What follows below is the commentary from Q4:17 for AWSM Fund:
Introduction: No Excuses
This is the part of the factsheet where the Fund Manager tells you about how tough it has been and lays out the circumstances for why the Fund has underperformed and how it is not really their fault.
I am going to do something different here and point out three things.
Firstly, I am personally invested in the AlphaWealth Prime Small & Mid Cap (AWSM) Fund. In fact, I have the majority of my liquid net worth invested in the AWSM Fund. Thus, I feel 2017’s poor performance just as acutely as any other investor and I am just as disappointed.
Secondly, Consolidated Infrastructure Group (CIL) had a c.-7.9% drag on AWSM Fund’s performance. This is one of the risks of a concentrated portfolio; our mistakes are amplified, but, luckily, so are our successes.
On this note, we have performed a deep introspection about how CIL happened, and we have inserted a number of new risk-focused processes into our methodology. Interestingly, our conclusion was not that our methodology was wrong. Rather, we concluded that we needed a greater focus on ever-changing qualitative risks. We have now built this added focus into our process.
Finally, AWSM Fund’s bad year is the nature of the beast. We are not always going to have good years. AWSM Fund is a concentrated portfolio of small caps. Over most short-term periods AWSM Fund is going to be volatile and lie at either the top or the bottom of its peer group. This volatility is the “risk” we accept in order to position ourselves for material outperformance in the long-term.
We offer no excuses but that 2017 has been a bad year for AWSM Fund. We do believe our methodology remains sound and we will do everything in our power to make 2018 a materially better year.
Could 2018 be the year of South African small caps?
We think 2018 should be a good year for AWSM Fund.
Three simple reasons:
- Investments tend to generate excellent returns when they are “cheap”:
- Top 40 Index’s PE is 19.6x and its Price-to-Book is 2.3x.
- Mid Cap Index’s PE is 25.7x and its Price-to-Book is 1.7x.
- AWSM Fund’s PE is 11.9x and its Price-to-Book is 1.2x.
- AWSM Fund could almost double and it would still be cheaper than both the “safe” blue chips on the JSE and its own benchmark.
- Yet AWSM Fund’s financial metrics are actually “better quality” than these indices (refer to chart earlier in this factsheet comparing ROE, GP, D:E and growth metrics).
- Investments tend to outperform when all other alternatives are “expensive”:
- Top 40 Index is trading at a premium to its 10-year average PE.
- Mid Cap Index is trading at a premium to its 10-year average PE.
- Even the MSCI World Index is trading at a premium to its 10-year average PE.
- These measures are also true if we compare each of these indices to Price-to-Book metrics.
- e. Almost all world equity markets are expensive relative to their own histories.
- Yet AWSM Fund is relatively cheap (see (1)).
- South Africa appears to be politically self-correcting:
- Following Cyril Ramaphosa’s election as the President of the African National Congress (ANC), we see green shoots of optimism regarding South Africa’s political prospects.
- AWSM Fund has already jumped nearly +8% (at the time of writing this) since the market began to price in a positive ANC NEC outcome in mid-December 2017.
- While domestic politics remain volatile, the combination of low South African-based small cap equity valuations with improving domestic sentiment may have a materially positive impact on domestic stocks.
- Historically, small cap stocks outperform their large peers during years of ZAR strength.
Note that we have not included a fourth reason: the quality, growth and value metrics of the companies that AWSM Fund holds. Arguably, though, this is one of the most important characteristics of AWSM Fund’s future returns, at least in the long-term.
Anything can happen in the markets, but we are optimistic going into 2018.
Conclusion: Short-term Volatility, Long-term Conviction
In conclusion, we are comfortable that we continue executing on our mandate in the AWSM Fund. Despite a disastrous 2017, we consider the AWSM Fund to be well positioned for the long-term.
As a reminder, the AWSM Fund strategy remains the following:
- Quality: We try to find good quality, fast-growing, listed small cap
- Value: Of these, we invest in the cheapest of them, though limit our individual investments to different sectors, markets and geographies.
- Concentration: Finally, we limit the number of stocks we hold to only the very best fifteen to twenty stocks (we currently hold eighteen individual investments).
In this way, we like to think that AWSM Fund holds a diverse, relatively lower-risk collection of only the best small cap investments out there and that it holds these investments in sufficient quantity to be really meaningful to us as investors.
As a co-investor into our Fund with the majority of my liquid net worth, I have absolute conviction in what we are doing and I am confident in our Fund’s future.
Keith McLachlan CA (SA)
Fund Manager of the AlphaWealth Prime Small & Mid Cap Fund