your time in the market?
The first is to have confidence in what works for you over the long-term – and stick to it.
The second is an understanding of some of the intangibles that make a really great company, such as culture and management. Typically very good managers have very high energy levels in the business, and we find that is especially true in the case of founder/managers. I have learned it is really important to back good management and also good Boards, who really care about the business they have responsibility for.
Who are your investor role models?
Oh, I have plenty. There’s Warren Buffet, obviously. In my early days, Peter Lynch’s “One Up on Wall Street” was a book that I really gravitated towards. Then there’s Joel Greenblatt, another US investor. At the moment, we often look to Terry Smith, an English fund manager who manages global large caps. He has a similar approach and a similar mentality to us, even though we’re operating in completely different spheres. There are also managers we follow on the macro side, even though we’re not macro investors by any stretch. For example, any time Stanley Druckenmiller says anything, that’s going to be of interest to us.
We are very grateful to you for managing Future Generation Australia (ASX: FGX) funds for us on a pro bono basis. Why do you do it?
First, we’ve known Geoff [Geoff Wilson, Founder and Director of the Future Generation companies] for many years, and we’ve always thought that Future Generation is a fantastic idea and a great initiative. To be honest, when we were approached by Geoff, it was an honour for us, given the calibre of managers that were in your portfolio. We were actually quite chuffed that you thought us worthy to be part of that group.
Secondly, both Chris Prunty [co-founder of QVG Capial] and I have three kids each. So we understand the importance of the next generation coming through and being well looked after, both mentally and physically.