A 'wonderful hunting ground'

-- | 25/11/2020 Text size Decrease

Lex Hall: The stellar gains of America's tech titans have dominated discussion lately, but is there value to be found among smaller companies? With me to discuss that today is Greg Dean from Cambridge Global Asset Management. He manages Cambridge's Smaller Companies Fund. Greg Dean, welcome to Morningstar. Greg Dean: Lex, thanks for having me. Hall: I thought I'd start, first of all, of course, with the obvious question which is the election, get your thoughts on that. A Biden presidency and a Republican controlled Senate is being touted by some as favourable for assets, particularly Asian assets. What's your view on that outlook? Dean: Well, it's certainly topical and has been for several months. One thing that's important to note for us is we basically try to avoid making calls on commodities, currencies, interest rates, and government policy. Just as a very function of being in the small cap market we're thankfully very immunized from those very sort of binary type outcomes, and they're outside the control of most companies. But I think what we're seeing, and actually, today was a very good reminder that these moments in time catalyse big shifts in monetary policy and fiscal policy and companies, entrepreneurs, entire industries can be reshaped overnight or what seems overnight, and I can recall back to 2016, when the banking sector went from the whipping child of the prior president to one that was all of a sudden quite favourably viewed under Trump, seemingly overnight. And what we're seeing with Biden is the concerns around his tax policy and that becoming enacted in the months post his inauguration, causing a lot of entrepreneurs and a lot of companies to sell really, really good assets because they're worried about higher capital gains tax. That's probably been the biggest impact that we've seen or could see in the shorter term. But I think, as you pointed out, markets typically like clarity, and if we are gridlocked, that probably puts a damper on the outlook in the shorter term. But stock markets don't react to elections over long periods of time, it just in the short term feels like they do. Hall: Okay. Let's talk about definition. Smaller companies obviously in Australia has a different definition in terms of size. What do you consider to be a smaller company? Dean: So, our range is $250 million to $10 billion. And that sweet spot for us really sits in the A$1 billion to $5 billion range. But we have leeway on either side to go down cap as well as hold some of our best ideas as they mature into sort of more mid-caps. Hall: It's a young-ish fund. It's been available to Australians for about two years. How is it being affected by COVID? Dean: That's a great question. So, one of the core tenants of the fund strategy is really resiliency and I'm happy at how things have performed, always sort of cautiously pleased, because things can go wrong overnight in this job. But the businesses that we own have been very well insulated from a lot of the uncertainty that we've seen and in many cases have taken advantage of a lot of the economic weakness, whether it was distressed competitors or an opportune time to right-size the cost structure. We've seen tremendous resiliency amongst the portfolio. And one of the big factors that we've been talking about for a long time is, we try to protect clients' capital through the avoidance of leverage, especially if it's just sort of permanent leverage, leverage that is required to earn an acceptable return. Some business models will just earn a very, very low sort of 2 per cent return on assets, but levered six times can earn an adequate return on capital. We tend to avoid those companies. Hall: Let's talk about the way you're seeing opportunities. I noticed that among your sector allocation 21 per cent or thereabouts is dedicated to consumer services. What sort of companies are you looking at there and what's your rationale for that? Dean: Yeah. So, consumer is this wonderful hunting ground that is – I don't want to say a catchall, but it can be very quite broadly described. And so, within that bucket we would have a company like Restoration Hardware, which has been one of the stronger performers for the fund this year. And I think if I told you or anyone told me back in February when we were buying the business when all their stores were closed and the stock was trading at sub 10 times earnings that we could make three times our money in the span of seven months. I would have said that's impossible. But with what we've seen as the trends have migrated in terms of not being able to travel and spending more at home, all of a sudden $6,000 couches have become a much more popular purchase for a lot of well-off families or individuals. And so, Restoration Hardware's business this year has accelerated and also relative to sort of the concerns that people had that brick and mortar retail was really going to suffer in 2020 with a lot of shops closed, they reminded people that over half their sales were generated online and I think we caught a moment in time with that company where people forgot a lot of the strengths of the business and were really focused on what could go wrong. And as were we, we always worry about what could go wrong, so we size the position accordingly. But that would be one example that sitting consumer that we think was sitting there and obvious to many, but not many took advantage of it. Hall: And on that note, finally, how long would you advise an investor to stay in your fund to realize the value add? Dean: So, our time horizon, in terms of when we're looking at companies is three to five years. We will actually discount cash flows over a 10-year period, but we're really trying to understand over a three to five-year period if the scenarios that we believe are likely to play out, what's the business worth and over a shorter timeframe, say, one to three years, what if we're wrong. So, I'd say that sweet spot probably sits in the three-year interval for clients to really consider a small cap allocation.

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