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:

1. Earnings beating expectations.
2. Margin of safety through a cheap valuation.
3. 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

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.

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

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 +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:

1. No one feels safe in America;
2. Many of these drivers work incredible hours (often in multiple jobs) to give their family a better life; and
3. 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

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.

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:

1. The US presidential election and what it might mean for the outlook for inflation, bonds and stocks.
2. Whether ‘immaculate disinflation’ is alive and well again in the US. Is this the rocket small caps need?
3. 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

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.

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.

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:

1. 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.

2. 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

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.

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

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.

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

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.