By Andrew Mitchell & Steven Ng
Co-founders and Senior Portfolio Managers
In our July 2020 letter to investors we review longer term performance and some key market themes that caught our eye, including a drop in volatility.
Dear Fellow Investors,
Welcome to the July 2020 Ophir Letter to Investors – thank you for investing alongside us for the long term.
Month in review: The four key themes that drove July
(Plus, what we’ve learnt investing during Covid)
We are pleased to have outperformed our market benchmarks again across each of our three strategies during July.
As market volatility receded, the benchmarks all provided small positive gains of between 1-2% for the month. These rises have built on the gains made since mid-March lows, with markets driven higher by fiscal and monetary stimulus by authorities, as well as some, albeit patchy, control of COVID-19.
Ophir Fund Performance
The Ophir Opportunities Fund returned +7.1% net of fees in July, outperforming its benchmark by 5.7% and has delivered investors 25.3% p.a. post fees since inception (August 2012).
The Ophir High Conviction Fund investment portfolio returned +2.8% net of fees in July, outperforming its benchmark by 1.1% and has delivered investors 18.9% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of -0.7% for the month.
The Ophir Global Opportunities Fund returned +2.3% net of fees in July, outperforming its benchmark by 1.3% and has delivered investors 28.6% p.a. post fees since inception (October 2018).
Two important long-term performance anniversaries
In this letter below we will take a close look at four powerful themes that stood out in the month of July.
But, before we do that, it’s important to note that whilst we strive to outperform over short horizons, we are also extremely focused on long-term performance. For investors, as opposed to speculators or traders, shares should always be thought of as long-term investments.
So we would like to highlight that the end of July marks an historic month for Ophir because our Ophir Opportunities Fund and Ophir High Conviction Fund reached their 8 and 5-year anniversaries since inception respectively.
During those periods, the Ophir Opportunities Fund has returned 32.3% pa (gross) and the High Conviction Fund 24% pa (gross).
To put their performance in perspective, below we show the rankings of the two funds against the Australian Small Caps universe to 30 June 2020 (last available) over the last 6 months, 1 year, 3 years and 5 years, according to the well-known and comprehensive Mercer Surveys of fund managers.
Mercer Survey – Australian Small Caps to 30 June 2020
Source: Mercer Investment Performance Survey of Australian Small Companies to 30 June 2020
Over the long term, on a five-year basis, the Ophir Opportunities Fund ranks number one to 30 June 2020. We are confident the Ophir High Conviction Fund will rank number two behind our Opportunities Fund – putting Ophir in the top two positions — when its recently achieved five-year number to 31 July 2020 is compared against peers in the next survey results released later this month.
Protecting capital, learning lessons
Yet almost as important to us as the long-term returns achieved, has been the protection of our investors’ capital since the start of 2020 when COVID-19 triggered an extremely challenging investment environment.
As you can see in the above chart, very few managers, including the long-term top performers, provided positive returns in the first half of calendar year 2020, when the ASX Small Ordinaries Index fell -9.2%.
We, Ophir, were one of the few.
Our experience during the torrid markets of the GFC no doubt helped prepare us for the COVID-19 bear market. But we have been around long enough to know, though, that not all lessons have been learned; and COVID-19 allowed us to consolidate previous lessons, as well as further refine our investment process.
Some key insights for us so far this year have been:
- Don’t try and meaningfully time the market during corrections/bear markets.
We believe it is incredibly difficult – and adds portfolio risk — trying to add alpha from materially changing the cash/equity split in the portfolio during market dislocations. We would rather use the extra volatility and dispersion to ‘high grade’ our investment portfolios. That is, we focus on taking advantage of the heightened mispricing in the market to add new ideas that have become better value.
- Manage risk in the good times as well as bad
It pays to keep a keen eye on our risk metrics for each company, and as a whole in each of our funds, during the good times because market corrections can happen very quickly. We would not have been in as good a position entering COVID-19 if we had paid less attention to the risks in our portfolios during the bull market of 2019.
- Prepare a bear playbook
Having a playbook for how to navigate a bear market is crucial otherwise it can be difficult to sort out the “signal” from the “noise” that bombards you from the newsflow when it arrives.
Years’ worth of alpha in calmer markets can be flushed down the drain in a downturn if it’s not all-hands-on-deck to put the playbook into action.
Some of our best ideas over the last few months have come from making sure we were ready to scour the landscape for quality companies trading at bargain prices. We bought from investors who were price agnostic and just wanted, or were forced, to get out.
- Size matters
COVID-19 once again showed the benefits of our Funds’ capacity constraints and stable capital bases.
The deliberately smaller size of our funds is an asset to all our investors.
It might not pay off meaningfully during calmer bull markets for years at a time, but during February and March it allowed us to focus single-mindedly on positioning the fund as best we could, without our attention being unduly distracted by trading liquidity of companies or any investor redemptions.
We continue to learn and evolve our investment process to incorporate new lessons. We fully expect this ongoing evolution (as opposed to revolution) of our investment process will continue for the rest of our investing career and is a challenge we look forward to.
Macroeconomic and market highlights
Moving back to July, four key themes stood out to us in during the month as we look across the global economy and markets:
- Lower equity market volatility
- A weaker US dollar/stronger Australian dollar
- A surging gold price
- The continued strength of Big Tech
Equity market volatility eases, but stay alert
Firstly, share markets are becoming more comfortable with COVID-19 uncertainty factoring in that the worst is likely behind us.
Investors, for example, seem to have looked past the US’s worst quarter of GDP growth since World War 2, and appear to be seeing the business cycle moving into the recovery phase.
Reflecting this gain in confidence, we are seeing fewer estimates of corporate earnings growth for 2020 being revised lower (chart below).
2020 consensus earnings expectations over the past 12 months
Source: Datastream, I/B/E/S, Goldman Sachs Global Investment Research
That’s leading to lower volatility. In July, the combined US share market’s realised volatility across up and down days was the lowest this year (chart below).
Upside realised vols moderated a lot versus March
Source: Bloomberg, Morgan Stanley Research
More broadly, we are not seeing Governments reinstitute widespread lockdowns that were so damaging to earnings estimates across the world in March, April and May.
It is by no means certain that will continue, but in many economies still struggling with COVID-19 there are high bars to jump before they return to strict lockdowns.
Fortunately, the only countries to see any material re-emergence in new cases since May lows are the US, Spain, Japan and Australia. So it has been possible for many economies to reopen without causing second waves.
Still, we think a return though to ‘normal’ levels of volatility ahead is likely premature. The list of ‘known unknowns’ at present is a long one.
COVID-19 still stands at the top of this list, and absent an immediate silver bullet vaccine, we are prepared, and in fact expect, further bouts of heightened volatility ahead.
A weaker US dollar/stronger Australian dollar this reporting season
During the last three months, the US dollar, against a basket of trading partners’ currencies (DXY Index), has fallen the most in over a decade (see chart below).
March’s ‘flight to safety’ to the US dollar has been reversed.
But the US dollar weakness also reflects the US’s relative lack of success dealing with COVID-19, and expectations for more and longer monetary stimulus from the Fed.
Source: Bloomberg, Goldman Sachs Global Investment Research
We can see this below with US three-year treasuries starting to fall and diverge from equivalent Australian rates, as investors expect further easing from the Fed.
On the other hand, the RBA has been generally been successful at keeping the 3yr government yield at 0.25% through “Yield Curve Control” measures.
Source: Bloomberg, Morgan Stanley Research
After the Australian dollar slumped to near US$0.57 in March it has been on a tear, trading up around US$0.72 recently.
Not only are interest rate differentials to the US now at very low levels, but the Australian dollar is showing its ‘commodity currency’ moniker still rings true, with commodity prices, particularly iron ore, rocketing higher on the back of Chinese stimulus induced demand, creating higher demand for the Aussie currency.
So going into this reporting season the Australian dollar — against the major currencies, except the Euro — will be higher than the last reporting season.
That means in general most Australian companies with offshore revenues and Australian expenses that aren’t fully hedged, will not have a tailwind from a weaker Australian dollar. The currency is now likely to be a more muted impact as financial results roll in.
Eureka: Benefiting from the surging gold price
The other move higher that caught our eye and is particularly important for our Australian equity funds, is the gold price hitting all-time highs.
With no yield, gold can be harder to value, so price rises tend to create its own momentum. There is no doubt, though, that demand for gold has risen, as seen by recent flows into gold exchange traded funds (ETFs).
Mn troy oz. Physical gold held by all gold ETFs globally
Source: Bloomberg, J.P. Morgan
What’s causing the rise?
Some investors are no doubt expecting higher inflation, while lower real interest rates has lowered the opportunity cost of holding gold (see chart below).
US Tips Yield vs Gold Price
Source: MST Marquee
On an industry sector basis, gold has long played an important part of the small and mid-cap segment in Australia.
The sector now makes up 12.0% of the S&P/ASX Mid Cap Index and 9.2% of the S&P/ASX Small Ordinaries Index, the largest industry sector in each.
We tend to not specifically target industry sector weights in our funds. However, given that volatility in the gold price can cause meaningful deviation of returns from the index if we are materially underweight, we tend to have selective exposure to what we see as the highest-quality operators in the gold mining sector.
For us, this is all about selecting the very best management teams in the sector, rather than trying to time gold price movements. This helped protect performance of our Australian equity funds during July where three of the top six performing stocks in the S&P/ASX Mid Cap Index were gold miners.
Big Tech rumbles on, but for how long?
Finally, as you know, one of the stories of the year has been the outperformance of the big US tech stocks — Microsoft, Apple, Amazon, Facebook and Google – as COVID-19 radically accelerates the adoption of tech.
The tech-heavy NASDAQ-100 index is now valued more highly against the US share market (S&P500) than it was at the height of the dot-com bubble.
Source: Bloomberg, U.S. Global Investors
Crucially, this time around, though, Big Tech has the profits, and growth, to provide some justification.
As seen below, the largest five stocks in the US share market — Microsoft, Apple, Amazon, Facebook and Google — have grown earnings over the last year, whilst the rest of the S&P500 have not.
Valuations, as measured by price-to-earnings ratios (P/E) have risen for both groups, but more for Big Tech as record low interest rates have increased earnings multiples investors are willing to pay.
The result: wonderful returns for the top 5 over the last year, and nothing for the rest.
YoY Contribution of EPS and P/E to Returns
Source: Standard & Poor’s, Thomson Financial, FactSet and Credit Suisse
We remain immensely grateful we don’t invest in the large cap space globally or in the US because large-cap managers there face a tough predicament: their view on Big Tech increasingly determines whether they outperform or underperform their benchmarks.
Establishing that view is incredibly difficult. Ultimately, you are trying to gain an edge on the most analysed companies in the world.
Big Tech may indeed have further to run. They have dominant market positions and structural growth tailwinds. But everyone knows this, and there is likely to be continued pressure to break up their market power, as typified by the recent testimony four of the big five were required to give before Congress.
For those who say nothing but lawmakers can break their dominance, similar things were said about IBM and the top 5 in 1972 (see below).
Top 25 members of the S&P 500
Data Source: FMRCo, Bloomberg, Haver Analytics, FactSet
Maybe this time will be different for the top 5. Their businesses are more reliant on self-reinforcing network effects, they have relatively low capital intensity business models, and low marginal cost products and services.
But if history is any guide, the investment returns of yesteryears’ biggest companies have eventually been undone by either disruption or excess valuations.
This, of course, is one of the key reasons we like investing in small and mid-cap companies: the universe is much wider, not as concentrated, and we believe it is easier to get an investment edge on a company.
As always, thank you for entrusting your capital with us.
Andrew Mitchell & Steven Ng
Co-Founders & Senior Portfolio Managers
Ophir Asset Management
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