The team at DMX, managers of the TAMIM Australian Equity Small Cap IMA, take a deeper look at the risks of managing a Small Cap portfolio and how to reduce the level of risk you are exposed to. Our conclusion is that, while broadly true, Small Caps aren't always as risky is their reputation suggests - you just have to know what to look for and what you're doing. The portfolio underlying the TAMIM Australian Equity Small Cap IMA has returned 69.58% in the 18 months since inception (at 31 September 2016).
Mitigating Risk In Small Cap Investing - October 2016 -
The portfolio underlying the TAMIM Australian Equity Small Cap IMA's 75% out-performance of the All Ords after fees since launch 18 months ago has been achieved by investing in high quality, small, growing businesses trading at a significant discount to fair value. In the interests of lifting the hood on the engine for the benefit of investors, we have taken the opportunity to compile an analysis of the portfolio's risk profile by looking at the portfolio's composition based upon stage in the business cycle, debt profile, fund cash levels and industry exposures. We believe the results emphatically show the TAMIM Australian Equity Small Cap IMA and underlying portfolio's performance has been achieved with a relatively low risk profile, and both remain well positioned looking forward for the same reasons.
TAMIM Australian Equity Small Cap IMA's Risk Analysis:
Firstly, it is worth highlighting the key characteristics of the companies within the TAMIM Australian Equity Small Cap IMA's investable universe of micro/small cap companies listed on the ASX:
These numbers may be sobering for some: a massive 81% of ASX-listed micro caps (market cap below $100m) are currently loss-making and 90% don’t pay a dividend. The smaller companies’ universe is clearly dominated by unprofitable, non-dividend paying companies with a strong weighting towards the resource and technology companies – companies that we consider to be at the higher end of the risk spectrum.
The challenge for the TAMIM Australian Equity Small Cap IMA is to find, research and ultimately invest in the relatively small number of small and micro-cap stocks which have lower risk profiles. In our opinion, companies which are profitable with good visibility around future earnings growth, and which also have strong balance sheets, offer a significant opportunity for long term out-performance, particularly when you invest whilst broader market awareness of these businesses is low or non-existent.
As a result, despite the fact that the ASX small and micro-cap universe is dominated by high risk, unprofitable companies, the TAMIM Australian Equity Small Cap IMA portfolio has been constructed such that these risks have been substantially mitigated.
The following 4 analyses of portfolio risk should provide valuable insight into the TAMIM Australian Equity Small Cap Individually Managed Account from a risk perspective:
1 - Cash Weighting
Why? Cash weighting is a clear portfolio risk input – a higher cash weighting indicates lower risk and vice versa.
Observations: The TAMIM Australian Equity Small Cap Individually Managed Account will generally carry a higher cash weighting than most funds reflecting our deep-held belief that our clients will benefit if we are positioned to take advantage of future periods of stock price volatility. There will be periods when “Mr Market” becomes overly emotional and will offer our high conviction holdings at significant discounts to our opinion of fair value. We want to be ready for this periods of volatility ahead of time. As a result, the IMA currently has a cash weighting of 22%. In terms of assessing the portfolio’s risk, this relatively large cash weighting provides a risk buffer but we would argue this high cash weighting is more important to generate performance upside than as a risk control. Selecting the right stocks is a far more efficient risk control in our experience.
2 - Portfolio Categorised By Company Life Cycle
Why? We have divided the underlying portfolio into a number of categories to reflect where each business is in the company life cycle, which in turn gives a guide (albeit subjective) regarding the portfolio's risk profile at a stock level. The life cycle categories we have used are:
Dividend paying, growing profits,
Profitable, not dividend paying,
Loss-making, emerging, fully funded, and
Loss-making, emerging, not fully funded.
The risk profile of these different types of investments starts at very low (Cash) and incrementally increases to very high (Loss-making, emerging, not fully funded). While simplistic, we believe a company that has committed to paying dividends and which has high visibility around future earnings can be classified as the most mature on the company life cycle scale, and among the lowest risk of listed equity investments. Conversely, a loss making, early stage business without sufficient funds to execute on its strategic initiatives is among the highest risk of listed equity investments.
TAMIM Australian Equity Small Cap IMA model – By Stage In The Business Cycle Profile:
Observations:With 61.6% of the underlying portfolio invested in dividend paying companies which are growing their earnings and 22.4% in cash, 84.0% of the portfolio can be categorised as low risk. Given our strategy is to invest in high quality businesses which are under-valued, it is pleasing to see that the data confirms we are doing what we say we are doing. The 61.6% exposure to companies which are paying dividends on the back of a growing earnings base, and which have been purchased at low earnings multiples, is the portfolio's core engine. These are the types of businesses we aim to get to know better than the market, and this in depth stock knowledge is core to our risk control. We are always questioning our assumptions and understanding of these businesses to ensure our conviction levels are warranted.
The portfolio has 5% invested in asset based opportunities. These are businesses which we also view as relatively low risk since we believe the value of their assets is significantly higher than the current market cap. Having said that, asset plays often don’t have the benefit of consistently positive earnings news-flow and are often dependent upon one large pay-off asset sale scenario. These stocks are arguably higher risk than the earnings growth, dividend payers as a result.
The underlying portfolio also has 11% invested in companies that are profitable but are not yet paying dividends. We expect a significant portion of this 11% to migrate across to become dividend paying in the coming year or so at which time the portfolio's risk profile will further decrease.
The underlying portfolio has no exposure to loss-making companies whether they be funded or unfunded. This implies the fund is actively avoiding the 81% of the sub $100m market cap universe which is currently loss-making and thus arguably higher risk. We believe this shows that the portfolio remains conservatively positioned in companies at the low risk end of the spectrum and will remain so looking forward.
3 - Portfolio Categorised By Debt Profile
Why? In our opinion a company’s balance sheet is a key input when assessing risk. Companies with strong balance sheets carry far lower financial risk profiles than companies with weak balance sheets. The reason is clear: debt-holders rank ahead of equity holders in the event of financial distress; so the larger the queue of debt-holders, the less likely equity holders will receive their funds in a worst case scenario. In addition, less debt means greater financial flexibility and less exposure to interest rate cycles.
TAMIM Australian Equity Small Cap IMA model – By Debt Profile:
Observations: 48% of the underlying portfolio is invested in stocks with net cash surpluses which is consistent with our objective of investing in high quality companies with strong balance sheets. These companies carry far lower financial risk than highly geared companies.
30% of the underlying portfolio is invested in stocks with modest gearing levels.
And 22% of the portfolio is in cash as mentioned above.
The underlying portfolio has no positions in highly leveraged businesses. We view the portfolio's overall financial risk as low and far lower than the broader smaller companies’ universe.
4 - Portfolio Exposure By Industry Exposure
Why? We believe looking at a fund’s sector weightings is another worthwhile way to make sense of any industry related risks which may only become clear from a top-down perspective.
TAMIM Australian Equity Small Cap IMA model – By Industry:
We view this as a well-diversified portfolio with a tilt towards defensive businesses.
It is worth noting that within each sector the stocks are generally quite different from one another so it is sometimes misleading to generalise based upon sector classifications. For example, Reverse Corp (ASX:REF) is classified as an Investment company whereas in reality the company is building its position in the online contact lens market which is ultimately a healthcare related activity.
The TAMIM Australian Equity Small Cap IMA’s risk profile is arguably lower than many may assume reflecting the underlying fund’s focus on high quality businesses with strong balance sheets, as well as our disciplined value investing approach. The portfolio remains very heavily weighted to high quality businesses which are growing their earnings and paying dividends, yet are trading on low multiples and often with net cash surpluses and excellent management. We believe these conservative investment foundations put the portfolio in good stead to continue its track record looking forward.
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