The fund manager Chris Demasi from Montaka Global Investments has outlined why it's worthwhile holding 'outlier' stocks in a share portfolio.
Demasi notes the Montaka portfolio is invested in 'compounders' like Amazon and Microsoft. These businesses are an important part of the portfolio and can deliver outperformance over the long term. This is because of their "strong positions in attractive markets that allow them to sustainably grow their earnings power long into the future", Demasi says.
But he says there is another type of stock worth looking at – "outliers" — which can become the long-term winners or compounders of tomorrow.
Image source: Getty Images
What's an outlier?
The fund manager would describe a stock as an outlier if it has "exceptionally high return potential". That's typically because it's much earlier in its growth journey. According to Demasi, they're "on their way to taking off, and that usually means they've got a lot of promising growth and value creation ahead of them".
Certainly, smaller businesses are not guaranteed to go on to great things. Demasi warned that there's "a risk it may not happen". But if a business does get there, the rewards can be "amazing".
Why should investors want to invest in outlier stocks?
Demasi thinks outlier stocks can make big returns for investors:
Successful outliers can add significantly to the return potential of the portfolio.
Outliers combine the large payoffs from early-stage success with the power of rapid growth as they go on to become compounders.
So, we think outliers represent an opportunity to really add meaningfully to the power of the portfolio's returns by complementing the compounders.
What are the risks?
Of course, the main risk is that the investment doesn't go well. The fund manager said that growth is a lot less certain for outliers than compounders. That's why Montaka allocates a "much smaller" weighting to outliers.
Montaka only invests a maximum of 20% of its portfolio in outliers. This is then spread across several names. Demasi explained how his team tries to limit the risk of such outliers:
No one position is going to be overly large, especially compared to what we do in the compounders.
And what we try to do is look for companies in that set of outliers that have different value drivers and risk factors as well, so that they're mostly unrelated and uncorrelated to each other.
Montaka also typically doesn't invest more in outliers if they've declined. This is a different approach to what happens with the portfolio's compounders. According to Demasi, when outliers drop in value, there "isn't that same level of certainty looking out into the future as you find with compounders".
What are some outliers?
For the Montaka portfolio, which is globally-focused, he referenced Spotify as the largest outlier position in the portfolio. Even though it already has half a billion users, it's "still establishing itself" and Montaka believes it's quite early on in its business lifecycle.
If Spotify can remain the number one player, build out its capabilities, and compete "furiously" against others like Apple and Alphabet's YouTube, it could be a "10-bagger" over the rest of the decade, according to Demasi.
The fund manager didn't name any ASX stock examples, so I'll point to a couple of articles I've recently written, like this one and this one, where I cover some smaller opportunities that I believe could grow significantly.
