Exploiting short-term price dislocations - the case for Australian sophisticated investors

Coming next, we have two presenters from the Spady and Small Companies Fund.

Their portfolio managers believe that there is a growing environment where equities are increasingly oversold and undervalued for short periods.

They observe a phenomenon in the last 10 years that with the influx of popularity of passive products, major institutions, capital requirement,

While their markets hurt mentality, equities are prone to being sold off hastily.

The Spady and Small Companies Fund seeks to identify these momentary mispricing opportunities and benefit from their appreciation.

Today we have Jess Moore and Nicholas Queen.

They are co-portfolio managers of the Spady and Small Companies Fund.

Jess is responsible for distribution and market research.

Nick, on the other hand, focuses on trading and portfolio construction.

The topic today is exploiting short-term price dislocation, the case for Australian sophisticated investors.

Welcome, Nick and Jess.

Thanks for having us, Angelina.

So, yeah, as you said at the top, we're excited to be able to deliver this presentation on how we've seen the growth in short-term mispricings in the Australian small company segment that we seek to exploit with the Spadim Small Companies Fund.

I'm Jesse, this is Nick, and we're keen to deliver this presentation.

So jumping right into it, it's probably worth us, we'll just go back one, it's probably worth us framing a little bit as to how herd mentality and the short-term price dislocations go, I guess, hand in hand.

As we know, social media has taken over our modern lives.

Everyone's addicted to their phones now, Android or Apple, looking at Twitter, LinkedIn, Instagram, whatever have you, about tips and tricks as to stocks that might be of interest to retail investors.

This herd mentality is amplified through social media because you've got people like Elon Musk,

who can, you know, very early on through the COVID period was able to, I'm not sure if he would call it influence, but he did influence the price of Dogecoin by calling it that it was going to go to the moon, or it was something that people shouldn't invest in and was a big, big supporter of cryptocurrency.

But what we've seen through this period is, as you get more public people onto these platforms, people that develop a following, they're able to influence particular stocks or particular asset classes through

their position or their perspective on that particular asset.

Interestingly, when you then start to look at the data a little bit more, and this is here where we talk about a bit about the buy side and sell side commentary, that if you look at an analyst, the economist actually did a really good piece of research on this in the late 2018, 2019, that if you look at buy side analyst ratings, 94% of their ratings will be a buy or a hold.

Only 6% will be a sell rating.

Now naturally the first question is why is that?

Well, because analysts need access to be able to get into these companies and speak to the CEO and speak to the strategy and speak to the management of those companies.

So you're not going to necessarily, or you'd be less inclined to give it a sell rating if it means you no longer have that access to that company.

So there really is a shifting momentum in our opinion.

of more commentary that leads towards why you should buy, why you should invest, why you should hold particular companies or assets versus those that say sell.

So you can see through the very basics of how herd mentality works, why it drives these aggressive swings in the market.

And then if we move on into something that's a little bit more broader for everyone, at least at this point in time is with ETFs, as you said at the top of the introduction, Angelina,

ETF products have grown extraordinarily and people can read and you can see there on the screen, but, you know, and as a 2000, the year 2000, there was only a hundred ETF products.

And now we have over 8,700 ETF products globally and they're in everything from oil to gold, to crypto, to particular segments of the market, whether it be global smalls or Aussie smalls, what have you.

And it really is shifting the momentum in those markets.

Um, purely on the basis of needing to hold an equally weighted exposure to that particular asset class or to that particular segment to reflect the underlying, um, the underlying assets in that ETF.

So that in itself, unfortunately doesn't result in a lot of traditional price discovery that a lot of fund managers would have done in the past, uh, to be able to build a portfolio that they think is going to exceed that their selected benchmark.

So what you have is companies being sold off unnecessarily purely so that that ETF, let's say it's a gold ETF and they're selling off gold company A and gold company B so they can buy a little bit more of gold C and gold D purely because they need to mimic how that benchmark has reflected over the last month or the last three months or the last six months, however often they rebalance.

So this is our case.

This is our argument to the market.

This is our thesis that with more ETFs, more passive money, lack of price discovery,

As you said as well, Angelina, the introduction or rather the growth of major institutions needing access to capital, it's creating these frictions in the market and the short term mispricings that we believe we can capitalise on.

And then that naturally feeds in quite well to the Spainian philosophy here, that with these influx of products, we're able to find mispricings in the market on a short time basis that we believe we can capitalise on for all investors in the fund.

So I'll pause there and I'll pass it over to Nick.

Cool.

So this is our performance lifetime contest.

This is our end of May data.

However, we do have the end of June subject to finalization.

So the fund return history profile is at five years now.

It's been quite a journey along the way, as you can see some significant bumps throughout the back end of 2018, naturally COVID, which we all remember.

And some of us wish to forget.

And obviously most recently the Ukraine

dilemma that we're hoping for a quicker than expected resolution, but doesn't seem it's going to go that way at this point in time.

So I'm quite proud of our results as Jesse touched on earlier, that the swing from passive money, the swing from active money to passive money has been astronomical over the last 25 years.

And in our opinion, too far in one direction.

And there are these daily opportunities for us to go out and look for businesses that have dislocated from their peer set.

And in our opinion, on an unfair basis, that

biggest differentiator of the Spading Small Companies Fund compared to possibly other small companies funds out there is that a high turnover rate allows us to buy companies and hold them for only 30 to 45 days on average.

We're moving in and out of positions, moving in and out of companies.

And as Jesse touched on earlier, we're ignoring a lot of that buy versus sell side research that's put out there because we believe it's heavily influenced by, you know, probably instances that don't reflect the company, but more reflect our society.

at large and needing that access.

So we've sort of discounted that out.

We like sticking to our knitting and we're saying that primarily by what we do is that we're diverging businesses away from their peer set.

And we think that there's an opportunity there that there's an overreaction by the market and they're temporarily oversold or possibly temporarily undervalued, which then leads into our investment strategy, which we'll jump into now.

I'll give a very quick high level of how our strategy is, or integrates.

So as you can see there on the screen, we have four key stages.

Stage one is the bulk of our work where we're filtering through end of day just the data to determine the companies that we believe through stage two, undervalued that we want to add to the portfolio, those we want to look at further and those that we think in our opinion are fairly valued.

Portfolio construction at step three is crucial.

We are building an equally weighted book, fully deploying capital or nearly fully deployed capital.

I think we have a few hundred bucks in the account at the moment.

So that's fundamental to make sure that we build a portfolio that can weather the storms on both fronts and then stage four is how we exit.

But I'll pass back to yourself Nick for stage one.

Oh, sorry.

So for us, this is a multi-step approach.

As we touched on earlier, we're looking to screen out businesses

that are possibly overvalued and unlikely to be a temporary dislocation to profit from.

And so we're doing this in a reverse order.

So we're screening out businesses that we say, right, they're doing quite well.

Step one is the macro filter.

We're looking at the all 300 companies on the ASX 300 and saying, right, which of these businesses is doing really, really well lately?

And there's unlikely to be a short-term dislocation and we'll screen those out.

The second step for us then says, okay, you might have a business that's underperforming the wider market, the ASX 300,

But compared to their peer set, they're actually doing really, really well.

It's something we'll also look to pass on there and maybe not take another look at.

Third step for us is the small company filter, getting the dissolute between obviously there's such a high concentration of financials at the top end of the 100 and saying, what's actually going on in the Australian engine?

And is it likely that this business is temporarily oversold compared to its peers?

And that's the third step for us.

Fourth step for us is the decay horizon, which then touches on how long has this business been separated from its peer set?

If this has been separated for 12 or 24 months, the chance that it's a temporary dislocation is low.

A business that's been dislocated from its peers set to seven to 28 days, well, it's very exciting.

And then we move into the last pass, which is the hurdle rate that says, how much fat do we need in this business to make it worth our while to get into?

Stage two for us, which we've touched on already, breaking apart those businesses and saying, what kind of valuations can we attribute to these?

And how likely is this to be separated from its peers?

allows us to then separate which businesses we want to buy in stage three.

Stage three for us as you can see here a bit of a heat map model.

We have our businesses that we say right we're willing to go in and buy these companies we think they're temporarily undervalued this is the price we're willing to pay and the same is true on the back end that leads into stage four which says these are the prices we're willing to get out of the company for however we won't jump out of the company

unless we've had another new position that we're willing to get into, as Jesse touched on earlier, to make sure we stay at that low cash weight and have our investors capital deployed at all times.

And that's essentially us, Angelina.

Thank you, Jesse.

That was wonderful presentation and you explained a few concepts really well.

And I do have some questions for you.

The first question is, what makes you different from other Australian small cap investment strategies?

I'll take this one.

Well, I think as Nick touched on earlier, Angelina, where we differ from our peers is that we have a relatively higher turnover rate of our portfolio.

by volition looking for those short term mispricings in the market.

So where a lot of our peers might look to buy and hold a book for a book, rather a suite of companies for 12, 24, maybe 36 months, potentially even longer, we're looking to buy a book that we believe at this point in time is temporarily discounted to their peers and to the market.

On average, that will result in a turnover of the full portfolio every 30 to 45 days.

So not a hard and fast rule necessarily, but it is something that by volition of trying to continually find those short-term mispricings, we do have that natural turnover.

But as Nick has touched on in the performance slide, it's done very well for our investors and for clients, and something that we will continue to pursue for definitely the long-term.

Thanks, JC.

the timing and it is active in management is really critical to how you manage your portfolio, make your decisions about buying a rich book.

So that is a segue into my next question is, in terms of your strategy, what investment environment suits your strategy the best?

It's a great question, Angelina, and something we are quite proud of that

Our fund has typically done well in higher volatility climates, which is often the climate that most other investors are heading to the exits.

We've done particularly well during the back end of 2018, as we know the housing market slow down.

well during covid that year the XSO went up six percent we went up 32 that year as we were able to find so many dislocations and we just finished off a great end of financing year last year the market went up five percent we've gone up approximately 22 as we touched on earlier pending the trustee finalizing individual numbers but that's the approximate at this point um you know that's significant alpha figures have been delivered to the clients and they're quite happy with

And, you know, quite happy to park the capital with us when things are going a little bit crazy.

And that's, as we said, when we find more of the dislocated opportunities and what's going on in the world at the moment, we look forward to this couple of years, hopefully finding out many, many more.

It seems to me that volatility is gold to you, in a sense.

Absolutely.

Yeah.

So how, how do you manage your cash numbers?

Just out of curiosity.

So for us, our biggest tenant is to never be sitting in cash.

We have within our IAM that will be less than 3% cash.

Operationally, we always market that we're less than 1% cash, but functionally within the business, we have a couple hundred dollars sitting in cash.

Our internal sort of mandate is if we have $1,000, we'll go and deploy that.

So we're always next to 100% fully deployed.

And how that works functionally is we then look at,

Okay, so we've entered into these companies, we've said we're willing to buy it at say $12.40, we're willing to sell it at $12.65.

Very different other small-cap peers that might have to buy for $12.40 and sell for $30.

And we're making these one, two and 3% movements over and over again, over a one month period.

And sounds super exciting once, but when you do it 12 times in a year, it adds up to quite a margin.

And then we say, right, well, we've got the business to $12.65, it might be trading at $12.68.

would be willing to get out of this business if we have a new business to deploy that capital into to make sure our cash weighting is very very minimal and stays under that one percent at all times functionally that means for us going and then saying right we want to get rid of this this and this company we might sell 25 000 50 000 that one or maybe 75 or 100 000 that one frees up some of that capital and then use that money as that's flowing in throughout the trading day

and then buying to maybe this company over here, and that company over there.

And sometimes you get to the point where you've run out of new buy opportunities, you've filled them up, if you like.

to a certain point where we are equally weighted within the book.

So we don't have any favourites.

And the businesses that we hold, we like having nice and evenly, it spreads our risk quite well.

We say, right, well, we've got a couple of cells, but they might just have to sit there.

And the same in reverse.

Sometimes you've got ample buying opportunities and the limited number of cells, which means you can only partially fill those buyers.

Again, maximising that equally weighted approach as best possible.

But naturally it's the stock market.

Some companies move up and down more than others.

So there is slight variances in that.

But we do try and stick to that as hard as we can.

Why not maximize the capital if it works to the best use?

Absolutely.

No point sitting on the sidelines.

Absolutely.

Thank you Jesse and Nick for the presentation and Q&A today.

It's great to see you today and all the best.