17 Oct, 2024

Letter To Investors - September

Letter to Investors • 16 mins read

NextDC – where Nvidia’s chips live

September.

For some it’s their favourite song – a funky and joyful classic by Earth Wind and Fire, released back in 1978.

“Do you remember
The 21st night of September?
Love was changin’ the minds of pretenders
…
As we danced in the night, remember
How the stars stole the night away, oh, yea”

But for share market investors, September has historically been the worst-performing month of the year. If you were going to leave your brokerage account alone for a month to “dance in the night”, September was the one to take off.

As we show below, on average over the last quarter century, the global share market (MSCI World Index) has fallen -1.5% in September. No other month comes close to being as bad, with a -0.3% fall the next worst.

September – the worst month of the year (MSCI World Index)

Source: Ophir, Bloomberg.

It’s not been because the market always falls in September, though – only 12 of the last 25 Septembers have lost money.

It’s because September has had some of the biggest stinkers for shares. 2022 (recession worries on higher rates/inflation), 2008 (peak GFC fears) and 2002 (Dot.com bubble bursting) all clocked up falls of around -10% or more.

It came as a welcome relief, though, that this September didn’t fall prey to history, with gains extending for the fifth month in a row.

In fact, to the end of September, the S&P 500 had its strongest first nine months of the calendar year since 1997! (Can I hear Earth Wind and Fire singing?)

During September in total return terms the S&P 500 rose +2.1%, while the Nasdaq gained +2.8% and the ASX 200 was up +3.2%.

September 2024 Ophir Fund Performance

Before we jump into the Letter in more detail, we have included below a summary of the performance of the Ophir Funds during September. Please click on the factsheets below if you would like a more detailed summary of the performance of the relevant fund.

The Ophir Opportunities Fund returned +4.6% net of fees in September, underperforming its benchmark which returned +5.1%, and has delivered investors +22.5% p.a. post fees since inception (August 2012).

🡣 Ophir Opportunities Fund Factsheet

The Ophir High Conviction Fund (ASX:OPH) investment portfolio returned +2.6% net of fees in September, underperforming its benchmark which returned +4.1%, and has delivered investors +13.2% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of +2.3% for the month.

🡣 Ophir High Conviction Fund Factsheet

The Ophir Global Opportunities returned +0.8% net of fees in September, outperforming its benchmark which returned -0.1%, and has delivered investors +15.5% p.a. post fees since inception (October 2018).

🡣 Ophir Global Opportunities Fund Factsheet

The Ophir Global High Conviction Fund returned +0.1% net of fees in September, outperforming its benchmark which returned -0.1%, and has delivered investors +10.1% p.a. post fees since inception (September 2020).

🡣 Ophir Global High Conviction Fund Factsheet

Un-inversion concern

September’s share market gains occurred despite the yield curve in the United States ‘un-inverting’ during the month. Historically, that’s been an ominous sign for the US economy and corporate earnings.

The un-inversion happened as the Fed kicked off its interest-rate-cutting cycle with an outsized 0.5% cut in its short-term interest rate, the Fed Funds Rate.

As we show in the bottom panel of the chart below, the yield curve ‘inverts’ – that is short-term interest rates (in this case two-year Treasury yields) rise above long-term interest rates (in this case 10-year Treasury yields) – with the purple line going negative when the Federal Reserve is raising short term rates to cool the economy and lower inflation. This is what happened in 2022.

Source: Ophir, Bloomberg.

Historically, when the yield curve un-inverts (green circles) it’s because the market expects the Federal Reserve to cut interest rates as the inflation fight is done – the market now starts worrying about the other side of the Fed’s mandate: maintaining full employment.

That is where we are today, as witnessed by the Fed’s 0.5% cut in September.

Naturally, some are worried that when the un-inversion happens, as seen in the middle chart above, that historically it has meant the Fed is too late and the labour market softens too much. The unemployment rate goes up (yellow line rises) and a recession (grey bars) and its attendant economic and earnings contraction ensues.

During the recession, the fall in corporate earnings typically sees the share market fall, as shown in the top chart by the drawdown (peak to trough fall) in the S&P500 index. Sometimes these falls are more mild (less than 20%), and sometimes they are very severe (greater than 30%).

Is history repeating?

But, pleasingly, the latest data in the US shows the labour market, while cooling, is holding up ok, at least for now. That’s reduced the probability of a recession in the US. In fact, the US unemployment rate, at writing, has just dropped back to 4.1% from 4.3% a couple of months ago.

What, despite higher interest rates, is providing support and helping avoid mass layoffs?

The US economy so far is being kept afloat by several things: continued jobs growth in non-cyclical areas like healthcare, education and the government sector; solid (though not spectacular) company revenues and household income growth; big government spending; and not-too-tight-for-not-too-long monetary policy.

But all eyes, including ours, will remain on the employment picture to see if the softening seen over the last year or so morphs into something more sinister.

China rockets

The other big news in September was the People’s Bank of China (PBoC) finally coming to the party with some meaningful stimulus. Calls have been loud for some time for big stimulus with China mired in slowing growth, a property sector overhang, rock bottom consumer confidence and deflation.

In the last week of September, the PBoC announced a stimulus program that included an interest rate cut, a reserve requirement ratio cut for banks, lowered mortgage downpayments, and support programs for the property and share market.

The Chinese share market loved it!

The MSCI China Index was up over 21% (!) over the last five trading days of September and the rally continued into early October*. Commodities that China voraciously consumes also rocketed on the news, as seen in the chart below of exchange traded funds (ETFs) that follow commodity miners.

*Though just at writing in the second week of October the Chinese share market has given back some of its September gains as the announcement of government fiscal stimulus has come up short of expectations.

Source: Ophir. Bloomberg.

In response, the ASX 200 Materials index in Australia rose over 12% in those same last five trading days of September.

In a relative sense this created a performance headwind for the Ophir portfolios versus their benchmarks, given we are structurally underweight the Materials sector.

(As a reminder, we prefer more industrial-type businesses that can structurally grow into big-end markets over time, rather than businesses who earnings tend to be more cyclical because of short term swings in – to us at least – largely unforecastable movements in commodity prices).

This was more of a headwind for our Australian Funds where the Materials sector makes up a greater proportion of our benchmark than our Global Funds.

The influence of Materials alone took our Ophir Opportunities Fund from outperforming its benchmark in the first three weeks of the month to underperforming by the end of the month.

As always, we are happy to wear the swings and roundabouts of relative performance due to short-term moves in commodity prices. If we get the earnings right long term in our typically industrial type businesses, investment performance will look after itself.

NextDC – from Microcap to Midcap – where Nvidia’s chips live

Ever since ChatGPT entered the public domain in November 2022, demand for anything artificial intelligence (AI) related has seen computer chip maker Nvidia skyrocket to become, at one point this year, the most valuable listed company in the world.

Naturally, Australian investors have been looking for an AI play on the ASX.

Enter NextDC, Australia’s leading listed data centre operator.

The company is not some ‘Johnny-come-lately’ here just to capitalise on the AI scene. It was founded by wildly successful Australian serial tech entrepreneur, Bevan Slattery – Australia’s answer to Elon Musk – back in May 2010.

NextDC listed on the ASX not long after in December 2010 when it IPO’d at $1 a share, giving it an $80 million market cap. IPO investors got a nice bump on day one with the stock closing at $1.52 a share! But it was definitely still in microcap territory.

Today it’s the 49^th largest stock on the ASX with a market cap of $11.2 billion and scratching on the door of the ASX Large Cap Index.

But wait a sec, what’s a data centre anyway, and doesn’t it all seem very mysterious what goes on inside these big data centre ‘boxes’ you might have seen around Australia? And how and why do they benefit from AI?

You’re about to find out.

What’s in the box?

No this is not like the movie Seven! But today’s modern data centres do resemble big boxes, or even mini-Westfield shopping centres in many ways.

Put simply, a data centre – a term born in the 1980s – is a computer room. In fact, some companies still have on-premises data centres/computer rooms where their IT infrastructure, including servers, are kept.

A data centre is the central, physical hub of an organisation’s digital operations. It’s the secure home with the power and cooling essential to operate the network of computer systems that house a business’s data. It is the beating heart of a business’s day to day operations.

Many businesses these days don’t store their IT infrastructure on premises, but rather use external providers like NextDC in what are called Colocation data centres that reduce redundancy and downtime at cheaper cost. You co-locate your IT infrastructure in NextDC’s ‘boxes’ along with that of other companies.

In this way NextDC is like Westfield, the landlord, and you are the tenant, renting space inside the box for your business’s equipment.

But what’s in the box, exactly?

There are really four main categories of ‘things’ you will find inside a NextDC data centre:

Computing infrastructure: mainly servers, rackspace, cages, and dedicated private suites (sounds like a fancy airline right)
Storage: your hard drives and solid-state drives
Network infrastructure: such as cables, switches, routers, and firewalls
Ancillary items: backup generators, ventilation and cooling equipment, fire suppression systems, and security and monitoring systems

Who uses the box?

NextDC has over 1,800 customers and they include

Enterprise customers (like Alibaba or any business that wants to move their IT infrastructure out of the office)
Telcos (like AT&T or Aussie Broadband), and importantly
So-called Cloud providers (like Google, Amazon and Microsoft), often called ‘hyperscalers’ because of their fast growth

Cloud providers deliver computing services, such as servers, databases, networking, software, storage and intelligence, via the internet. That allows them to offer faster and more flexible resources, high-performance capacity, as well as scalability.

Basically, any services that don’t require physical proximity to the IT hardware in use can be considered candidates for cloud delivery. Don’t have or want your own IT infrastructure? You can use Amazon Web Services, Microsoft Azure or Google Cloud.

But those cloud providers have IT hardware too … and they need to store it somewhere. NextDC provides the data centres for cloud providers to store their hardware. (They even have names for data centres where only cloud providers are in there – they are imaginatively called Cloud Data Centres.)

Which leads us to NextDC’s marketing tagline: “Where the Cloud lives”. Sorry to crush the dreams of those of you who thought it was all happening in satellites in the sky. At least they can get a private suite for their gear at NextDC!

AI turbocharges demand

But perhaps more appropriately for why AI investors have been attracted to NextDC is that it’s also where Nvidia’s chip live. Those servers and racks and cages are stuffed with silicone chips. And AI tools like Generative AI models such as ChatGPT are some of the most chip hungry software applications out there.

The impact of A.I. on data centre demand is not just about increasing capacity, which is clearly does through increased hardware and data storage needs. A.I. workloads often require special hardware called graphic and tensor processing units (GPU/TPUs) which consume more power and generate more heat than traditional servers. Specialised cooling and power distribution systems have had to be designed, along with new network infrastructure to support the low latency (read speed critical) needs of A.I. applications.

Westfield needs more land

A.I. needs are only adding to existing demand of enterprises moving to the cloud and by some estimates is increasing that demand by four to five fold!

Hyperscalers are therefore battling it out to secure the supply (tenancies) of new data centres. They have the hottest product in town, cloud services, and they need somewhere to sell their goods from.

Australia, so far, is behind the US in terms of AI deployment but it’s running hard to catch up.

This is seeing NextDC increasingly move from providing colocation services for businesses’ private IT infrastructure, to hyperscalers.

Like any good landlord, when your building is full, NextDC is searching for more land.

Today, NextDC operates in all the major Australian cities (sorry Hobart) and also some regional areas too, with New Zealand and parts of southern Asia in the works. Sydney has the most, with four operational and another four in the pipeline or under evaluation.

NextDC Data Center locations

Source: NextDC company website

The next AirTrunk?

Historically it’s taken three years to fill a NextDC data centre with tenants. Today it still takes three years, but the size of the data centres is now roughly three times that of the old ones.

The landscape is also changing.

Many of NextDC’s big competitors aren’t publicly listed, but instead are in private hands. Most public data centre providers have been taken over and taken private. The amount of capital they need to grow is well suited to ownership by big global pension funds that are accumulating inflows.

This represents an opportunity for NextDC.

Deals are happening. Australian competitor, AirTrunk, was recently taken over by a big global pension fund at 20x contracted EBITDA giving an AUD$24 billion valuation.

Takeover or not, the opportunity remains ripe for NextDC. It currently sits in an oligopoly in Australia competing against AirTrunk and CDC (partially owned by New Zealand based and listed company Infratil).

Asia looks to be the next big regional growth leg, with Google eyeing that region and looking for data centre partners.

NextDC is also prioritising so-called Edge Data Centre investments. They’re the next stage in data centre development, where smaller centres are strategically located physically close to the edge of a network, and the populations they serve, to provide low-latency high-performance computing for latency sensitive applications like virtual reality, financial systems, gaming or the Internet-of-things (IoT).

This 14-year-old company might still be in its teenage years, but like most teenagers, it still has a lot of growth ahead.

A big winner for Ophir

We first bought into NextDC in the Ophir Opportunities Fund on the 28th of November 2013 at $2.01 when it was a $415 million market-cap company.

As the company grew, we then bought it in our Ophir High Conviction Fund on the 18^th of April 2016 at $2.80 when it was a $700 million market-cap company.

We have held NextDC ever since and it now trades at over $17 with a market capitalisation of around $11.2 billion at writing.

Source: Ophir. Bloomberg.

It has been one of our longest-held positions in our Australian Funds, and we have gotten to know the company very well over our more than decade of ownership.

Of course, like most great growth stories, it’s not been all smooth sailing. The bottom chat shows the drawdowns (peak to trough falls) of its share price since IPO. (20%, 30% and even 40% falls have been seen over the journey and some of them quite regularly.)

Doing the work and staying the course has certainly paid off, though, with the share price rising at a 22.0% per annum clip since we first purchased in 2013.

NextDC is and remains a classic Ophir stock. A fast growing business, growing into a big end market, with long term company and industry tailwinds. And A.I. is only just starting to put a big gust behind that tailwind.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Senior Portfolio Managers

Ophir Asset Management

This document is issued by Ophir Asset Management Pty Ltd (ABN 88 156 146 717, AFSL 420 082) (Ophir) in relation to the Ophir Opportunities Fund, the Ophir High Conviction Fund and the Ophir Global Opportunities Fund (the Funds). Ophir is the trustee and investment manager for the Ophir Opportunities Fund. The Trust Company (RE Services) Limited ABN 45 003 278 831 AFSL 235150 (Perpetual) is the responsible entity of, and Ophir is the investment manager for, the Ophir Global Opportunities Fund and the Ophir High Conviction Fund. Ophir is authorised to provide financial services to wholesale clients only (as defined under s761G or s761GA of the Corporations Act 2001 (Cth)). This information is intended only for wholesale clients and must not be forwarded or otherwise made available to anyone who is not a wholesale client. Only investors who are wholesale clients may invest in the Ophir Opportunities Fund. The information provided in this document is general information only and does not constitute investment or other advice. The information is not intended to provide financial product advice to any person. No aspect of this information takes into account the objectives, financial situation or needs of any person. Before making an investment decision, you should read the offer document and (if appropriate) seek professional advice to determine whether the investment is suitable for you. The content of this document does not constitute an offer or solicitation to subscribe for units in the Funds. Ophir makes no representations or warranties, express or implied, as to the accuracy or completeness of the information it provides, or that it should be relied upon and to the maximum extent permitted by law, neither Ophir nor its directors, employees or agents accept any liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. This information is current as at the date specified and is subject to change. An investment may achieve a lower than expected return and investors risk losing some or all of their principal investment. Ophir does not guarantee repayment of capital or any particular rate of return from the Funds. Past performance is no indication of future performance. Any investment decision in connection with the Funds should only be made based on the information contained in the relevant Information Memorandum or Product Disclosure Statement.

17 Oct, 2024 Should investors be joining the gold rush?

18 Nov, 2024 How will Trump’s epic win affect the share market?

17 Oct, 2024

Should investors be joining the gold rush?

Investment Strategy • 6 mins read

Back to Insights Back to Insights

Gold has been grabbing headlines. You would most probably have seen the precious metal has surged to all-time highs. And gold bars have cracked US$1 million for the first time ever this year.*

*Gold bars typically weigh 400 troy ounces and the gold price surpassed US$2,500 for the first time ever in August this year.

In Australia, gold miners now make up 7.6% of the ASX Small Ords Index – making it a key player in the local investment landscape.

But should investors be joining this gold rush and increasing their exposure?

In this month’s Strategy Note, we explore gold’s history and what is driving the gold price today. And, importantly, we look at how at Ophir we are gaining exposure to surging gold prices while remaining true to our core investment philosophy.

Gold versus Equities

From 1971 to the early 2000s, the gold price had been relatively stable. Gold was, for the longest time, considered a hedge against inflation, economic shocks and currency devaluation.

Then gold soared in 2003 in the lead up to the Iraq war as investors used the commodity as a safe-haven asset. (By coincidence, the first gold ETF was launched in 2003 on the ASX).

All up, since the decoupling of the gold standard in 1971, the gold price has increased from US$43 to US$2,642 per troy ounce at time of writing.

On the face of it, this appears to be a good investment. But the return from gold has been meagre when compared to equities. From 1971 to now, while gold has returned 5,977%, the S&P 500 has delivered a return of 24,472%.

Gold’s Relationship with Real Yields

So why has gold gone up at all?

There is no simple answer.

There is an element of basic supply and demand at work. Gold is a physical asset with a finite supply, so less supply over time should cause an uplift in its price. Similarly, any boost in demand should also see its price rise.

(ETFs have provided easier access to the commodity, so this would also have helped increase demand.)

Another driver has been real yields – the nominal bond yield minus inflation.

Historically, at least most of the last two decades, gold has been inversely correlated to real yields.

When real yields are trending higher, and fixed income investments provide adequate income to beat inflation, the gold price has decreased because it becomes relatively less attractive as a non-yielding asset. When real yields are falling, the gold price tends to increase because those real yields become less attractive.

Source: Ophir. Bloomberg.

This inverse correlation is not perfect but has remained consistent over time.

Why the relationship fell apart

But wait – why has gold pushed higher in recent times when real yields are increasing?

If correlations had held, shouldn’t the gold price have been trending lower over the last two years?

Has the relationship changed?

From 2022 through 2023, it appears three things have all taken turns in pushing the gold price higher, despite the surge in real yields:

Firstly, the Russia-Ukraine war in early 2022 seemed to increase gold’s attraction as a safe haven.
Then the rise in inflation expectations throughout 2022 seemed to see more investors buy gold as an inflation hedge.
And, finally, as the US dollar depreciated through late 2022 and 2023 it increased the attractiveness of gold, which is priced in US dollars, to foreign buyers. One such buyer has been central banks which, according to the World Gold Council, purchased more than 1,000 tonnes of gold in 2022, more than two times the annual average of the previous five years. For example, China has been reducing their US Treasury bond holdings while increasing their gold reserves. India is also increasing their gold reserves at an increasing rate.

Source: Ophir. Bloomberg.

A return to normal

Since late 2023, when the US Federal Reserve signalled they were done hiking interest rates and that rate cuts were on the cards for 2024, real yields have started falling again.

History suggests that during rate-cutting cycles the negative relationship between real yields and the gold price tends to strengthen.

And that is what we have seen since late 2023: real yields have fallen and the gold price has continued to surge to new all-time highs.

Where it goes from here is anyone’s guess. But if you expect real yields to continuing falling back to their longer term average of around 1.5%, then there still may be a little upside to the gold price left near term.

Backing the manager: How Ophir invests in gold

To paraphrase Warren Buffett – “[gold] won’t do anything … except look at you”.

We have a similar sentiment at Ophir: That gold itself is not a worthwhile investment because it is a non-yielding asset and has no cashflows.

However, over the years Ophir has invested in the gold space and done reasonably well.

But we do not invest in gold itself. Instead, we invest in good miners who run gold mines efficiently and economically with strong cashflows following.

As with other non-mining companies, we look for gold producers that will beat on earnings and raise guidance for their next results.

We have built up expertise in Australia of identifying the best mining – and in this case gold mining – managers and management teams.

For us, it’s more of a case of backing the jockey (management), rather than the horse (the specific commodity). We expect these jockeys to have their expertise result in higher cash flows over times, despite the natural cyclicality of the underlying commodities they are leveraged to.

Backing the jockey works particularly well for the gold sector as their capital bases are smaller compared to other commodities so that you can buy an old mine and turn it around pretty quickly. Contrast this to an iron ore mine that needs billions in capex to make a difference.

The sales and marketing effort for gold is also MUCH easier. One of our old investing mentors used to say all you need to do is charter a plane, put the gold bars in it and fly to a major city and that was the extent of your sales effort! Compare that with the comparative logistical complexity of rail, ports, shipping and the like to get iron ore to its destination.

Historically, in the gold sector, we have invested in Bill Beament when he ran Northern Star (now at Develop Global). And we currently invest in a number of high-quality gold miners, including Luke Creagh at Ora Banda.

So despite typically being underweight the Materials sector in our Australian funds, where it is a big part of the index, we haven’t shied away from the sector and have made some great money for our investors by sticking with a few first-rate managers.

But we leave it to the likes of Ora Banda and its gold experts to make short-term decisions based on the commodity price. And we invest in the strategic nous of management and the operational effectiveness of the business over the longer term – just as we would in any other sector.

18 Sep, 2024 Letter To Investors - August

17 Oct, 2024 Letter To Investors - September

18 Sep, 2024

Letter To Investors - August

Letter to Investors • 14 mins read

Back to Insights Back to Insights

Thinking Rate Cuts, Fast and Slow (+ a portfolio addition surprise)

You’ve probably heard of Daniel Kahneman – the recently deceased psychologist who won the Nobel Prize in Economics in 2002 for his groundbreaking work on behavioural economies.

Kahneman summed up much of his life’s work in his wonderful 2012 book, “Thinking, Fast and Slow”. (For those who haven’t, it’s a must read.)

Kahneman divided our brains and our thought processes into two characters:

System 1: Fast, automatic, intuitive and often subconscious, but prone to biases and errors.

System 2: Slow, deliberate, analytical, effortful and conscious. Our ‘slow’ brain is often used for complex decisions and calculations that require logical reasoning.

Things can, of course, go wrong in both brains. But it is System 1 that is most prone to cognitive biases like overconfidence, anchoring, framing effects and loss aversion.

Kahneman taught us that we are not the perfectly rational beings that economics once assumed. Yes, quick rules of thumb can help us get through life easier and quicker, but they can also get us into trouble.

What does this have to do with investing?

Well, plenty. If you fall prey to these biases in investing, you can lose serious money. (Way before Kahneman, even Warren Buffett’s teacher Ben Graham knew this when he said: “The investor’s chief problem, and even his worst enemy, is likely to be himself.”)

But the ‘fast’ versus ‘slow’ dichotomy has major relevance to investing today.

After being on hold since July last year, the US Federal Reserve is almost certainly going to start its rate-cutting cycle this month. You’d remember that global share markets sold off when talk of Fed rate hikes began back in 2021; and they sold off again then when the Fed actually raised rates in 2022. So does that mean that when the Fed starts to cut rates, it will be good for shares?

Well not so fast.

August 2024 Ophir Fund Performance

Before we jump into the Letter in more detail, we have included below a summary of the performance of the Ophir Funds during July. Please click on the factsheets if you would like a more detailed summary of the performance of the relevant fund.

The Ophir Opportunities Fund returned +1.9% net of fees in August, outperforming its benchmark which returned -2.0%, and has delivered investors +22.3% p.a. post fees since inception (August 2012).

🡣 Ophir Opportunities Fund Factsheet

The Ophir High Conviction Fund (ASX:OPH) investment portfolio returned +0.9% net of fees in August, outperforming its benchmark which returned +0.0%, and has delivered investors +13.1% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of +2.3% for the month.

🡣 Ophir High Conviction Fund Factsheet

The Ophir Global Opportunities returned -0.4% net of fees in August, outperforming its benchmark which returned -2.1%, and has delivered investors +15.6% p.a. post fees since inception (October 2018).

🡣 Ophir Global Opportunities Fund Factsheet

Be careful what you wish for

Just as fast ‘System 1’ thinking can sometimes get you into trouble, fast rate cuts by the Fed can also be a worry.

ND Research broke up the last 17 Fed rate-cutting cycles dating back to the 1950s into ‘fast’, ‘slow’ and ‘non-cycles’. (Fast cycles are those with at least five cuts in a year; slow is fewer than five cuts; and non-cycles are those with just one cut.)

As you can see in the chart below of the cycles, slow rate cut cycles (in blue) are the best for the share market (here the S&P500 index). Fast rate cut cycles (in orange) are the worst. (Non-cycles – in green – while technically the lowest performer, aren’t really rate cutting cycles at all with only one cut registered in 1967 and 1968 in a sideways moving market).

1954-8/30/2024. The chart and table shows S&P 500 Index performance around the start of Fed easing cycles. Y-axis is indexed to 100 at start of first rate cut. An index number is a figure reflecting price or quantity compared with a base value. The base value always has an index number of 100. The index number is then expressed as 100 times the ratio to the base value. A fast cycle (orange line) is one in which the Fed cuts rates at least five times a year. A slow cycle (blue line) has less than five cuts within a year while a non-cycle (green line) is case with just one cut. Black line represents all first cuts. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

Why?

As we saw in the 2001 Dot.com bust-related recession, and the 2007-2009 Great Financial Crisis, when the Fed acts aggressively via ‘emergency’ rate cuts, it is usually responding to a recession or financial crisis characterised by falling corporate earnings. Investors become risk averse and slash the valuations they place on those now-reduced earnings.

Our friends at Charles Schwab have taken this data a step further and looked at the maximum drawdown (that is peak to trough fall) in the 6 and 12 months after the Fed’s first cut.

Again, it’s clear that fast cycles tend to see bigger sell offs. (It also looks like fast cutting cycles have become more common in more recent decades.)

Source: Charles Schwab

So, what is the market expecting today?

Fixed income markets have priced in between nine and ten 0.25% rate cuts over the next year, with at least one 0.25% cut priced at each of the next six Federal Reserve meetings. If that eventuates, it will put this cycle in the ‘fast’ cutting camp.

At writing, however, equity markets don’t seem nearly as worried about a fast rate-cutting cycle as fixed-income markets – as witnessed by many major share market indices trading near all-time highs.

That might be because, while a sharp rate-cutting cycle is expected, it will only take the Federal Funds Rate back to a ‘normal’ level of around 2.75-3%. At those levels, rates won’t fall into the ‘stimulatory’ (below 2.5%) or ‘ultra-low’ levels near 0% that you might expect if a recession was forecast.

The positive news

The bottom line: share market investors should hope for a slow rate-cutting cycle because that means economic growth and corporate earnings are likely holding up well, providing support to share prices.

If fast rate cuts are on the cards, just like our errors in System 1 thinking, things are more likely to go awry in the near term in share markets.

There is positive news, however: on a 12-month horizon, both slow and fast cutting cycles have, on average, seen positive S&P500 returns.

For the rest of this month’s Letter to Investors, we wanted to give you some insight into a company that has been recently added to our Global Funds but that has been around literally for ages.

You’ve probably read one of their books!

Time to hit the books

It’s 1807. Thomas Jefferson was the US President. It’s the year Robert E Lee, the Confederate General during the American Civil War, was born. The Napoleonic Wars were raging. And it’s the year Charles Wiley opened a tiny print shop in Manhattan.

When Charles died in 1826, his son John took over the business. Like any good son, he put his name on the business as if he were the founder(!). It became John Wiley. Eventually, when his kids joined the business, the company adopted its current name: John Wiley and Sons – though today many just call it Wiley (NYSE: WLY).

Wiley is now one of the world’s largest publishers, with products ranging from academic journals and articles, to textbooks and professional assessments.

If you went to university, chances are you read a book with ‘Wiley’ on the cover.

At its heart, Wiley enables the creation of new knowledge at the frontier of thinking in such diverse areas as science, medicine, technology, engineering, business, economics and finance.

The business is broken up into two key segments:

1. Research

Wiley has one of the world’s leading portfolios of journals and operates the Wiley Online Library. It is the home to some of the most prestigious academic journals in the world, including the Journal of Finance.

Source: AppAdvice – The Journal of Finance

2. Learning

Learning includes academic publishing and courseware for higher education students, as well as books and assessments for professionals. The content is increasingly valued for GenAI models, a topic we’ll touch on later. Learning also includes books such as the well-known ‘For Dummies’ series – books that probably provide investment advice a little more accessible to the average punter than the wonky Journal of Finance!

Source: for Dummies – A Wiley Brand

Wiley’s competitive advantage lies in a number of things:

its massive content library which includes circa 2,000 journals and over 40 million published articles;
its relationships with some of the brightest minds in the world as authors;
its incumbent category leadership; and
its brand and reputation that has spanned centuries.

Ok, but why does Ophir own it, you ask?

Doesn’t Ophir only invest in new up-and-coming, fast-growing companies?

4 reasons why we own Wiley

We invest in companies that we believe are growing faster than the market thinks; and we don’t overpay for that growth. Sometimes that is a new business; and sometimes, as in the case of Wiley, that can be an old business that for whatever reason is experiencing new, accelerating growth.

Essentially, there are four key reasons why we like Wiley today:

1. It’s easier to find bargains where no one is looking

Despite Wiley being around $A3.5 billion in market cap and generating over $A2.5 billion in revenue, only one broker analyst covers the stock: the previously-unknown-to-us CJS Securities. If Wiley was listed in Australia, its market cap would put it in the ASX mid-cap universe, for which the median number of broker analysts for a company is 13!

Talk about under researched.

It’s easier to find $100 bills still lying around on the street when you are the only one walking down it.

Our investment process is all about getting an edge on a company over the market. The fewer the analysts ‘doing the work’, the more likely we’ll be able to get an edge and find a company outperforming the market’s consensus. Just one broker, CJS Securities, is in effect the ‘market consensus’ for Wiley.

2. Earnings acceleration through digitisation

We expect the business to grow earnings 15-20% pa over the next few years. Revenue has been accelerating after research submissions for journals rebounded post COVID and because Wiley has been digitising its back catalogue of journals/articles over the last few years. Revenue from its digitised back catalogue is dropping through to its bottom line at higher incremental gross profit margins (over 80%). A cost-cutting program, including divesting three non-core business, now just complete, is also helping its bottom line.

3. Competitor IPO shows Wiley’s valuation is attractive

Over in Europe, their big German competitor, Springer Nature, has just announced its imminent IPO and listing on the Frankfurth Stock Exchange. We have met the company multiple times and one of our team very recently travelled to the UK to meet them as part of the pre-IPO “testing the waters” and to gain more intel as a part of our Wiley holding. We think it’s likely Springer’s team of Tier 1 bulge bracket Investment Banks (JP Morgan, Morgan Stanley and Deutsche Bank) will seek a valuation multiple of around 20x 2025 earnings. Wiley, which is growing at a similar rate, is trading on a much cheaper 13x 2025 earnings. We think its likely that the Springer Nature listing will bring significant interest to the space, and Wiley, given its similar growth and business model, but much cheaper valuation.

4. Free optionality: GenAI

You might not think a company that has been around for over 200 years would be at the forefront of artificial intelligence (AI). But Wiley just closed its second licencing agreement with a business customer so they can utilise its content to train their Generative AI (GenAI) models. Most this initial interest is relates to book content in the Learning Division. We can also see this broadening out in the future to the Research division’s academic journal and article content.

So far, Wiley’s GenAI agreements have been for back catalogue content three years or older. But, again, this could become a more recurring revenue source if Wiley provides access to its latest content on an ongoing basis. With around 40 million published articles, Wiley is sitting pretty as a prime source of information to train these models now, and into the future.

For investors in Wiley, this is a completely unpriced and free option. We have seen Shutterstock and Getty Images, whom we have spoken to, recently cash in on the opportunity to use their catalogue of images for training GenAI models. Reddit, the social media forum, also recently signed a deal with Google to use content for its AI training models. Its March IPO has been a success.

All up, Wiley ticks the three key investment selection criteria for us:

Earnings beating expectations.
Margin of safety through a cheap valuation.
Free or cheap growth optionality in the future.

Source: Ophir

So, though Wiley’s been around a while, this is definitely a case of an old company that has some new tricks.

While the small cap market overall waits for its catalyst to start outperforming large caps again, we remain focussed on finding businesses like Wiley that have their own unique catalysts to drive growth and fund performance today. No matter the broader interest rate or macroeconomic backdrop.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Senior Portfolio Managers

Ophir Asset Management

18 Sep, 2024 Is your fund manager skilful or just lucky?

17 Oct, 2024 Should investors be joining the gold rush?

18 Sep, 2024

Is your fund manager skilful or just lucky?

Investment Strategy • 8 mins read

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There is no doubt in the world of sport that the likes of 20-time tennis Grand Slam winner Roger Federer outperforms because of skill, not luck. When investors evaluate the performance of equity funds, however, it’s not as obvious which funds are skilled or have just been lucky.

Fund manager league tables were recently released for the last financial year, and the media, as usual, trumpeted funds with hot performance.

But now is a particularly difficult time for investors to assess fund managers. With markets rising, some funds have just been lucky and ridden strong gains. There is now a danger that investors chase these hot, lucky funds and become saddled with poorly performing investments for years.

In this article we outline how investors can try to tell which funds managers have ‘skill’ – and can be expected to keep outperforming for a long time — and those that are simply ‘lucky’ and likely to disappoint when markets change.

If investors can spot the difference, they are significantly more likely to choose the right fund for them, a fund that delivers sustained performance, and a fund that ultimately helps them reach their financial and lifestyle goals.

The skilled few

The big problem for investors is that few funds are truly skilled.

In a 2014 report on equity investing, Willis Towers Watson, the global investment consulting firm, argued that only 10 per cent of fund managers could be considered genuinely skilled over the long term, while 70 per cent show mediocre performance and 20 per cent are inferior.

The fact that so few managers were deemed truly talented is a product of the multiple forces which influence portfolio performance, such as:

Being lucky
Gambling on high-risk stocks during a rising market
Having exposure to the right investment style at the right time
Taking on hidden risks like selling put options
Being skilled

Obviously, managers that perform via the first four should be avoided. But how can we tell who has the right qualities to be considered genuinely talented managers?

4 attributes of the skilled

Although no specific rule book exists on how this should be judged, we believe that skilled investors have four characteristics in common.

1. They perform through time

The number one attribute of skilled investment managers is their performance over time. By studying this, we can observe if performance has aligned with their intended investment style. For example, if they are a “Growth” style manager have they tended to perform well when that style is in favour? If they are an “all -weather” manager, have they been able to perform well through all different kinds of market environments? We can also measure how persistent returns have been across different stages of the market cycle.

2. They have a high number of winning bets

One should also study the number of bets made over time. A manager who makes many bets over time, and wins a reasonable number of them, deserves to be rated far higher than a manager whose success is solely attributable to one or two knockouts. The former manager has been tested more times, and hence we can be more confident in their ability to replicate that success in the future.

3. They are on a quest for “better”

Besides just looking at each manager’s track record of returns, those with skill at investing have an attitude to their craft that combines intensity, flexibility, and humility. These managers have a passion for investing and are constantly striving to put in the work to become more skilled investors.

4. They accept the role of chance

At the same time, best-in-class investors are aware of the role of chance in their investment outcomes and don’t try to paint their success as pre-ordained. By contrast, fund managers who don’t realise how much chance impacts their results can end up being painfully stubborn or arrogant. And when the environmental variables that help outperformance eventually stop, a humble manager is more likely to adapt and evolve their process commensurately.

The harsh reality is that even a skilled investment manager will underperform at times, and an unskilled manager can outperform, potentially even for years. Still, the longer the period over which a given investment manager delivers superior performance, and the larger the investment base involved, the more likely the results reflect skill rather than luck. To put this another way, over time as an investor becomes more skilful, their performance should become more consistent.

Like medical research

So how do professional fund manager selectors statistically test whether a fund manager’s performance is truly different from their benchmark, or the market?

They perform tests similar to the type medical researchers use to test whether a drug’s treatment of a condition is statistically different from a placebo.

A simplified example of this test is below:

Where:

T = the so-called ‘test statistic’

X = is a measure of the outperformance (if positive) or underperformance (if negative) of the fund versus the benchmark

N = is a measure of how long the fund has been going for

S = is a measure of the volatility of the outperformance or underperformance of the manager through time

A ‘test statistic’ greater than about 2 means you have 95%+ confidence that the manager’s outperformance or underperformance is different to zero. This level of confidence is the most commonly used to determine if something is truly different from its comparator or baseline.

3 takeaways

What you can quickly see is that both the greater the size of the outperformance and the longer the manager’s track record are both positive attributes. Also, the lower the volatility of the outperformance, the more likely that outperformance is ‘statistically significant’ (different to zero) and due to skill rather than luck.

Some takeaways from this are:

You should pay less attention to 12-month returns reported by the press in the newspaper because returns this short have a greater potential to be due to luck, rather than 3, 5 or 10-year returns.
The larger the outperformance, the more likely this is to be due to skill, which can sometimes make up for a short track record. A word of warning though on this one: It is a good idea to test whether a manager has simply been ‘punting’ the fund and has made a big lottery-type payoff on one, or a small number of bets, or whether it is due to a broader series of unrelated investments.
Smaller, consistent outperformance may potentially be more likely to be due to skill than large, but volatile outperformance. There is a trade-off here.

Secretly skewing to small caps

More sophisticated statistical tests also exist to help ensure managers aren’t simply outperforming by taking more risk than is embedded in the benchmark or market they are trying to outperform. A manager, for example, might claim outperformance during a bull market, but they only outperformed because they used leverage in their fund to increase its risk, and hence returns, in that market environment.

Finally, we need to question whether a fund’s investment returns represent exposure that could be obtained at a much lower cost by investing through passive-type products. In such instances, there is no need to pay fees to a skilful investment manager to access these returns.

For example, small-cap equities, which is our space, have tended to outperform large-caps across many different equity markets over long periods of time. Investors should turn their nose up at large-cap managers who skew their funds to small caps, and where their small cap holdings have accounted for a meaningful share of their outperformance over their large-cap benchmarks.

Sorting the skilled from the plain lucky

To summarise, it is clear there is much to think about when trying to determine whether a manager’s returns have been due to skill rather than luck.

Hopefully we have dissuaded you though from putting too much weight on a manager’s short term annual returns reported in the so-called ‘leagues tables’ in the press!

At Ophir we judge the performance of our funds, and our analysts who contribute to it, primarily on its size, duration, consistency, and number of unrelated positions that have led to the result. We also seek to control for excessive risks that could jeopardise absolute performance over the long run.

As long-time readers will know, we think there are two other key criteria that help the skill of any manager shine through:

Alignment: nothing focuses your mind and skills like having your own money on the line when investing. As Charlie Munger has said: “Show me the incentive and I’ll show you the outcome”. Having a significant percentage of your own wealth at risk we believe increases the incentive to perform well.
Capacity constraints: Size kills performance. Managing a lot of money is hard – it can impact your nimbleness and force you to operate in more efficient markets that are more difficult to outperform in. As Warren Buffett has said: “Anyone who says that size does not hurt investment performance is selling”. A skilled manager who has been outperforming for years can quickly turn into an apparently unskilled manager whose performance drops off when they start managing a lot more money.

There are of course many other factors to consider as well when trying to disentangle the skilled from the unskilled, but the above is what we consider to be some of the most important here at Ophir.

23 Aug, 2024 Letter To Investors - July

18 Sep, 2024 Letter To Investors - August

23 Aug, 2024

Letter To Investors - July

Letter to Investors • 13 mins read

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What we think could be the next 10 bagger on the ASX

The share market party kept rolling in July, with little to indicate August’s looming ‘flash crash’. The story of July was the massive rotation from the Magnificent 7 (Apple, Microsoft, Nvidia, etc) into US small caps.

The Russell 2000 US small-cap index was up a whopping +10.2% (in USD) for the month. The S&P 500 eked out just +1.2%, with the Mag7 actually falling -0.6%.

The small-cap surge provided a big tailwind to our Global Funds’ performance during the month.

Small caps globally have had to play second fiddle to large caps since late 2021. As far as the US share market is concerned, there have only been two periods since then where small caps have had some time in the sun. One was back in December last year; the other July just gone.

What do they have in common?

Essentially, during those two periods the market started to price in a higher chance the US Federal Reserve would cut rates (see chart).

Source: Bloomberg. Ophir.

Higher interest rates, starting in late 2021/early 2022, caused small caps to underperform. Lower rates may be their saviour.

The one complicating factor? Whether the long-discussed US recession will eventuate or not.

Like a manic depressive, the share market in recent times has been lurching from ‘soft landing’ rate-cut hopes (good for markets and small-cap outperformance) … to recession and emergency rate cut fears (bad for markets and potentially small-cap underperformance).

While the economic consensus, if there is one, remains in the soft-landing camp, views are wide and outcomes uncertain.

July 2024 Ophir Fund Performance

The Ophir Opportunities Fund returned +5.2% net of fees in July, outperforming its benchmark which returned +3.5%, and has delivered investors +22.2% p.a. post fees since inception (August 2012).

🡣 Ophir Opportunities Fund Factsheet

The Ophir High Conviction Fund (ASX:OPH) investment portfolio returned +2.8% net of fees in July, underperforming its benchmark which returned +3.8%, and has delivered investors +13.1% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of -1.1% for the month.

🡣 Ophir High Conviction Fund Factsheet

The Ophir Global Opportunities returned +9.3% net of fees in July, outperforming its benchmark which returned +8.0%, and has delivered investors +15.9% p.a. post fees since inception (October 2018).

🡣 Ophir Global Opportunities Fund Factsheet

Great risk/reward in small caps

We like the asymmetry for small caps; that is, they have big upside performance potential but limited relative downside to large caps if things get rough.

We think cheap valuations versus large caps (especially in the US) are likely to be the kindling for small-cap outperformance in the US, with soft-landing rate cuts likely to be the spark. (Based on market pricing, those rate cuts will almost certainly start from next month at the Fed’s September 17-18^th meeting.)

But if a US recession happens, along with supersized emergency rate cuts by the Fed, small caps will almost undoubtedly fall. However, given the chasm in valuations, those falls will likely be less – or at least not much more – than large caps.

The US small cap price-to-earnings (PE) ratio is currently at 16.5x versus 24.3x for large caps. US small caps have not been as cheap versus large caps since the Dot.com bubble 25 years ago. When the bubble burst and recession followed, large caps fell more than small caps because their valuations had to drop from nose-bleed levels.

When US recessions have ended, across all the major share markets in the world, small caps have then significantly outperformed in the first year of the market rebound.

In our view, the relative case for global small versus large caps over the next 5-10 years has not been as compelling as it is today for at least a quarter century. We don’t know the exact catalyst, but as Warren Buffett says, “price is what you pay, value is what you get”.

For the rest of this month’s Letter to Investors we wanted to give you a deep dive on the ‘Who Am I’ company that we flagged in last month’s Letter to Investors – ASX listed company Life360. We think Life360 has the best chance of any ASX-listed company of being a ‘10 Bagger’ (increases in value 10 times over) over the next 5-10 years.

Facebook for friends … LinkedIn for business … and Life360 for family?

When travelling in the US for work there is a lot of down time in the back of an Uber travelling between meetings.

You inevitably start talking to the driver about their families and, of course, America’s favourite topics: crime, homelessness and gun laws.

From the hundreds of these uber rides we can tell you three things:

No one feels safe in America;
Many of these drivers work incredible hours (often in multiple jobs) to give their family a better life; and
The number of drivers that use Life360 with their families has grown exponentially over the last five years.

Life360 is a ‘freemium’ app. The app provides real-time location services for families. You can set up notifications to get an alert when your child arrives at school, leaves school and then arrives home.

If you want to pay for a subscription, you get driver reports, which show how your child is driving (are they speeding? using their mobile phone? etc), roadside assistance, towing, and crash detection with emergency response.

Today, there over 70 million users worldwide, 40 million of those in the US, and two million paying a subscription for the app (think US$15/ month).

Incredibly, on Apple’s ubiquitous mobile operating system (iOS), Life360 now has the fourth-highest daily active users of any social networking app in the US … and the 13^th highest of any app! (You’ve obviously heard the names of all the other big-use apps, like YouTube, Facebook, TikTok, Instagram, Snapchat and Spotify.)

Why we own Life360

We have owned Life360 since mid-2020 when it traded at around $3.50 per share (Ophir owns the stock in all our Australian equity funds including the Ophir Opportunities Fund and the Ophir High Conviction Fund (ASX:OPH).

We were attracted to the growing subscriber base, the ability to move to a tiered subscription model and the free optionality inherent in their user base.

The stock has certainly taken us on a rollercoaster ride. At one stage, it fell close to $2.50. At writing, it was trading at just over $18 per share.

Essentially, there are three key reasons we own Life360:

1. Life360 is going viral in the US and has an ultra-low cost of acquiring customers

Life360 has been spreading like wildfire through the US, especially in the South. Some 13% of Americans are now using Life360 regularly, up from 6% just four years ago. In the Southern States, like Texas, up to a quarter of people are using the app.

Source: Life360 Presentation

The Southern States are still the fastest-growing States in the US. Could Life360 go from 40 million to 100 million users in the US? There is no evidence growth is slowing.

Now it is starting to spread globally.

Importantly, Life360 reported that between 70% and 80% of users sign up because of word of mouth. Recently, the number of users downloading the app has accelerated, despite the company spending less on marketing and advertising.

To help make its app even more viral in the next couple of years, Life360 is set to release its ‘Pet’ product, which will allow pets to be tracked with GPS live in the app. Life360 will also release elderly care, where an elderly parent can have a wearable device integrated with the app. The wearable could feasibly detect a fall and automatically send an emergency dispatch, as well as notifying family members. Life360 is becoming a ‘cradle to grave’ business targeting a huge global end market.

2. The potential to be a powerful ‘Facebook-like’ ad business

Life360 has the potential to become like Facebook and become a marketing business. Like a newspaper, Facebook uses content to attract a crowd and sell adverts. But with Facebook, the user creates content for friends for free. Facebook then targets the best ads to users consuming the content. This creates a very valuable loop: low cost to acquire customers through free content; ultra-low cost to create content; and the ability to target ads algorithmically .

We view Life360’s location services as the ‘content’ created by the family unit. Family members are always creating content for other family members to consume. Moreover, Life360 uses that content to target ads using algorithms and achieve high conversion on those ads. Why might they have the best algorithms to target advertising? For the app to work, they always need to know your location. What other app can claim this? That data is a goldmine for advertisers.

In February this year Life360 announced that it will launch advertising on its platform. From the first second of that day Ophir were buying more stock, even when the stock was up over 20%.

We estimate there will be over 100 billion views on their app over the next 12 months. We have spoken to many people in the digital advertising industry. Their insights suggests that Life360 should be able to charge advertisers somewhere between $3 and $6 per 1,000 views in three to five years’ time on the app in the US.

Interestingly, Life360 included the Uber example (below) in their latest chart pack to illustrate the potential of advertising for the company. This suggests they are thinking along the same lines.

In five years, we believe advertising will likely generate more revenue than Life360’s subscription business. However, the true excitement comes from their margins. In our view the subscription business has the potential to get to 30% profit margins in 2029. But given the content is free and acquiring the customers is free, we think digital advertising can deliver 80% plus profit margins for Life360.

3. Even more opportunities from add-on products like auto insurance

But we don’t see the business stopping there. Life360 has other ‘free options’ – products with massive upside potential that aren’t being valued by the market – embedded. Like auto insurance. Given Life360 knows who is speeding, and the generally good versus bad drivers, they have the ability to price risk better than the standard insurer. Could they offer discounted car insurance to the best drivers who drive infrequently through safe areas at low-risk times? Again, they will have no cost to acquire customers given they are existing users of the app.

Teenage debit cards are another latent opportunity. Parents can pay pocket money through the app and watch how their children spend it in real time. From the days of the Dollarmite account through Commonwealth Bank, signing up kids has been a great way to win long-term customers for a bank. Greenlight is a private US operator in this space, and we estimate it makes well over $100 million of ongoing revenue at high incremental margins on revenue growth.

Importantly, you are not paying for any of these potential businesses where Life360 will have a huge comparative advantage in the cost of acquiring customers and data collected from location services.

Source: Life360 Presentation

The key risk

The key risk for us, of course, will be Apple’s ‘Find My’ app.

It allows Apple users to do many (but not all) of the same things the free Life360 app does. It is conceivable, especially in an AI world, that Find My becomes a lot better and Life360 is not able to stay meaningfully in front of Apple.

While we don’t know what Apple will do here, it’s important to note that Android and Google have been moving away from location services.

Importantly, over 50% of families using Life360 have at least one family member on an Android phone. Given the inoperability between Android and Apple’s iOS, the Find My location services will not be effective for those entire family units.

A rare Aussie 10-bagger opportunity

It is not every day you come across a business listed in Australia that is growing globally above 20% per annum and has 70 million active customers. In the next few years, we will watch and see if Life360 can flex its free product offering to grow to become a truly global platform business.

The hard work has already been done in building the crowd. While Apple will always remain a risk, the potential to make 10x your money in Life 360 means that, to us, there is bigger risk not owning Life360 than worrying about what Apple will do next.

There are no certainties in investing, but Life360 is a company that has us pretty excited. A small cap company growing fast, into a big global end market, with lots of free options for business expansion. Now that’s the type of company we love at Ophir.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Senior Portfolio Managers

Ophir Asset Management

24 Jul, 2024 Letter To Investors - June

18 Sep, 2024 Is your fund manager skilful or just lucky?

24 Jul, 2024

Letter To Investors - June

Letter to Investors • 12 mins read

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Welcome to the June Ophir Letter to Investors – thank you for investing alongside us for the long term.

Immaculate disinflation to the small cap rescue?

Investors have had to contend with inflation, the start of rate cutting cycles, a bifurcated US economy, and wars in Europe and the Middle East. If that wasn’t enough, another force has been thrown into the blender: politics.

Snap French and UK elections started things off. Joe Biden’s woeful first presidential debate performance saw the US get involved. Then, spectacularly and tragically for the innocent victim in the crowd, former President Donald Trump narrowly survived an assassination attempt at a rally in Pennsylvania. And just now President Biden has withdrawn from the race.

Most relevant for June’s performance in our Funds was the risk aversion the French elections injected into the Paris stock market, a market where Ophir has a number of portfolio holdings. French stocks dropped just shy of -14% during the month!

Sacre Bleu!

Source: Bloomberg. Data from 31 May 2024 to 30 June 2024.

In this month’s Letter to Investors, we’ll look at how we manage exposure to individual countries, like France. Then we’ll touch briefly on three key important topics:

The US presidential election and what it might mean for the outlook for inflation, bonds and stocks.
Whether ‘immaculate disinflation’ is alive and well again in the US. Is this the rocket small caps need?
And, finally, we’ll play a quick game of ‘Who am I?’ We ask you to guess this ‘family friendly’ high conviction stock we hold in our Australian Funds. We think this stock is a potential 10-bagger! (Read or scroll to the end of this Letter to play!)

June 2024 Ophir Fund Performance

Before we jump into the letter in more detail, we have included below a summary of the performance of the Ophir Funds during June. Please click on the factsheets if you would like a more detailed summary of the performance of the relevant fund.

The Ophir Opportunities Fund returned +2.8% net of fees in June, outperforming its benchmark which returned -1.4%, and has delivered investors +21.9% p.a. post fees since inception (August 2012).

🡣 Ophir Opportunities Fund Factsheet

The Ophir High Conviction Fund (ASX:OPH) investment portfolio returned -0.8% net of fees in June, outperforming its benchmark which returned -1.4%, and has delivered investors +12.9% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of +1.2% for the month.

🡣 Ophir High Conviction Fund Factsheet

The Ophir Global Opportunities returned -2.2% net of fees in June, unperforming its benchmark which returned -2.1%, and has delivered investors +14.4% p.a. post fees since inception (October 2018).

🡣 Ophir Global Opportunities Fund Factsheet

Quelle horreur! This is why we don’t bet the farm on one country

By far the main contributor to underperformance in our Global Funds during the month was our overweight exposure to France. Without this, we would have outperformed.

Why are we overweight French listed companies?

It is certainly not from any particular view on the French economy or political risks. Rather, from a bottom-up perspective we have found some great ideas in France.

The political uncertainty around a hung Parliament, however, triggered indiscriminate selling in June, and the four French companies we hold fell around -10% to -13% during the month in Euro currency terms.

Ultimately, this volatility doesn’t change our investment thesis on any of these businesses and they have, in general, recouped some of June’s falls in July at the time of writing.

From a portfolio management perspective, though, it does raise an important point: We will never bet the farm on a certain geography versus our Global Funds’ benchmark – the MSCI World SMID Cap Index.

We are bottom-up stock pickers, not macro allocators. We don’t make large, active (over- or under-weight to benchmark) geographic allocations based on a belief that a certain country’s share market will deliver superior risk-adjusted returns.

Typically, we do not go more that plus or minus 20% overweight or underweight a certain country in our benchmark. Most often it is 10% or less.

We don’t want an event like what happened in France in June to be the major determinant of whether we out or underperform over the medium to long term. We want performance to be based on getting the fundamentals of individual companies we own right – that is, identifying businesses with superior growth prospects that are underappreciated by the market.

Historic US market calm before the political storm?

Making money in your large-cap share portfolio has been easy of late with lots of return, yet very little volatility.

The S&P 500 just put on another 3.6% in June, and the Nasdaq added a further 6.0%. The VIX – the so-called ‘fear index’ in the US – has been plumbing lows at the 12-13 times range. This signals the market has very little concerns about a bumpy road ahead.

Another, far simpler, method of looking at recent market calm is the number of days the S&P 500 has gone without a 2% fall.

We have just eclipsed 350 days – the longest streak without a 2% pull back since 2007, just before the GFC. That’s quite an auspicious record to now hold.

In fact, a stretch of calmness by this measure has only occurred 11 times in the last 100 years!

Source: Bloomberg. Data to 22 July 2024

3 things investors can expect from a second-term Trump

However, we know from history that the months right before a US election tend to be more volatile times for share markets.

Will this time be different?

After Biden’s poor showing in the first presidential debate, and the attempted assassination attempt on his debating partner and challenger, Trump, it has become much more likely ‘The Donald’ will add to his title as the 45^th President of the United States by becoming its 47^th.

There is still time between now and November for things to change, but the market has been starting to price in the greater odds of a Trump victory. (At writing, President Biden has stepped aside from challenging the 2024 election with Kamala Harris the likely Democratic candidate as highlighted in betting markets – see chart)

Source: Bloomberg: PredictIt odds for who will win 2024 U.S. Presidential Election

From what we know so far, a Trump presidency will likely focus on four main policy initiates, including:

Limiting imports and reshoring economic activity
Curbing migration
Extending the Trump era tax cuts, and
Repealing the Inflation Reduction Act (IRA).

Given this, what should investors expect from a Trump Presidency? Here’s what we think is likely:

Higher-for-longer inflation

Import and migration restrictions, as well as extending tax cuts, are all inflationary. All else being equal, this could mean inflation remains above the Fed’s target of 2% for some time, at least the next two years.

Higher bond yields

The combination of higher inflation, rising government debt and stronger economic activity will likely put upwards pressure on bond yields. We could see US 10-year bond yields in the range of 5-6%.

Higher equity prices

Extending corporate tax cuts will provide a shot in the arm for US profits and margins. Trump, as he was during his first Presidency, is a market-friendly leader and we expect he will want to continue that in his second term. A key caveat is whether rising bond yields become a headwind to equity market performance. The speed of any rise will be the key here. We know that, initially, rising bond yields weren’t a headwind to share market gains during Trump’s first term in office.

Overall, we expect the market to like anything that increases the odds of a Trump presidency.

But history suggests we should still expect the share market to get more volatile as we approach election day, and that, if Trump wins, higher inflation, bond yields and equity markets become incrementally more likely.

Will ‘immaculate disinflation’ rate cuts rocket smalls caps?

As regular readers and many investors would be aware, since the latest equities bull market started in late 2022, there has been little market breadth. Small caps have dramatically underperformed, and a small handful of mega-cap tech companies have driven the market.

One of the few times market breadth has widened during this bull market was in December last year. That’s when the US Federal Reserve first indicated they were likely done raising interest rates this cycle, and that rate cuts were likely in 2024.

As of writing in July, we have just seen another big signal that indicates that small caps are poised to outperform on the back of so called ‘soft landing’ rate cuts by the Fed.

US inflation data for June, released on the July 11, was notably softer than expected. US annual Core CPI is still 3.3%, but on a three-month basis is annualising at 2.1% – virtually bang on the Fed’s 2% target.

Fed Chair Powell appears to be getting the “further evidence” that inflation is softening that he needs in order to cut rates this year. At the same time, unemployment remains relatively low.

Global Small Caps reacted by posting their second-largest outperformance over Global Large Caps in history! (see chart for outperformance of 3.03% on the 11^th July 2024).

And for good measure the Russell 2000 – the small-cap index – had its largest outperformance versus the Nasdaq ever!

Source: Bloomberg. Data to 11 July 2024

This was a MAJOR market rotation day.

It gives investors some idea of where market positioning and demand is likely to move if a soft-landing rate-cuts scenario continues to play out. This rotation of small cap outperformance, at the time of writing, has continued in the days after the 11th July.

For those wondering what might the catalyst be for small caps to catch up their monumental underperformance versus large caps and mega cap tech, it’s clear: soft CPI and impending Fed rate cuts.

The market has now fully priced in (i.e. a 100% chance) a Fed rates cut of at least 0.25% in September.

Is this the starter’s gun small caps have been waiting for?

If the economy holds, and the rate-cutting cycle starts on the 18^th September as predicted by markets, it is looking increasingly likely based on recent market behaviour.

Who am I? – The Ophir Company guessing game

Now, let’s play a game.

I am US tech company listed on the ASX. Earlier this month I listed on the NASDAQ.

My product is a smartphone app that families use to share their locations.

That app lets me know if my teenager, who has just gotten their drivers licence, is speeding or, God forbid, has crashed the car.

I have 25 million daily users. They use my app at least 5 times per day (that’s a lot of worried parents!!).

In February, on the day I announced I would introduce advertising to my free users, my share price soared nearly 40%.

We think Duolingo is a good ‘comp’ (comparative company) to assess the potential upside to revenues and valuation for this company from introducing an advertising income stream.

I am a top holding and top performer in the Ophir Opportunities Fund and Ophir High Conviction Fund (ASX:OPH).

My share price is up over 125% in the last 12 months.

Who am I?

I am Life360 (ASX:360) and if you want to know why Andrew Mitchell thinks I could be a 10 bagger in Ophir’s portfolios … click on the link here to listen to Andrew’s interview with Murdoch Gatti on The Rate of Change podcast.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Senior Portfolio Managers

Ophir Asset Management

17 Jun, 2024 Letter To Investors - May

23 Aug, 2024 Letter To Investors - July

17 Jun, 2024

Letter To Investors - May

Letter to Investors • 14 mins read

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Welcome to the May Ophir Letter to Investors – thank you for investing alongside us for the long term.

Earnings matter longer term. Are they starting to again?

We often get asked, “who are your investment heroes?”

Many might think the obvious answer is Warren Buffett.

But that award actually goes to Peter Lynch.

Lynch managed Fidelity’s Magellan Fund from 1977 to 1990, generating remarkable returns. Magellan averaged a 29.2% annual return, nearly twice the S&P500’s 15.8%.

Lynch’s strategy is closely aligned with ‘GARP’ (Growth At a Reasonable Price). The strategy looks for companies growing faster than average (growth), but with a strong focus on not overpaying for that growth (reasonable price).

GARP, of course, is the general approach we use here at Ophir.

Lynch popularised “investing in what you know”: focusing on insights from everyday life, such as the products you buy at the supermarket, to get a market edge. On weekends, the Ophir investment team’s text chat group pings with investment ideas to investigate inspired by things we’ve seen in everyday life.

Lynch also coined the term ‘ten bagger’, the rare feat where an investment rises ten times its original purchase price. We’ve been lucky to bag a few ten-baggers and a handful of stocks in our portfolios definitely have ten-bagger potential.

Lynch’s two most famous books are ‘Beating the Street’ and ‘One Up on Wall Street’, both must-reads for any share market newcomer.

But perhaps our favourite Peter Lynch investing dictum of all time is:

“Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or a few years. In the long term, there is 100 percent correlation between the success of the company and the success of its stock.”

(For proof of this, check out the ‘Key drivers of stock performance’ chart from our last Letter to Investors (https://www.ophiram.com.au/letter-to-investors-april-5/).)

As you probably know, our portfolios have weathered one of those short-term periods where share prices become disconnected from earnings.

In late 2021 through mid-2022, small-cap growth companies, in which we invest, got hammered as interest rates increased. Yet at the same time, their underlying earnings continued to grow.

But is that beginning to change?

During the recent reporting season, in our Global Funds at least, earnings momentum and ‘beats’ finally looked like they are being rewarded by the market again to a degree we haven’t seen for some years. This is good news for investors as earnings growth and positive share price reactions to it are the most sustainable form of performance generation in our funds.

We’ll explore this theme further in this month’s Letter to Investors, using a core stock holding, Zeta, as an example of a stock where the share price is finally catching up with stellar earnings beats.

And we’ll also look at what the current bearishness of Wall Street strategists can and can’t tell us about what lies ahead for markets.

May 2024 Ophir Fund Performance

Before we jump into the letter in more detail, we have included below a summary of the performance of the Ophir Funds during May. Please click on the factsheets if you would like a more detailed summary of the performance of the relevant fund.

The Ophir Opportunities Fund returned +3.1% net of fees in May, outperforming its benchmark which was flat, and has delivered investors +21.8% p.a. post fees since inception (August 2012).

🡣 Ophir Opportunities Fund Factsheet

The Ophir High Conviction Fund (ASX:OPH) investment portfolio returned +2.5% net of fees in May, outperforming its benchmark which returned +0.2%, and has delivered investors +13.1% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of +1.2% for the month.

🡣 Ophir High Conviction Fund Factsheet

The Ophir Global Opportunities returned +5.8% net of fees in May, outperforming its benchmark which returned +1.2%, and has delivered investors +15.0% p.a. post fees since inception (October 2018).

🡣 Ophir Global Opportunities Fund Factsheet

There’s a bear in there.

Share markets continue to put on gains during May, with the big gorilla of share markets, the United States, leading the way once again. The NASDAQ, S&P 500, and Russell 2000, were up 7.0%, 5.0% and 5.0% respectively. The S&P 500 at writing closed at 5,361 (10^th June), a new all-time high.

The S&P 500 is up 12.4% this year and 49.9% from the start of this bull market in October 2022. If you were a momentum investor, surely you’d think this rally had more legs right after such strong gains?

Not so says Wall Street.

Below, we show the S&P 500 end of 2024 price target for 27 of Wall Street’s finest Investment Strategist from all the major brokers.

Broker	Strategist	S&P 500 year end target	Change from current level (5,361)
UBS	Jonathan Golub	5,600	4.5%
BMO	Brian Belski	5,600	4.5%
DZ Bank	Sven Streibel	5,600	4.5%
Wells Fargo	Chris Harvey	5,535	3.2%
Deutsche	Bankim Chadha	5,500	2.6%
Natixis	Emilie Tetard	5,500	2.6%
Societe Generale	Manish Kabra	5,500	2.6%
Oppenheimer	John Stoltzfus	5,500	2.6%
HSBC	Nicole Inui	5,400	0.7%
BofA Securities	Savita Subramanian	5,400	0.7%
Yardeni Research	Dr Ed Yardeni	5,400	0.7%
RBC	Lori Calvasina	5,300	-1.1%
Barclays	Venu Krishna	5,300	-1.1%
Ned Davis Research	Ed Clissold	5,250	-2.1%
22V Research	Dennis Debusschere	5,250	-2.1%
Piper Sandler	Michael Kantrowitz	5,250	-2.1%
Goldman Sachs	David Kostin	5,200	-3.0%
Ameriprise	Anthony Saglimbene	5,200	-3.0%
Fundstrat	Thomas Lee	5,200	-3.0%
BNP Paribas Exane	Greg Boutle	5,150	-3.9%
Citi	Scott Chronert	5,100	-4.9%
Stifel	Barry Bannister	4,750	-11.4%
Evercore ISI	Julian Emanuel	4,750	-11.4%
Scotiabank	Hugo Ste-Marie	4,600	-14.2%
Cantor	Eric Johnston	4,400	-17.9%
JP Morgan	Dubravko Lakos-Bujas	4,200	-21.7%
BCA Research	Peter Berezin	3,500	-34.7%

Source: Bloomberg. As at 11th June 2024

Their average and median forecasts for the end of this year are 5,146 and 5,250 each. That’s -4% and -2% respectively below the current S&P 500 level.

In fact, 60% of them have the S&P 500 going backwards over the rest of 2024.

Pretty bearish stuff right!

The most bullish forecaster, UBS, has an implied return of 4.5%. That’s bang in line with what you could get per annum by parking your cash in safe-as-houses 10-year US Treasury Bonds.

So, should investors be selling up and parking their money in cash?

Not so fast.

The track record of any one strategist, or even the collective, is not that stellar.

Returning to Peter Lynch, he says:

“Nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you are invested.”

The same strategists were all too bearish at the start of 2024. Every one of them had their end-of-2024 forecast eclipsed by the end of May, just five months into this year.

Not betting big on a recession call

While we wouldn’t be putting all our chips on one star strategist, or tilting our portfolios majorly on the current relatively bearish collective view, we think there are a couple of insights to be gained from the strategists’ outlook:

In their commentary, most strategists see limited upside because valuations on the S&P 500 are already very high at 25x P/E (12-month historical earnings). Corporate earnings growth should also be limited because economic (real GDP) growth is forecast to be subdued at sub 2% for the rest of 2024. This suggests that any attractive share market returns will be found in cheaper pockets. Fortunately, small caps with better growth prospects (at Ophir, finding these is our raison d’etre) is one of these areas.

While economic soft landing in the US has become more likely over the last year, recession still remains a possibility. This is THE key reason groups like JP Morgan and BCA Research have material downside for the S&P 500 in their forecasts. This cannot be ignored, and is one of the reasons – along with ‘at the coal face’ company outlooks and other leading economic data – that we have not loaded up on cyclically exposed growth companies, despite a reasonable probability of growth-supporting US rate cuts this year.

Similarly, though, we are not positioned in an overly bearish fashion either. Like the proverbial boy who cried wolf, long-time recession callers (such as JP Morgan and BCA Research) have consistently been proven wrong over the last 1-2 years. Even if they are ultimately proven right, and a US recession does occur in the next year, being early is the equivalent of being wrong in markets.

Staying on our Peter Lynch theme he notes:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves.”

Bottom line: don’t bet too big on any recession call.

No economic forecaster’s crystal ball is that crystal clear.

Reporting season – earnings finally coming to the fore?

May was a great month for performance across the Ophir Funds, with all outperforming materially. But it was the Global Funds that were the standout.

The best part was that it was earnings ‘beats’ and momentum that drove the outperformance. This is the best driver because it’s what our investment process targets.

It is, by far, the most sustainable driver of outperformance over the long term.

If outperformance was driven instead by style tailwinds – for growth stocks or small caps – then this is unlikely to persist indefinitely and may just as easily reverse in the future.

In May, most companies in our Global Funds reported Q1 earnings results with a high level of earnings ‘beats’ (earnings coming in more than 2% above market consensus expectations) and ‘raised’ guidance (earnings guidance raised by the company for the next quarter/full year).

The biggest takeaway, though, was not that the number of ‘beats’ and ‘raises’ was good, but rather the market reaction.

You can see in the bottom row of the table below the outperformance of the Ophir Global High Conviction Fund compared to its benchmark for the key reporting month each quarter.

Global Funds – Reporting Season Outcomes

Source: Ophir. The results are weighted by the portfolio weights of the constituents that reported. GHCF Alpha = Net Outperformance during the main month of each reporting season (August, November, February, May)

While we were getting similar levels of ‘beats’ and ‘raises’ in the last few quarters, we weren’t getting significantly rewarded with share-price gains.

That changed this quarter, with these companies generally up around 10-30% on the month in May after their good earnings results.

This is a stark change from late 2021 and 2022 where, despite similar levels of good earnings results, Fund performance during reporting seasons – compared to our benchmark – was negative as high inflation/rates saw steep falls in valuations offset the positive earnings benefit.

Zeta beats rewarded

It is too early to be confident the greater role of earnings in performance for our Global Funds will continue in the short term. But we remain highly confident that, regardless, it will continue to stand our long-term performance, as it has historically, in good stead.

To bring to life this recent marked change in market sentiment towards some of our holdings in the Global Funds, we thought we’d share with you the example of Zeta Global Holdings (ZETA US).

Zeta is an AUD$5.4 billion market cap New York Stock Exchange-listed marketing technology company. It was founded in 2007 and listed in 2021.

Its data and AI-powered cloud platform provides enterprise users with customer intelligence and marketing automation software solutions.

Zeta has the largest omnichannel market platform with identity data of customers at its core, over 40% of the Fortune 100 as customers, and competes with the marketing cloud offerings of Oracle, Adobe and Salesforce.

The company has grown revenue by +20% for the last 9 quarters and has more than doubled revenues from US$368 million to US$729 million over the last three years.

Since listing, Zeta has consistently beaten market expectations on fundamentals, with circa 5-10% revenue beats each quarter.

We show this below in the black line where broker consensus expectations for revenue for the next 12 months has consistently been revised up each quarter that the company has reported its financial results.

Zeta’s Share Price Growth Catching Up to its Sales Growth

Source: Bloomberg. Zeta Share Price & Estimates Sales Figures 6 July 2021 – 31 May 2024.

Despite this consistent growth in the key driver of the business, the share price has been far more volatile and lagged the growth in revenues. That is until very recently.

Zeta has delivered ‘beats’ over the last few quarters, including the most recent quarterly result on May 6th, but it was only more recently that the market has rewarded this consistent growth.

In Lynch’s words, there has been “no correlation between the success of a company’s operation and the success of its stock” for Zeta over 2022 and 2023.

But “in the long term there is 100% correlation”, with forward revenues and the share price both growing almost identically about 29% over the last three years.

Following our north star

This remains the perpetual challenge for investors.

You are not right or wrong in the short, or even the medium term, because Mr Market tells you through a share price that doesn’t reflect fundamentals.

Rather, when prices move away from fundamentals, it creates opportunities for investors to increase or lighten positions as the circumstances dictate.

You may never know the exact catalyst, but, ultimately, share prices follow a north star … and that north star – Ophir’s north star – is company fundamentals.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Senior Portfolio Managers

Ophir Asset Management

17 Jun, 2024 LIC/LIT big discounts – Permanent purgatory or rate cut relief ahead?

24 Jul, 2024 Letter To Investors - June

17 Jun, 2024

LIC/LIT big discounts – Permanent purgatory or rate cut relief ahead?

Investment Strategy • 7 mins read

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Australian Foundation Investment Company (AFIC) is the largest Listed Investment Company (LIC) or Trust (LIT) on the ASX, with a market cap of around A$9 billion. It’s also the most liquid and oldest (listed in 1936!).

The fund has an enviable, very-long-term outperformance track record.

Since the late 1980s, AFIC has traded on an average premium to Net Tangible Assets (NTA) of +1.8%. That premium reached nearly +20% in 2022.

Yet AFIC now trades at a 7 to 7.5% discount to NTA, putting it in the lowest 5-10% of its discount-premium range in AFIC’s history.

So, what gives? Why such a historically big discount? And what does that mean for the outlook for other listed funds, such as our own Ophir High Conviction Fund’s LIT (ASX:OPH)?

An alternative explanation

Investors give several reasons for LIC & LIT premiums and discounts, including:

Supply and demand
Size of the LIC or LIT
Liquidity of the fund
Investor sentiment
Market direction
Investment performance

But so many of these reasons fail to explain AFIC’s historically large discount.

AFIC is a large, liquid fund, with good recent one and five year performance. The Australian large-cap dominated index (ASX200) is within a whisker of all-time highs, so we have a fairly bullish market.

What else could explain AFIC’s historically high discount?

We think it’s interest rates.

Below, you can see the premium and discount of AFIC on a monthly (orange line), and six-month moving average basis (black line), since the early 1990s.

We have added a red line, which is the average of the US Federal Reserve’s Fed Fund Rate and the Reserve Bank of Australia’s Cash Rate, inverted.

LIC/LIT premiums/discounts move with rate hikes/cuts

Source: Bloomberg

It’s clear: lower interest rates (a higher red line) have been associated with higher premiums to NTA … and higher interest rates (a lower red line) have been associated with higher discounts to NTA.

Managing OPH’s big discount

Our Ophir High Conviction Fund (ASX:OPH) has been listed on the ASX as a LIT since late 2018.

It has traded as high as a +20% premium, and as low as an -18% discount to NTA. Overall, it has traded close to par with an average discount of -2.2%.

However, like AFIC, it currently trades at a larger-than-average discount, in OPH’s case circa -11% at writing.

We, of course, are working hard to help manage the discount, including:

Enhanced marketing to make investors aware of the value on offer to investors if they buy the fund at a discount, particularly given it has an attractive +13.1% (net) p.a. NAV investment total return since inception in 2015, versus its benchmark of +9.1% p.a.;
Signalling to investors the value we see on offer through us (Andrew and Steven) personally buying units in the Fund recently; and
Using the buyback mechanism to buy OPH units in the Fund when we see compelling value on offer.

We have used all three of these since the Fund was listed.

Do interest rates affect discount/premiums for the broader pool of LIC/LITs?

It’s important, however, to understand whether other factors that are out of our control, such as interest rates, influence the cyclical nature of the premium and discount for OPH.

OPH has only been listed for a little over five years, so we need to look to longer-running LIC/LITs to see if our ‘rates relationship’ hypothesis holds, and not just for AFIC.

The evidence strongly suggests it does hold.

Below, we show the relationship between interest rates and the 38 long only Australian and Global Equity LIC and LITs on the ASX. Though not a perfect relationship, the black line – the average premium or discount on these funds – has broadly moved inversely with interest rates in both the US and Australia[1].

LIC/LIT premiums/discounts move with rate hikes/cuts

Source: Bloomberg

Another way to view this is through the average and median premiums or discounts that have prevailed in the equity LIC/LIT market on the ASX for different Fed/RBA interest rate ranges. We show this below for all 38 equity LIC/LITs from the chart above:

Range for Average of Fed/RBA policy rate	Average Premium/Discount	Median Premium/Discount
0-2%	-4.6	-3.8
2-4%	-6.0	-6.9
4-6%	-8.3	-8.8
6-8%	-12.4	-11.8

Source: Bloomberg. Data since January 1992 and includes premium/discount history for 38 equity LIC/LITs on the ASX using history back to their inception dates.

While premiums are rarer on average for the full contingent of equity LIC and LITs, it is clear, larger discounts do tend to be associated with higher interest rates.

From TINA to TIARA

This is certainly the case today, with the Fed Funds Rate the highest since the year 2000 and the RBA Cash Rate the highest since 2011.

We think it’s fair to say that the highest interest rates seen in 10-20+ years in the US and Australia is weighing on LIC/LIT premiums and discounts. That’s because higher rates are likely providing an alternative investment to LIC/LITs for some investors, which is impacting demand.

Basically, we have shifted from an interest rate world of 0% during COVID in 2020 and 2021 where the ‘TINA’ (There Is No Alternative to equities) moniker was in play and many saw shares as the only investment choice to “TIARA” (There Is A Reasonable Alternative) where fixed income and even cash investments have become more attractive again.

The OPH premium and discount has not been immune, as you can see by the yellow line in the chart above.

In the chart below, we have zoomed into the period since OPH listed in December 2018.

LIC/LIT premiums/discounts move with rate hikes/cuts

Source: Bloomberg

It traded at a premium for a few months after listing, but then fell to a discount in 2019 following recent rate hikes in the US[2].

However, when the Fed and RBA cut rates in early 2020, in response to the outbreak of COVID, OPH shot back to a premium, and the average discount for equity LIC/LITs as a whole shrunk.

Later in early-to-mid 2022 both the Fed and RBA (along with other developed economy central banks) starting hiking interest rates in response to ‘sticky’ inflation pressures.

In some of the fastest rate hiking cycles seen in decades, the OPH premium became a discount, and the average LIC/LIT market discount also began to widen again.

Springtime for LIC/LITs?

So where to from here?

We have made the case that LIC/LIT premiums and discounts in general across the market tend to be cyclical. And that cycle is heavily influenced by the direction and level of interest rates. Rates are by no means the only factor, and other factors can be more meaningful for individual LIC/LITs.

But if history is any guide, interest rate cuts are likely to be a catalyst for LIC/LIT discounts to shrink in general and premiums to widen.

Which begs the question: when is the rate-cutting cycle currently forecast by markets likely to start?

Currently, there is a greater-than-50% chance the Fed will start its cutting cycle in just over three months’ time in September. While for the RBA, rate cuts look likely to start in either very late 2024, or early 2025.

It has been a frosty winter for discounts for many LICs and LITs on the ASX in the last year or two.

But summer may be just around the corner.

[1] Policy interest rates in both the U.S. and Australia have broadly moved in line with each other since the early 1990s with coordinated hiking and cutting cyles. The exception is the U.S. Federal Reserve hiking cycle from late 2015 to late 2018 – a period over which the only change by the RBA was 0.5% of rate cuts over six months in 2016.

[2] Proposed franking credit changes by the Opposition Government in Australia in 2019 and arguably an oversupply of LIC/LITs to market also likely contributed to bigger discounts for LIC/LITs during this period.

15 May, 2024 Letter To Investors - April

17 Jun, 2024 Letter To Investors - May

15 May, 2024

Letter To Investors - April

Letter to Investors • 13 mins read

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Welcome to the April Ophir Letter to Investors – thank you for investing alongside us for the long term.

Trust the Process

After five consecutive months of big gains it was bound to end. Global share markets finally fell in April, the first monthly pull back since October last year.

Why?

Unfortunately, the market can’t tell you. Sometimes it happens for no good reason at all. But everyone loves a narrative, so here goes…

Evidence has been building the last few months that inflation in the US isn’t coming down as quickly as the US Federal Reserve or economists in general would have hoped or forecast. This has seen annual core CPI (Consumer Price Inflation) in the US show signs of bottoming out somewhere north of the Fed’s 2% inflation target (red line below).

As a result, US interest rates, both of the short and long-term variety (see yellow line below for key long-term US 10-year government bond rate) moved higher. Back in the third quarter of 2023, when the US 10-year bond rate started moving through 4.5%, share market weakness set in and that is what looks to have occurred in April just gone (black line). The share market can deal with higher interest rates to a point, then they start to impact valuations.

Stickier inflation/High bond yields weigh on U.S. share market in April

Source: Bloomberg. Data to 30 April 2024

Pull backs in share markets are healthy and are to be expected. If they moved up in a straight line, they would cease to be risky and you wouldn’t get superior long-term returns relative to other asset classes.

For now, this dance is likely to continue. On the one hand, still-reasonable earnings growth globally is seeking to push share markets higher. While on the other, the vicissitudes of inflation data and their flow-on effects to interest rates are providing temporary headwinds (in the case of April) or tailwinds to company valuations and ultimately share markets as a whole.

In this month’s Letter to Investors, though, we’d like to step back and examine a vital principle: the importance of focusing on ‘process’ and not ‘outcomes’.

We look at how this principle applies to the investment process that has successfully guided us as professional investors for around two decades each; but also explore how it applies to individual stock holdings … including the painful example of Australian software company, Altium.

You don’t always get the outcome you want in the short term. The good news, however, is that our long-held investment process is currently bearing fruit for our Global Funds during the current reporting season.

April 2024 Ophir Fund Performance

Before we jump into the letter in more detail, we have included below a summary of the performance of the Ophir Funds during April. Please click on the factsheets if you would like a more detailed summary of the performance of the relevant fund.

The Ophir Opportunities Fund returned -1.2% net of fees in April, outperforming its benchmark which returned -3.1%, and has delivered investors +21.6% p.a. post fees since inception (August 2012).

Download Ophir Opportunities Fund Factsheet

The Ophir High Conviction Fund (ASX:OPH) investment portfolio returned -3.3% net of fees in April, underperforming its benchmark which returned -2.6%, and has delivered investors +12.9% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of -4.8% for the month.

Download Ophir High Conviction Fund Factsheet

The Ophir Global Opportunities returned -2.1% net of fees in April, outperforming its benchmark which returned -4.3%, and has delivered investors +14.1% p.a. post fees since inception (October 2018).

Download Ophir Global Opportunities Fund Factsheet

The risk of ‘resulting’

It’s 2014 at the end of Super Bowl XLIX with 26 seconds left. The Seattle Seahawks were down by four points against the New England Patriots.

The Seahawks were on the Patriot’s one-yard line just outside the end zone and it was only the second down[1]. It was a golden opportunity for the Seahawks to snatch a victory.

Seahawks coach Pete Carroll called a timeout and told his quarterback to pass the ball instead of making a running play.

The quarterback passed. But the Patriots intercepted the ball, and the Seahawks lost a game that they looked like they were about to win.

Coach Carroll was crucified by fans for the passing decision. Many see it as the worst call in Super Bowl history, perhaps all of NFL history!

But was it a bad decision?

Former World Series of Poker Champion and cognitive behaviour expert, Annie Duke, thinks not.

In her book ‘Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts’, Duke highlights that, based on 15 years of NFL data, the probability of a short pass interception is below 2%.

The Seahawks were much more likely to score a touchdown, or make an incomplete pass that would have barely used any clock time (and doesn’t count as a down).

If a touchdown results, you’re a genius who won the game doing what the opposition didn’t expect you to do. While an unsuccessful running play loses precious time off the clock and only allows time for one more play.

Just because the low probability event happened (an interception), it doesn’t make it a bad decision by the coach.

Duke sums it up nicely:

“What makes a decision great is not that it has a great outcome. A great decision is the result of a good process, and that process must include an attempt to accurately represent our own state of knowledge.”

The takeaway: in games where there is chance, and the probabilities aren’t certain (i.e. 100%), you can’t judge a decision by a result.

So-called ‘resulting’ is what poker players call the tendency to judge a decision based on its outcome rather than its quality. Investors need to avoid ‘resulting’ at all costs.

Two decades of trusting our process

At Ophir, we are highly focused on the ‘process’ principle at the portfolio level.

As long-time readers will know, we (Andrew and Steven) started out as Australian small-cap investors around 15-20 years ago. Then, as our most successful ‘Aussie’ investments increasingly became global as they expanded overseas, we launched into global small caps some six years ago.

Through that time, the ideal company in which we invest has not changed. It is typically AUD$500 million to $10 billion in market cap, growing revenue and profits above the market (so generally 10%+ per annum), taking market share, and growing into a big end market wherever that is in the world.

We strongly believe, and the evidence backs it up, that earnings drive company share prices in the long term. You can see this in the chart below where revenue growth, changes in margins and free cash flow all add up to earnings growth, which dominates as the driver of share market returns over time. And providing you don’t overpay for that above-average earnings growth, you give yourself a great chance of generating attractive investment returns and beating the market averages.

Key drivers stock performance – S&P 500 (1990-2009)

Source: Morgan Stanley Research

We also believe that one of the best indicators of above-average earnings growth over the longer term is strong earnings growth today that is beating market expectations.

If you were a fly on the wall in our investment team meetings, you would hear us focussed on how confident we are that our portfolio companies are likely to beat the market’s expectations for revenue and profit growth at their next result.

This, however, doesn’t guarantee you good investment returns in your portfolio in the short term. Changes in valuations multiples (yellow bar above), both at a stock and portfolio level, can swamp the fundamentals of revenue and earnings growth.

This was particularly the case in late 2021 to mid-2022 in our funds, and in particular our Global Funds, where despite still overwhelmingly getting the earnings right, valuation multiples decreased to a degree not seen since the GFC for the entire cohort of small-cap growth-orientated businesses globally, which is of course the pond that we fish in.

(As we discuss below, that’s beginning to change.)

Why we’re happy with this process … despite

But at Ophir, we are also focussed on the ‘process’ principle for individual holdings, as the example of Altium shows.

Altium (ALU) is an Australian stock we held last year in the Ophir High Conviction Fund (ASX:OPH). It makes the most widely used software for the design and manufacturing of printed circuit boards.

But towards the end of 2023, one of our analysts warned us there was going to be an earnings hole at the first half 2024 result due in February 2024.

If we are highly confident an earnings miss is looming at an upcoming result, we will either down-weight the position or sell to zero. In this case the instruction was clear: get out entirely!

Just weeks later, in mid-February, Japanese chipmaker Renesas Electronics lobbed a takeover bid for Altium at $68.50 – a circa 34% premium to the closing price of the company’s shares the day before, valuing the business at A$9.1bn in an all-cash deal.

Our analyst was livid and there was definitely a few swear words in the office! We had lost the chance at significant outperformance by selling the stock early.

Were we (Andrew and Steven) upset at the lost performance opportunity? No!

The reason is simple: The analyst did all the correct work, as part of our process and made the right call with the information they had at the time.

We will never hold onto a company because a takeover offer might be lobbed – the probability is usually just far too small and uncertain.

Low and behold, in late February when Altium came out with its result, it reported a big miss to earnings, that, but for the takeover offer, would normally have seen the stock fall upwards of -30%.

Altium (ALU) share price and earnings

Source: Bloomberg

Our analyst made the right call based on the percentages – a recommendation to sell Altium based on a likely upcoming earnings miss – and this isn’t invalidated due to a small-probability left-field takeover offer effectively rendering the earnings miss meaningless.

The rewards are finally coming

Investing is a long-term game, and you may not be rewarded on every stock at every earnings result. But if you work hard and follow the process on the inputs, the outcomes will look after themselves. Using outcomes on every decision to judge the quality of that decision is a recipe for disaster.

While our Funds’ underperformed in late 2021 to mid-2022, it wasn’t due to us suddenly getting the earnings wrong. We just weren’t being rewarded (getting the outcome) for following our process which helps us to get the earnings more right than not.

The good news is that, more recently, that reward is coming. This reporting season, in particular, for our Global Funds, companies posting earnings beats are seeing their share prices rise and hold on to those gains. As an example, 4 of the top 5 contributing stocks to our Global Funds performance during April was due to earnings results above market expectations where positive share price gains were made as a result and held on to during the month, despite the benchmark falling meaningfully.

Perhaps this is because we don’t have the big headwind of higher interest rates so forcefully anymore, which hurt valuations of small-cap growth-orientated stocks so much.

Perhaps it’s because investors are seeing the attractiveness of valuations outside of the ‘Magnificent 7’, including in small caps.

Perhaps it’s because with slowing economic growth, investors are willing to pay up for growth where it can be found cheaply.

Or maybe, just more simply, it’s a return to what normally happens: companies that are growing faster than the market expects get rewarded.

[1] For non-NFL fans, in American Football you get four attempts to move the ball at least 10 yards up the field. The first of these tries is “first down”, the next “second down” and so on. Once they make it 10 yards or further the downs reset and it’s back to first down.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Senior Portfolio Managers

Ophir Asset Management

17 Apr, 2024 Letter To Investors - March

17 Jun, 2024 LIC/LIT big discounts – Permanent purgatory or rate cut relief ahead?

17 Apr, 2024

Letter To Investors - March

Letter to Investors • 13 mins read

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Welcome to the March Ophir Letter to Investors – thank you for investing alongside us for the long term.

Small Caps vs Large Caps – Don’t be penny wise but pound foolish

The good times kept on rolling for share markets in March, with a sea of green across the world as recession fears in the U.S. continued to fade.

Global equities rose +3.3% (MSCI World (USD)). But this was bested by the UK (+4.8%, FTSE 100), European (+4.4%, Stoxx 50) and Australian (+3.5%, ASX 200) share markets.

U.S. large caps (S&P500) were up strongly (+3.2%), but they were more of a laggard this month, with U.S. small caps (+3.6%) outperforming.

With March largely lacking in company-specific news – as Q4 reporting mostly finished in February – shares took good economic news to be good news for markets.

Leading economic indicators, like Purchasing Manager Indices, inflected higher. There was also continued robust labour market numbers in the U.S. Both suggest a recession is not on the doorstep there.

The number of expected interest rate cuts in the U.S. this year continue to be dialled back. Markets are now forecasting less than two 0.25% cuts at writing – well below the six being forecast at the start of Jan). Bond yields are rising and the share market rally since the recent October market lows has started to broaden out from large caps to smalls and mids.

So are we finally witnessing the start of a long-awaited small-cap revival?

In this month’s Letter to Investors, we examine three key issues:

What could the catalyst be for a period of sustained small-cap outperformance?
The worst-case scenario of a U.S. recession. (The good news is that this scenario is largely priced into small caps versus large caps, which will limit small-cap relative downside if the U.S. economy turns south.)
The extreme valuation difference between U.S. small versus large caps and how history is suggesting great relative returns ahead for smaller companies.

When you put all three together, it becomes clear that small-cap stocks are a very attractive proposition relative to large caps, which is giving investors a rare window of opportunity now to buy into small caps.

March 2024 Ophir Fund Performance

Before we jump into the letter in more detail, we have included below a summary of the performance of the Ophir Funds during March. Please click on the factsheets if you would like a more detailed summary of the performance of the relevant fund.

The Ophir Opportunities Fund returned +8.7% net of fees in March, outperforming its benchmark which returned +4.8%, and has delivered investors +21.9% p.a. post fees since inception (August 2012).

🡣 Ophir Opportunities Fund Factsheet

The Ophir High Conviction Fund (ASX:OPH) investment portfolio returned +6.2% net of fees in March, outperforming its benchmark which returned +4.1%, and has delivered investors +13.5% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of +13.0% for the month.

🡣 Ophir High Conviction Fund Factsheet

The Ophir Global Opportunities returned +2.5% net of fees in March, underperforming its benchmark which returned +3.8%, and has delivered investors +14.8% p.a. post fees since inception (October 2018).

🡣 Ophir Global Opportunities Fund Factsheet

What worked … keeps working

It’s hard to get away from the fact though that what ‘worked’ in 2023, has kept on working so far in 2024.

Below we show this for the U.S., the world’s largest share market (by a country mile!).

Larger & growthier continued to outpace smaller & value in 1Q24

Source: Piper Sandler

We break down U.S. share market returns into large, mid and small caps, vertically; and Value, Core and Growth style companies, horizontally.

2023 was all about large cap growth style companies leading the way, particularly the mega cap tech ‘Magnificent 7. Meanwhile, small caps and value were definitely laggards.

2024 has started largely the same, though with some more breadth, particularly winners coming from the mid cap growth cohort of businesses.

Interestingly, all large and mid-cap styles hit new all-time highs (ATH) during the March quarter, while small caps remain significantly off their highs.

As a small-cap manager, this continues to be painful for us in a relative sense. But as regular readers will know, small caps are now extremely attractive relative to large and mid cap companies.

What could be the catalyst for small cap outperformance?

The most common question we get from investors who understand why we are so bullish on the outlook for small caps globally versus large caps is: “What is the catalyst for smalls caps to start outperforming?”

Relative valuations at multi-decade lows for small caps (which we address again later in this letter) is one big reason to be bullish over the next 5-10 years.

But cheap relative valuation is not a catalyst.

The standout and most simple catalyst we believe is simply lower interest rates. And, more specifically, ‘soft landing’ rate cuts.

December last year was a great case in point. It was the only sustained period of significant market breadth and small-cap outperformance since the beginning of this most recent share market rally in October.

We show this in the chart below which maps the relative performance of U.S. small caps (Russell 2000) to large caps (S&P500).

December 2023 showed market breadth and smalls outperformed on “peak rates/cuts ahead” talk from the Fed

Source: Bloomberg

So what happened in December?

It was when the U.S. Fed said for the first time this hiking cycle that they are likely done increasing rates, and when they predicted in their ‘dot plot’ that meaningful rate cuts where likely in 2024.

The starters gun for rate hikes that was shot back in late 2021 had seemingly been holstered.

The closer we get to the expectation of soft-landing rate cuts becoming a reality (currently forecast by the market in Q3 this year), the closer we may be to small caps having a key catalyst for outperformance.

The natural question then becomes: what if we don’t have a soft landing and US recession fears, which have been lingering for the last 12-18 months, finally becomes a reality?

Small caps’ already big underperformance suggests limited relative downside in a recession

It’s an excellent question because around a recession, small caps typically fall first and further than large caps … but then recover the quickest.

We show this in the gold bars below where, outside of the Eurozone, share markets across all the major regions, including Australia, all highlight biggest peak to trough share market falls in small caps compared to large caps around U.S. recessions.

(The reason small caps don’t underperform in the Eurozone is largely a data limitation. Small-cap data for the Eurozone is only available for the last three U.S. recessions (2001, 2008 and 2020). And one of those – the 2001 dot com related recession – was unusual, with large caps falling more than smalls due to the nature of the related tech bubble – heavily influencing the Eurozone result.)

In the black bars, what we have also shown is the maximum peak-to-trough underperformance around U.S. recessions across all the regions. This has varied from as low as -6% in Japan, to as high as -20% in Australia – both during the 2020 COVID-induced recession.

What is most striking is that, as the grey bars show, outside of Australia, in every major region small caps have already underperformed more than in any previous recession[1]. (And in the case of Australia the current -17.5% underperformance is just shy of its historical maximum of -20%.)

The key point here is that, if a recession was to occur in the U.S. this cycle, small caps across the world have generally already underperformed large caps by more than they have historically in any recession. So this may limit the size of any underperformance (or they may even outperform!) … should a recession happen.

Smalls already underperforming Large Caps by more than historical maximum around recession (except Aust but its close!)

Source: JP Morgan, Bloomberg. Data to 31 March 2024.

[1] Using small cap data where available for the last six U.S. recessions back to 1980.

Source: JP Morgan, Bloomberg. Data to 31 March 2024.

What typically happens on the other side of a recession in small versus large caps?

Outperformance!

Below we show the historical average outperformance in small versus large caps in the 1 (gold bar), 2 (black bar) and 3 years (grey bar) after the recession-linked low in the major share market regions.

Average Small vs Large Cap outperformance in years since recession linked equity market trough (100% Hit Rate in Year 1)

Source: JP Morgan, Bloomberg.

What you can see is that across the board in every major region, including Australia, small caps on average have outperformed large caps in the first year.

Not only that but the hit rate is 100%. That means that, not only is there small-cap outperformance on average, but this outperformance has occurred in the first year on every occasion in every region!

The other point is that all, or at least the vast majority, of that outperformance is delivered in the first year. A more granular analysis shows that much of it occurs in the first 3-6 months. So don’t bother trying to time it because it happens so quick you will probably miss it.

The key takeaway for us (Andrew and Steven) is that there is an asymmetry in the payoff of smalls versus large caps globally even if a recession occurs for two reasons:

The downside versus large caps may be more limited given the already extreme underperformance for small caps, and
The outperformance on the rebound of small caps has been historically consistent, quite significant and front loaded.

That’s why we say, when it comes to small versus large caps globally: don’t be penny wise and pound foolish.

That is, if you ‘pinch pennies’ to avoid the downside (if any given the underperformance already) of small v large caps if a recession occurs, you risk missing the likely big upside (the ‘pounds’) in outperformance of small caps on the other side of any recession.

Given this attractive payoff, both of us have been consistently allocating personal funds into our open global small/mid cap fund since about mid last year.

How much better could smalls caps be than large caps over the years ahead?

As regular readers will know, over the last few months we have highlighted just how extreme the valuation differences are in small cap land compared to large caps (and also even to mid caps).

While valuations are rubbish at predicting returns over the next week, month or year, at the market level they are generally very good over periods like 5-10 years.

Below we show the differences in relative valuations (using the Cyclically Adjusted Price-Earnings ‘CAPE’ Ratio) between US small (Russell 2000) and large caps (S&P500) and their subsequent 10-year relative returns.

Russell 2000/S&P500: Valuations and Returns (10 years)

Source: Bloomberg.

It is crystal clear that the cheaper U.S. small caps are to large caps (a lower starting relative CAPE ratio), the more small caps tend to outperform large caps over the next 10 years.

The relationship is so good that these starting valuations explain almost 2/3s (64%) of the subsequent return difference.

Today the Russell 2000 CAPE ratio is 19x versus 32x for the S&P500 or a relative valuation of 0.6. That’s about the lowest/cheapest since 2000.

Historically, when U.S. small caps have been this cheap versus large caps, they have gone on to outperform them by around 5% p.a. over the next decade.

This is a big deal.

A 5% return on a $100,000 investment, for example, would give you a $63,000 gain over a decade. But a 10% return would give you a $159,000 gain – more than twice the gain due to the benefits of compounding.

For investors that have never considered allocating to small caps, and who have been riding the recent wave of large-cap outperformance, we hope we have made a compelling case for why we think, like it always does, the cycle will turn and we’ll again have the wind at our back as small cap investors.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Senior Portfolio Managers

Ophir Asset Management

15 May, 2024 Letter To Investors - April

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