You never know where the next opportunity will come from

In a market that’s been turned upside down by COVID and lockdowns, Jon Moog, Chief Investment Officer of the Pengana Global Small Companies Fund, says it’s critical to adapt and remain flexible, as “we never know where the next wave of investment opportunities will present themselves.” This global small cap specialist is practicing what he preaches, having recently pushed himself and the team to invest in areas that “would have been unthinkable 10 years ago.” This includes areas such as cannabis, online gaming, and a marketplace for freelancers.

In this Q&A, Jon shares four characteristics that they’re looking for in a new investment idea, explains why small caps could be set for a period of outperformance, and he discusses some recent additions and removals from the Global Small Companies portfolio.

Could you describe how your team identifies an opportunity within the 50,000+ stock universe of small caps?

We do not employ screens and the team is set up as generalists. I want the team focused on the most interesting ideas we can find at any time. Ideas generally come from one of two places.

The first is our watchlist, which is where a lot of our institutional knowledge is housed. The watchlist is comprised of 350-400 companies which we have built through bottom-up fundamental research, and thousands of management meetings over the last decade. These are all businesses that meet our criteria, and we would love to own, but are at the wrong prices. During time of market distress, we use this list to move quickly and get invested in high quality businesses we know well. We used it in March and April to generate many of the new ideas in the fund.

We are also constantly trying to source new ideas. Typically, the focal area for new ideas exhibit the following characteristics:

1. Under-followed and/or under-owned
2. Price dislocations created by temporary problems
3. Corporate reorganizations and spin-offs
4. Quality companies where Lizard disagrees with market thesis / pricing

The focus at Lizard is to find the high-quality companies, pay a cheap price for them and allow them to compound for us. We believe this is the best way to not only generate returns, but also to achieve long-term capital preservation.

The process to get a new name into the book typically takes 2-6 weeks. The diligence process can be extensive, with multiple rounds of team discussions. Ultimately, I make the decision if something goes into the book. We can move much more quickly on a watchlist name, requiring perhaps only an hour or two of maintenance work before we begin to buy it.

Do you see yourself having more conversations with management through online means in the future? Can calls replicate sitting down with the management teams, inspecting their facilities etc.?

The steep increase in interactions was more driven by the need to get our heads around what was happening to businesses during the crisis. The environment was changing so rapidly there was really no substitute for talking with managers. In March, we were able to talk to Chinese businesses already rebounding from their shutdown, while most of Europe and North America were just beginning to close. This gave us a much better perspective, and sense of the duration and shape of recovery.

Most management teams have transitioned to a Covid world and are providing interactions via video calls. We have been able to utilize our networks in many markets to ensure good communication and information flow. Given the most recent spike in Covid, most companies are not taking in-person meetings. While we hope to get back to the in-person meetings as soon as it is safe, the adoption of video call has been a great substitute.

What do you think is causing the current disconnect between expensive valuations in large caps, and the relatively cheap valuations among small companies?

Two main factors are driving it in our view. The first are the significant fund flows into passive and ETFs over the last three years. These flows have disproportionately impacted large caps, pushing up their valuations. It is also no secret that small caps tend to sell off the hardest in market disruptions. This was true in the COVID sell off, as less liquidity leads to more dramatic price moves as investors sell. This is already starting to reverse. Small caps have outperformed large caps in Q2 and Q3 of 2020. While there may be some short-term volatility, we expect small caps to outperform over the medium-term as the world returns to growth.

Small caps tend to outperform out of a crisis for two reasons. We have already talked about the first, which is liquidity. As money moves back into the market, we see small caps move fastest and hardest. Secondly, these businesses tend to be less diversified with more operating leverage. In a sell-off they tend to underperform and are the cheapest at the bottom of a cycle. You then get faster growth in recovery earnings combined with cheap valuation, which fuels small cap outperformance.

Given the global nature, every stock must have unique and individualized risks. What risks concern you the most when looking at markets and your portfolio?

This is always an interesting question and my answer changes over time based on the environment. The world is currently awash with liquidity, driven by low interest rates and fiscal stimulus. This has encouraged significant risk-taking behaviour in many pockets of the market. I worry most about a disruption to this liquidity. Should the environment change I think it could have a materially negative impact on many parts of the market.

Last year, you wrote about the 2 questions you ask yourself when you are hit with an unexpected downgrade: 1) Has there been a change in the competitive advantage of the underlying business that we own? 2) Is any piece of our thesis really broken or is this just a temporary problem? Could you talk about a recent situation where you have applied this thinking when exiting a position?

Exiting a position can be the most challenging decision investors are faced with. We recently exited Wizz Air, a long-time holding. Wizz Air is low cost airline in Eastern Europe with a market leading position. It has many of the attributes we look for in an investment and is a company we admire greatly. Despite having the lowest cost base in the industry and a great balance sheet, we are always very wary of demand problems. If a demand problem is clearly temporary, then that is something we can live with. In this case, there is no way to know how long it will take for travel demand to bounce back. Our concern is that demand will take longer to return than people expect, and the industry will still need to go through a significant capacity reduction to survive. This situation is a good example that sometimes you need to make challenging decisions when the outcome is not certain. Here we believed the best way to preserve capital was by eliminating the risk from the portfolio.

You set two goals in order to navigate the pandemic: 1) to preserve capital in the short term, and 2) to use the crisis to acquire superior businesses that will drive your portfolio for the next three to five years. On the point of acquiring superior business, could you talk about a recent portfolio addition that has fit this brief?

Canada Goose is a name we started buying this July and a good example of taking advantage of an out of favour equity. Despite an equity price that had been under pressure since December of 2018, the company has been significantly improving its distribution and geographic reach. Dani Reiss, the CEO and largest shareholder, has his eyes set on creating a truly global brand with the ability to drive new product introductions. Importantly the company has shifted a significant portion of its sales onto their online platform and is well positioned to grow rapidly in China this winter. We believe the market is just beginning to appreciate the growth still ahead of this brand.

Another example, Kindred, a European online gaming business, was a business we were investing in during the crisis. The company earns roughly one-half of its revenue from sports betting and the other half from online casino wagers. Kindred has a focus on responsible gaming. Regulation of the Swedish online gambling market and cancellation of professional sports during the COVID crisis created a perfect storm for the business near term. The consequent selloff presented us with an opportunity to acquire a market-leading European operator on very attractive normalized earnings. The European market should continue to grow over time, and Kindred will grow along with it. Management is patiently planning an entrance into the U.S. market, which may create additional value.

What has been your biggest takeaway from the year that will influence your investment decisions into the future?

The pandemic is unlike anything many of us have ever lived through. For investors, it’s a similarly unique time forcing many to question conventional investing wisdom. The most important takeaway for us is that we must be able to adapt to changing circumstances, while staying true to our core investment values. We have pushed ourselves hard to invest in new areas such as cannabis, online gaming, and an online marketplace for freelancers, all of which would have been unthinkable 10 years ago. We must continue to adapt and remain flexible because we never know where the next wave of investment opportunities will present themselves.

Access to a vast investment universe

The Pengana Global Small Companies Fund provides exposure to a diversified portfolio of predominantly listed global small and mid-cap companies. To learn more about where the team are finding opportunities, use the contact form below or visit their website for more information.