Ask A Fund Manager
The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In this edition, Cyan Investment Management director and portfolio manager, Dean Fergie, reveals two Aussie businesses that are winning big contracts, and some ASX-listed foreign companies to avoid.
The Motley Fool: What's your fund's philosophy?
DF: Our philosophy is to find smaller, less well-known stocks that are commercially proven but not well-recognised and likely to go through a sustained growth phase for the next 3 to 5 years or more.
We tend to avoid really speculative businesses and businesses that are mature, and look for the next ones that are up-and-coming.
MF: So is it fair to say that your investments are focused on smaller cap?
DF: Yeah. Our philosophy is that the bigger you get, the harder it is to grow at double digit-plus rates. So by definition you have to look down at the spine of the market.
MF: How's the fund going this year with all the volatility?
DF: The short answer is volatile. We took a lot of pain when COVID first came out and then have retraced some of that and more since that time.
MF: Did you manage to buy anything during the March dip?
DF: We bought quite a few stocks. I think we played it reasonably well. But you can probably always do a little bit better in hindsight.
What I saw is the stocks or the funds that were really defensively positioned in March did really, really well. Then in April and May they all did relatively poorly and vice versa.
We made some smart investment positions, but did we put all our money into that cohort of tech stocks that have done exceptionally well? No, unfortunately not.
I think more than ever it's a really important time to be diversified. Because if you've got all your stocks in a really defensive basket, or a really aggressive basket, or technology-laden, or value-based, there'll be times when you'll do incredibly well and times where you'll do incredibly poorly. And it's very uncertain when those periods are going to be.
Buying and selling
MF: What do you look at closely when considering buying a share?
DF: The ability to scale… Obviously that leads to technology businesses, specifically software, but also businesses that can grow organically or that are embarking on potentially a new kind of business angle that's not largely been explored already.
We look at a lot of tech businesses, financial services, and we're quite big in education. We've dabbled quite successfully in some food businesses — one of our early investments that was successful was Bellamy's Australia Limited (ASX: BAL). Professional services as well.
MF: What triggers you to sell a share?
DF: Disappointment in terms of management execution, or potentially if there's new competitors to come into the market, or just companies [that] disappoint on an earnings front.
If you think you're losing money on something, or if something's changed, just sell out. Take the capital loss and move into something that's more successful. That's the way we look at things.
MF: Even if the company is doing reasonably well, would you sell out because it's reached a certain target that you might have set for yourself?
DF: Yeah, there's an element of that. I guess what happens is that if you have stocks that become very successful, they become quite a large part of your portfolio. We have a hard limit of not having any one position more than 10% of our portfolio. So when you have businesses that rise exponentially, you're forced to sell them down. I think that's sensible.
One of the beauties of stocks is that you have these incremental changes to your holdings. It's not like buying a house where you're either all in or all out. You can fine-tune your exposure to stocks relatively easily and cost-effectively.
That's one of the great advantages of the stock market that I think a lot of investors don't really take advantage of. They want to buy everything at the bottom and sell everything at the top, and that's unrealistic.
So we just buy more stocks at lower prices and sell more of them at higher prices, and not try and be too binomial about those decisions.
What's coming up?
MF: Where do you think the world is heading at the moment?
DF: I wouldn't be alone in saying that the broader economy has got a lot of challenges ahead. But what we're seeing in 2020 is that there's been a massive disconnect between economic outlook and the stock market. They just don't reflect each other anymore.
A lot of that has actually been driven by incredibly low interest rates. Just emotionally, investors don't want to leave their money in any kind of defensive asset class if it's not giving them any return.
So every opportunity where there's a market dip, they've looked at getting into the stock market. And even the biggest funds, the pension funds, and massive super funds tend to be allocating more towards equities. On top of that, you've got a massive amount of retail day traders in the market sending stocks sky high with massive volumes.
So whilst I think the near-term economic outlook does look challenging, I don't think it's necessarily a bad thing for the stock market because even if you've got businesses that are earning 3% or 4% earnings yields and potentially 1% or 2% dividend yield fully franked, that's a better outcome, if you're prepared to take the capital risk, than leaving your money in the bank right now.
At the end of the day, that's what drives the stock market, demand versus supply.
MF: That situation you just described, do you think it's a fundamental structural change that's here to stay? Or do you think the situation will return back to "normal"?
DF: It will depend on the direction of interest rates. They clearly can't go very much lower unless they go negative and I don't think that's looking like a realistic outcome.
I would suggest that a lot of that rotation into stocks has already happened. The All Ordinaries Index (ASX: XAO) is not back to pre-COVID highs, but it almost is. Certainly the smaller end, the Emerging Companies Index, is 10% above where it was pre-COVID.
So you're seeing a lot of money flow back into the stock market really, really aggressively. And it almost creates its own demand. It's almost like this elastic band in that you rail against the bullishness of the stock market till it runs so far that you just give up and cave in — and go and buy stocks like everyone else.
But there are patches of the market that look crazily overvalued.
When we saw a potential vaccine come out and all those tech stocks tumble within the space of a day, I think that was a little bit of a warning sign — a canary in the coal mine — that it just can't go on forever.
Sooner or later, all investors are going to come back to buying things on fundamentals.
Overrated and underrated shares
MF: What's your most underrated stock at the moment?
DF: One stock that we've held for a while and just hasn't performed like we expected is a business called Quickstep Holdings Limited (ASX: QHL), which is an advanced carbon fibre manufacturer.
They do a lot of work for the defence force… It's capped at sort of $60 million [market capitalisation], it does about $80 million in revenue, and is moderately profitable.
They just penned a deal to buy a maintenance division of Boeing Co (NYSE: BA), which will add to their revenue. We look at that on just basic earnings multiples and revenue multiples and think it looks really cheap.
Then when you look at it versus a number of these other advanced manufacturers in terms of like Titomic Ltd (ASX: TTT), AML3D Ltd (ASX: AL3), and Amaero International Ltd (ASX: 3DA)… it just looks ridiculously good value. So that's one we like.
It's been a long slog for them to get where they are now, but they've got a lot of cash on their balance sheet. Contracts with global defence force businesses like Boeing, Lockheed Martin Corporation (NYSE: LMT) and Northrop Grumman Corporation (NYSE: NOC) — I just think it looks like a no-brainer in terms of a business to buy into, but the market just hasn't recognised it yet.
Another one that's going great guns at the moment is a hospital software provider called Alcidion Group Ltd (ASX: ALC). Again, they just signed a $9 million deal with a hospital in the UK. And they've got more than 20 million bucks in recurring revenue. They're getting very close to profitability. Global rollout. Reference sites.
MF: I see that one's spiked up this month?
DF: Yeah. It hasn't really done too much in the last 6 to 12 months. Everyone got pretty excited, went from I think about 6 cents to about 30, and has sort of come back.
With a lot of stocks, they run on momentum and then they kind of lose a bit of momentum and people get bored and they want to be on the next big thing regardless of what it is. So often you need a new contract or something new to excite people about it.
I think [Alcidion]'s one of these businesses that just hasn't been big on announcing new contracts, but they've signed some that are really, really significant for a business that size.
And you've seen that with the success of companies such as Pro Medicus Limited (ASX: PME) and the like. When those businesses get some success, certainly overseas, they can become very, very big businesses.
MF: What do you think is the most overrated stock at the moment?
They're all speculative businesses that are doing nothing in terms of revenue, keep sucking in investor cash, and don't make money. And they've got valuations in the hundreds of millions of dollars and I'm not necessarily sure that they've got anything particularly special.
I'd say the same thing about businesses like Titomic — [they] don't really do much and they're still capped at a couple of hundred million bucks.
MF: Do you think there's a phenomenon these days of amateur investors egging each other on in internet forums?
DF: Oh, no doubt. A lot of investors will buy stocks because they're going up. It's pure speculation, but they just want to be in something because they think it'll be worth more next week than this week, not because they understand it, not because they think they're buying it at a cheap price, just simply because it's going up.
You look at Kogan.com Ltd (ASX: KGN), Temple & Webster Group Ltd (ASX: TPW), Adore Beauty Group Ltd (ASX: ABY) as well. They've all got good business models, but the selling product online is not necessarily a business that's got huge barriers to entry. I mean, anyone can open up a Shopify store.
Sure, you don't have the customer base, you don't have the reputation, you don't have the buying power, but they're not businesses that I think should be trading on 6 times sales and 100 times earnings. I can't see them scaling up any time soon.
There's a lot out there that I would be very, very wary of on a purely valuation perspective.
MF: Which stock are you most proud of from a past purchase?
DF: Afterpay Ltd (ASX: APT) is the obvious one.
MF: Do you still hold it?
DF: No, we sold out a while ago.
One that we bought quite a while ago is RAIZ Invest Ltd (ASX: RZI). That one did struggle for a while. It's an online investing platform — I think they offer a really, really good product. Their app's got great functionality.
They're getting a lot of long-term customers — more people are interested in investing. I think that's a business that's got tailwinds from the structural change that people want to think more about investing in stock markets and not leave their money in the bank.
Secondly, it's a technology play and it's getting good growth both here and they're looking to launch overseas as well. So that's one that I think will go really well.
But probably our two biggest winners we've ever had are Afterpay and Bellamy's and, oddly enough, we made a lot of money out of Experience Co Ltd (ASX: EXP) for a while before it kind of went really badly.
Stocks never go up and down in a straight line. And that's one where we got in early and managed to get out enough of them that we ended up getting a good return for our portfolio over a period where it went up 2 or 3 times before they… struggled a little bit.
MF: Has COVID-19 changed or altered your investment methods at all?
DF: What's happened is that investors, if you think of yourself as a traditional strong "numbers and valuation" player… then you would have left a hell of a lot of money on the table.
I think you're naive to think that the market is just driven by valuations. It's not. It's driven by sentiment, excitement, enthusiasm, momentum, those sorts of things. And they will drive stocks much higher than might be, in your view, intrinsic value. And they can all disappear overnight.
So you've got to appreciate that there's a lot of other drivers in the market other than pure financial fundamentals and try and kind of second guess where other investors are going to either see risk or opportunity in the market — and try and take advantage of that.
Advice for your readers is try and blend a little bit of fundamental analysis with what you see as an opportunity and excitement towards positions.
Probably the highest profile stock float this year has been Adore Beauty because it's a mainstream business. A lot of females know about it. It's run by a female founder. It's a great news story.
But it was, we thought… incredibly expensive.
People I saw were saying "Oh look, you know, there's a girl… and she wants to buy shares because she thinks it's a really good company."
You've got to put a framework of what you're buying around it. What are you getting for your money? And if you don't know that, you shouldn't really be investing because it's not that straightforward.