How a Fund Manager Views Risk

Conventional wisdom would suggest that small companies are riskier than large blue chips. Cromwell Phoenix Opportunities Fund challenges that wisdom.

Over five years ago, Cromwell launched the Cromwell Phoenix Opportunities Fund (the Fund) to capitalise on Phoenix Portfolios’ “Best Ideas” investment strategy across a much wider universe of predominantly microcap stocks.

The Fund focuses on the very smallest opportunities and seeks to exploit the fact that, for commercial reasons, this sector of the equities market attracts little if any coverage by either brokers or professional investors and as a result can provide some very interesting opportunities for disciplined fundamental investors who are willing to look at true microcap stocks.

The Fund holds a portfolio of between 25 and 40 ASX-listed securities across a wide variety of industries and is focused on companies that have been around for some time with track records that can be analysed and business models that can be understood.

To maximise the alignment of interests between investors and the fund manager we have done the following:

  1. Capped the Fund size at $40 million (which is extremely low by competitive standards), in order to remain nimble in the market
  2. Phoenix Portfolios made a substantial co-investment into the Fund, such that they are the single biggest investor
  3. Set investment management fees based entirely on performance, so if the investment isn’t performing, we don’t get remunerated (strong motivation).

How Do We Think About Risk?

Many financial commentators define risk based on the volatility of returns. In that sense, an investment in any small company that potentially doesn’t pay a dividend, doesn’t have a steadily growing income and whose share price movements can reflect a lack of liquidity can very easily be considered risky. Sensible portfolio construction can diversify away some of this stock specific volatility but markets can always cause gyrations in small illiquid stocks.

Another way to think about risk is to consider the potential for a permanent loss of capital. In this regard, assessment of risk relies heavily on fundamental stock analysis which tries to identify the value of each investment across a range of scenarios to estimate value compared with the current trading price. To the extent that our Fund is able to take positions in stocks that trade at deep discounts to their fundamental value, we believe the process builds in a margin of safety which shields the Fund’s portfolio from downside risk. The bigger the gap between assessed value and a company’s share price, the bigger the margin of safety.

An Example to Illustrate the Margin of Safety

The Fund made an investment in National Cans Industries (NCI) back in December 2011 at prices between $1.02 and $1.05 per share. Phoenix’s estimate of fundamental value at that time was around $1.80 per share. The investment was therefore supported by a large margin of safety. The company’s very strong cash-rich balance sheet significantly mitigated the potential for a material and permanent loss of capital.

NCI was involved in the manufacture and sale of a range of metal and plastic products (paint tins, aerosols and small drums). The stock had performed poorly for many years with the company suffering from excess capacity in the industry and large increases in raw material costs. The initial position represented approximately 4.5% of the Fund’s portfolio. At that time, NCI had no debt, net current assets per share of $1.02 (predominantly cash and working capital) and had been modestly profitable every year for the previous decade. In addition, the stated book value of $1.97 significantly undervalued NCI’s considerable property assets which were held at historic cost less depreciation.

In March 2012, just a few months after the Fund’s investment, the controlling shareholder, the Tyrrell family, put forward a takeover offer at a price of $1.84 which approximated our estimate of fundamental value.

Is a Passive Portfolio of Blue Chip Stocks More or Less Risky Than This Fund?

It depends how you think about risk and it depends on market conditions. Paying too much for a stock is always risky whether it be a small cap stock or a large well known company. Telstra, for example, is a blue chip company, but buying Telstra at the peak of the dotcom bubble would have resulted in a substantial loss of capital even 15 years on.

A passive fund will hold stocks to replicate its benchmark no matter what the market conditions. Our Fund, on the other hand, will only hold “best idea” opportunities and gets to choose from an enormous range of listed stocks with a margin of safety – the passive fund has no such protection.

Diversification works for both portfolios. Interestingly however, a portfolio comprising the biggest 200 listed companies in Australia is surprisingly concentrated. The big four banks represent approximately 25%1 by market cap. If banks are overvalued, they will still represent 25%1 of a passive fund’s investments. Add Telstra, BHP, CSL, Wesfarmers, Woolworths and Macquarie Bank and the top ten represent over 44%1 of the portfolio, thereby diminishing the benefit of diversification and increasing portfolio risk.

Track Record of Low Volatility

Measuring the risk of a permanent loss of capital is difficult. However, the following heat map provides some evidence from history, of the performance of the Fund on a month by month basis.

Focusing on traditional risk metrics, the volatility of returns of the Fund in the four and a half years since inception compares favourably with the same metric for the S&P / ASX 200 Accumulation Index as shown in the table below.

Fund

Volatility of monthly returns1

Cromwell Phoenix Opportunities Fund

9.0%

S&P / ASX200 Accumulation Index

12.0%

Conclusion

Every investment carries risk, and an investment in the Fund is no exception. There will be periods of time where market pricing of the stocks held by the Fund will reflect misery and the performance of the Fund will be negative. However, over long periods of time, Cromwell is confident that Phoenix Portfolios’ “best ideas” approach will continue to identify solid investment opportunities and expect downside risk to be softened by the margin of safety applied to its stock selection.

Footnote:
1. As at 31 December 2016

Disclaimer:
Cromwell Funds Management Limited ABN 63 114 782 777 AFSL 333214 (CFM) has prepared this article and is the responsible entity of, and the issuer of units in, the Cromwell Phoenix Opportunities Fund ARSN 602 776 536 (the Fund). In making an investment decision in relation to the Fund, it is important that you read the Fund’s product disclosure statement dated 17 April 2015 (“PDS”). The PDS is issued by CFM and is available from www.cromwell.com.au or by calling 1300 276 693. This article has been prepared without taking into account your objectives, financial situation or needs. Before making an investment decision, you should consider the PDS and assess, with or without your financial or tax adviser, whether the Fund fits your objectives, financial situation or needs. CFM and its related bodies corporate, and their associates, do not receive any remuneration or benefits for the general advice given in this article. If you acquire units in the Fund, CFM and certain related parties may receive fees from the Fund and these fees are disclosed in the PDS.

Phoenix Portfolios Pty Ltd ABN 80 117 850 254 AFSL 300302 (“Phoenix”) is the investment manager of the Fund. None of Cromwell Funds Management Limited (ABN 63 114 782 777 AFSL 333214), Phoenix nor their related entities, directors or officers makes any promise or representation, or gives any guarantee as to the success of the Fund, distributions, amount you will receive on withdrawal, income or capital return or the taxation consequences of investing.

Please note: Any investment, including an investment in this Fund, is subject to risk. If a risk eventuates, it may result in reduced distributions and/or a loss of some or all of the capital value of your investment. The risks of investing in the Fund are typical of the risks associated with managed investment schemes that have an investment strategy that involves investing in shares of Australian listed companies. Some of the significant risks of the Fund include individual investment risk, market risk, diversification risk, legal and regulatory risk, manger risk, withdrawal risk, derivative risk and liquidity risk. Please see the PDS for further information on the risks associated with this Fund. Past performance is not a reliable indicator of future performance. Forward-looking statements in this content are provided as a general guide only. Capital growth, distributions and tax consequences cannot be guaranteed. Forward-looking statements and the performance of the Fund are subject to the risks and assumptions set out in the PDS