This pattern creates big payoffs in small stocks 80% of the time

Market efficiency refers to the degree to which a market price reflects all available information. The larger and more liquid the market, typically the more efficient it is at pricing assets. Inefficiencies become more pronounced as investors venture into smaller and less liquid markets.

That is the appeal of small companies on the ASX for Simon Shields, Portfolio Manager at Monash Investors. Shields explains that a key part of the Monash process is to identify recurring patterns that result in the market mispricing stocks to the upside or downside.

“For companies that are going to have very large increases in their earnings over time, [the market] tends to find it very hard to price those companies in the near term," he says. 

Shields says companies such as Harvey Norman (ASX: HVN) in the 90s, Flight Centre (ASX: FLT) in the early 00s and more recently Lovisa (ASX: LOV) are classic examples where investors have failed to price the store rollout potential.

In this interview, Shields talks about inefficiencies in the market today, why he likes the listed structure for the Monash Absolute Active Trust (Hedge Fund) ASX: MAAT and two small caps that he believes have big payoffs.

Key points

• 0:00 - Introduction
• 0:40 - The case for an exchange-traded managed fund (ETMF)
• 2:25 - The role of the Monash Absolute Active Trust in a portfolio
• 3:36 - Recurring patterns that Monash looks for in stocks
• 5:58 - The changing valuation landscape for growth companies
• 8:40 - Telix (ASX: TLX)
• 10:09 - Johns Lyng Group (ASX: JLG)
• 11:15 - The role of shorting in Monash Absolute Active Trust (Hedge Fund) (ASX: MAAT)
  

Click on the interview below to watch the video or read an edited transcript below. 

Fund Information

• Name: Monash Absolute Active Trust (Hedge Fund) (ASX: MAAT)
• Asset Class: Australian equities
• Description: This Exchange Traded Managed Fund (ETMF) is an actively managed fund targeting 6% p.a. income distribution. The ETMF does not track a benchmark. It is a long-biased, long/short Australian equity fund that invests in a diversified portfolio of Australian listed equities.
• Objective: The Fund’s investment objective is to deliver positive returns over a full market cycle while limiting the loss of capital over the medium term.
• More information: (VIEW LINK)

Edited Transcript 

Why did you choose to offer your strategy as a listed product?

Well, first up, not everybody wants to invest in an unlisted trust where you've got to actually fill out an application form one way or another, they'd rather be able to buy and sell units on the share market. And until recently, LICs have been the only opportunity for people to do that. But they've got various issues at times. They could be trading at a discount, for example, or might have low liquidity.

We originally offered an LIC and it had those problems. So we converted to an exchange traded managed fund. So now you've got all the advantages of a unit trust, plus you've got the liquidity, plus you're trading around NTA and plus you've got all the governance structures with a responsible entity to protect your investment.

What are the benefits of that governance structure?

So when you invest in an LIC, the governance structure is the same for a business. So a business that has got revenue and customers and so forth has a board of directors where the person with the largest share holding could control the company and they really get to decide what's going on. That happens with LICs as well. You can get a controlling shareholder or a dominating shareholder. Their interest may not be the same as that of every other investor.

When you're investing in a unit trust and you've got a responsible entity, they're making sure that all unit holders get looked after equally. They're not preferencing one set of rights over somebody else's or looking after somebody's interest over somebody else's. It's worked extremely well for the industry having R.E.s, and we do have that with our exchange traded managed fund.

What is the role of your fund within a portfolio?

We're giving them an investment in the Australian share market into opportunities and in a way they probably can't do for themselves. So what does that mean? We're not going out there and giving them an index-like portfolio that they could just buy off the shelf from somebody.

We're not going out there and just predominantly investing in large cap stocks where they could get some broker reports and make their own decision about whether or not they want to buy the shares.

We're investing in companies where you've got to do some work to dig, to find opportunities that have large payoffs where we can invest short as well as long, where they're predominantly small-cap because they tend to be the stocks that have those opportunities at a point in time.

And because we're very close to the information sources, the releases to the stock exchange, the releases by the company and the broker reports on these things as well as our own work, we are nimble and we have a fairly high turnover in a way that they wouldn't be able to trade for themselves.

When it comes to the investment strategy and your process, what are people getting access to and what do you think is unique about the way you invest?

The most unique thing, if I can use that term, about what we do and the thing that differentiates us most from other people, is we look for recurring business situations and recurring patterns of behaviour.

So the share market has demonstrated over and over and over again, there are a number of situations where it finds it difficult to price things well in the near term. For companies that are going to have very large increases in their earnings over time, the market tends to find it hard to price those companies well in the near term. It works not only on the long side, but also on the short side.

There are recurring situations where eight times out of 10, a company's going to go very badly but the market has trouble pricing the full extent of how badly that business will end up.

Are you able to give a more specific example of how that plays out in the market?

Certainly. Well, in the case of long companies, one thing that we've seen over many, many years is when companies have store rollout strategies. So you've got a business that has a successful retail concept and that retail concept's getting replicated through time.

Now, it only lasts a certain period of that company's business cycle, but we saw it in Harvey Norman in the mid-'90s. We saw it in Flight Centre in the late '90s, early 2000s, and we saw it in JB Hi-Fi in the early 2000s. We're currently seeing it in Lovisa.

And during these periods, you're seeing like-for-like growth anywhere from between five and 15%. And then on top of that, you're seeing store rollout. It's more like 10 to 20% per annum, or in some cases like at Lovisa at the moment, even higher than that at the moment.

And when you have that combination and you've got a good business in terms of the margin control, in fact probably expanding margins, then you see some very oversized earnings results. We are talking about 30-40% per annum in terms of earnings growth. Then, you see a much bigger outcome in terms of the share price growth. And so all those companies I mentioned, they tripled to quintupled their share prices over the course of four or five years.

You mentioned earlier you typically look outside the larger companies on the ASX. What are some of the important trends that you've picked up?

Well, it's been such a dynamic period the last few years with COVID and then can't overplay the huge inflexion point where we went from not having inflation to having transient inflation, to having persistent inflation and what that's meant for interest rates, what that's meant for discounts, for valuations in the stock market.

Growth companies have been massively derated as those having looking further out for those cash flows, they're worth much less than what they were when the discount rates were much lower.

And so that's thrown up a great deal of opportunities.

So normally we're very focused on the small caps. That is the place where we can find these oversized returns. In fact, we're seeing some larger cap companies at the moment that have fallen in share price on the back of the fact that they've got longer term earnings growth and they've been derated significantly.

So we're finding more opportunities there than usual, and that means rather than having say less than 10% of our portfolio in large cap, we're getting more around the 30 to 35% in large cap at the moment.

But we're still finding some of those small cap opportunities as well.

So is the opportunity for you in that environment to actually move into the bigger end of the market where potentially the quality of the company and the resilience of the company is a bit better?

Yes, that's right. So companies that we've looked at previously and that we wanted to get an exposure to because we could see they were just fantastic companies, but we couldn't make the price right. We couldn't get the payoff that we wanted for our investors, but we've gone into now.

So for a great example of that as realestate.com.au. You've got a derating on the stock because of the increase in inflation and interest rates and risk. At the same times, you've got a downturn in the property market and a reduction in the volume of advertising for property. So the market being relatively short term has decreased that share price and it's just an incredible franchise.

The stock's got magnificent pricing power. It's such a tiny fraction of the total sale value of the house that it's charging.

And of course, that sale value goes up over time, so it's not a hit at once and that's it forever. It can actually keep increasing its prices over time because it'll still remain a very small fraction of that total value.

What are some of the major positions and the key positions in your fund right now that people would be getting exposure to?

Well, again, some companies perhaps that they haven't heard about so much Telix (ASX:TLX). Telix is as an Australian company that provides a drug that cancer patients need. Cancer patients need to be able to identify exactly where in their body the cancer is, and it's been pretty hard to do that with existing technology. But Telix has a radioactive molecule, a drug that attaches itself to cancer and is very easy to spot when they get scanned. And so it's providing much greater detail for doctors to identify the cancer to such an extent that they can monitor the progress of the cancer and monitor the patient's reaction to treatments over time from the cancer.

Now it's doing it for kidney cancer, it's doing it for prostate cancer, and imaging is just the first stage. The company's growing its sales at a very rapid rate at the moment, but where it will really hit pay dirt is if it can turn from not just imaging but into treatment. So as we've seen with companies before, like Sirtex with SIR-Spheres, if you can actually target the cancer with radiation enough at where the cancer is, you can actually treat the cancer. And once they get through the trials, if that pans out, this company will be an absolute beast.

What's another example of a key position that people would get exposure to?

Simon Shields: Another name that they might not be so aware of as a company called Johns Lyng Group (ASX:JLG), which is an Australian building construction repair company. Now, typically construction companies can be very volatile and go up and down with the market and have their margins go up and down and perhaps even go bust. But this company is essentially a one-stop shop for insurance companies and the insurance company work is very regular. There's always people making claims. Johns Lyng comes in and does its quote on a cost plus basis. Every so often, there are catastrophes, and then it's got a heap more work to do.

It's preferenced by the insurance companies because it has a national footprint and it's a one-stop shop. It's also doing similar work for stratas. Now, where it's starting to really hit its straps is it's taking this model to the United States, and it's penetrating the United States very rapidly. It got a beachhead by acquiring some businesses in the United States. And the United States is very amenable to this model, and we're seeing terrific earnings growth out of Johns Lyng at the moment.

Could you tell me a little bit about the shorting process and what's happening in the short side of the portfolio at the moment?

Well, shorting is different to going long in a stock. While we price stocks for long and we price stocks for short, we want to see that payoff, we don't look for as big a payoff out of the shorts because it's much harder to see a company go to zero than it is to see it fall by 50%.

On the other hand, our longs can actually double, triple, quadruple in value over time. So we don't look for as big a payoff, and we don't put anywhere near as much weight in the shorts as we do the long.

Typically, we'll only put about 2-2.5% in a short, and shorts will typically be less than 10% of the portfolio overall. Now, we've seen some recurring business situations and patterns of behaviour when it comes to shorts. One of the big things is when the business starts to have competitive forces go against it.

So you've probably heard of Porter's Five Forces. It's the power of suppliers, it's the power of competitors, of customers, of changes in regulation. When these factors start to go against them, such as more competition coming in and you start to see some pressure on pricing power, it sounds very theoretical but in the real world, it actually means a great deal. And we've seen time and time again how companies collapse their earnings when these things happen.

So we've had many examples over the years in the portfolio. A recent one that we've closed out not too long ago was Tyro (ASX:TYR). And Tyro fell a great deal on the back of that extra competition that came from the likes of Square, which took over Afterpay from the likes of Apple. You can see Smartpay's coming in. This is all terminals for convenience stores and cafes and restaurants to actually have their Mastercards waved and so forth.

And so the pricing's come down, loss of market share and the share price actually has collapsed quite badly. But shorting's only one part of the portfolio and it's a relatively small part of the portfolio.

Overall, we're mostly long investors. But again, it's just another string to our bow, another thing that we can do that really retail investors can't do for themselves.

Ends

More information 

For more information about the Monash Absolute Active Trust (Hedge Fund) ASX:MAAT please visit the fund website.