From humble beginnings, Acorn Capital has forged a reputation as one of the most respected fund managers in Australia’s microcap sector. Here we talk to Douglas Loh, Acorn Capital’s head of equities, about Acorn’s investment journey over the past 15 years.
In 1998 Barry Fairley, the founder of Acorn Capital, wanted to know why the cost of capital was so high for the junior gold mining company he managed and part-owned.
He quickly identified that the cost of capital was high for all small companies (or microcaps, as Acorn Capital subsequently defined them), and recognised that if the cost of capital for small companies was high then the potential for investors in those companies was also high.
But small companies routinely failed, the microcap sector lacked liquidity, and the standard of corporate governance was poor. Offsetting these challenges was the fact that 74 percent of the ASX stars over the previous decade had started as microcaps (1), and both buy and sell side research for these companies was almost non-existent.
So Barry founded Acorn Capital and developed a structured investment process that sought to mitigate the risks particular to the microcap sector, while exploiting the opportunities it represented with extensive investment and academic research. The basics of the investment process to emerge included sector and style neutrality, a best of sector approach, intensive industry and company research, a large number of small bets and patient dealing. That investment process remains the foundation of Acorn Capital’s investment approach today.
A research intensive approach remains Acorn Capital’s strength, and the business currently invests across three distinct strategies: the microcap sector of the Australian market—made up of companies that lie outside the top 250 companies on the ASX; private, unlisted microcap companies in Australia; and the (smaller end of the) small cap sector of Asian markets (excluding Japan).
"An investment manager can consistently add value in relatively inefficient markets not necessarily through market timing, but through sound investment research and a reasonable degree of diversification."
In 1999 Acorn Capital formed a joint venture partnership with Australian Unity. Its flagship microcap strategy reached institutional capacity in 2003 and has remained at capacity ever since.
The Acorn Capital Wholesale Microcap Trust remains open, and since inception it has generated a return of 11.34% p.a. (at 31 January 2014), outperforming the benchmark index by 4.80% p.a.(2)
Douglas, what are some of your observations over the past 15 years in microcap investing?
This chart demonstrates how microcaps have performed against the broader market since independent data coverage of the microcap sector commenced in 1989. It plots the differential in 12 month rolling returns between the S&P/ASX All Ordinaries Accumulation Index against the Australian microcap index.
One year relative performance of SIRCA microcap index versus All Ordinaries Index
Source: Acorn Capital, SIRCA
As you can see, periods of microcap sector relative underperformance (when compared to the S&P/ASX All Ordinaries Accumulation Index) have frequently been followed by periods of outperformance. This is a cyclical phenomenon and explains a great deal about investor behaviour in the Australian market. ‘Herd mentality’ results in investors chasing in-favour sectors of the market until they inevitably become too expensive and then start looking in those sectors that have been neglected. We have seen this with the microcap sector, which had its largest period of underperformance against the All Ordinaries Index (over this time period) for the 12 months ended April 2013.
Since then we have seen investor interest return to the microcap sector, which has resulted in its recent outperformance versus the All Ordinaries Index.
As the drivers of microcap performance are different to its large cap peers, it makes for a good diversifier against the broader market. Although microcaps carry higher risk, investors are rewarded with higher returns and investment potential.
Acorn Capital was founded in 1998 with a team of two. How has the investment team grown over time?
Today Acorn Capital employs 24 people, with a team of 20 investment professionals.
We have significantly augmented the team over time, with a focus on hiring industry specialists to analyse the sectors they specialise in. Having thorough and in-depth industry knowledge is critical to finding successful companies in a sector where the odds are often tipped against the average investor.
Because of the nature of the microcap companies we research, analysts need an in-depth level of industry and technical knowledge to truly understand companies in the sector. With information much thinner on the ground in comparison to the larger end of the market, analysts often have access to a much smaller pool of data and need to be able to draw conclusions and make decisions to invest with less ‘formal’ information available to them.
For example, when researching exploration companies our analysts need to understand the geology of an exploration site, the metallurgy of the rocks and the intricacies of local and federal mining regulations. These are only some of the factors a resource analyst will have to look at. The invaluable knowledge that comes from having worked in the industry also comes in handy when evaluating the capability of an exploration company’s management team.
How has your investment approach changed over the past 15 years?
It really hasn’t. Our view is that the microcap sector continues to be inefficient and quality, bottom-up fundamental research will be rewarded with outperformance.
We continue to believe (and our performance backs this up) that a well-resourced team of industry analysts who genuinely understand their sector, companies and management will always be able find the most attractive stocks. We remain long-term investors, and diversification by sector and stock continues to be integral to our portfolio construction.
Tell us about your longest holding.
Amcom Telecommunications is a stock we have held in our portfolio since 2001. We first entered the stock at a price of $0.19, and today its stock price is $1.985 (as at 31 January 2014). During this time, we have seen the company grow from $21 million in market capitalisation (at the time of first purchase) to $485 million (as at 31 January 2014).
Source: Acorn Capital
Today, Amcom provides data connectivity and telecommunications services, and operates four divisions: fibre and networking, internet services, voice and applications, and data centres.
When we first looked at the business some 14 years ago its primary asset was an extensive fibre optic network that connected major buildings in Perth. Its Perth fibre network was performing well, and was delivering solid revenue and earnings growth. However, the main attraction was the strategic value of the asset, holding particular appeal to an infrastructure owner such as Optus (the next largest network behind Telstra).
The company continues to be well-managed, it has a clear competitive advantage, and its business model and strategy are pragmatic and logical. We will hold Amcom in the portfolio as long as we continue to rank it as one of the best stocks in the microcap telecommunications sector.
For more than 15 years Acorn Capital’s research approach has been uncovering star stocks well before they become household names. Can you provide an example?
We currently hold the Reject Shop (TRS), having first purchased the stock in May 2004 at $2.00. As at 31 January 2014 its share price was $11.20. It had a market cap of $47 million when we first invested, and has since grown to $323 million (as at 31 January 2014).
Our initial investment thesis was about TRS servicing a segment of the market that was at that point in time occupied by many small players: think $2 shops operated by mum and dads. It was clear to us that there was a competitive advantage for a larger organised player like the Reject Shop, on economies of scale as well as providing a consistency of product to the end customer.
For those who are looking to get into microcaps, what do you recommend as a holding strategy?
Our research has shown that although it is possible to outperform through market timing, it is an extremely difficult feat to consistently accomplish. For example, as the chart below shows, if you were to miss only the best three months of any three year and five year period, your performance would drop dramatically on average by 9.85% p.a. for three year periods and 6.91% p.a. for five year periods. This shows how difficult it is to correctly time the market, and the consequences of getting it wrong even by a little.
Average microcap sector performance over three and five year periods
Source: Acorn Capital
Investors who have stayed fully invested in the Acorn Capital Wholesale Microcap Trust since inception have enjoyed returns of 11.34% p.a. (to 31 January 2014), an outperformance of 4.80% p.a (3) . This demonstrates that an investment manager can consistently add value in relatively inefficient markets not necessarily through market timing, but through sound investment research and a reasonable degree of diversification.
It also highlights that the microcap sector is more likely to reward investors with an investment timeframe of more than five years.
You have seen some dramatic swings in the market over the past 14 years. How has the Acorn Microcap Trust performed over this period?
Acorn Capital’s research-driven investment philosophy and strategy has enabled us to successfully manage funds in large inefficient markets, and outperform the index in 12 out of 13 calendar years since inception. By way of example, this chart shows the outcome if $10,000 was invested in the Acorn Capital Wholesale Microcap Trust at inception in February 2001, versus the Trust’s benchmark (the Acorn Capital/SIRCA Microcap Accumulation index) and the broader Australian sharemarket measured by the ASX 300.
$10,000 invested in the Acorn Capital Wholesale Microcap Trust since inception (4)
Source: Acorn Capital
1. Acorn Capital defines ASX stars as the 100 top returning ASX stocks on an absolute basis over the past decade (Dec 2003 – Dec 2013)
2. Returns are calculated after fees and expenses and assume the reinvestment of distributions. Past performance is not a reliable indicator of future performance. The inception date for performance calculations is 28 February 2001. Benchmark is the Acorn Capital/SIRCA Microcap Accumulation Index. SIRCA is the Securities Industry Research Centre of Asia Pacific. For the same period the S&P/ASX All Ordinaries Accumulation Index returned 5.04% p.a.
Australian Unity Funds Management Limited ABN 60 071 497 115 AFSL 234454 is the responsible entity for the Acorn Capital Wholesale Microcap Trust. This product is managed by Acorn Capital Limited ABN 51 082 694 531.
The information in this article is general information only and does not take into account the financial objectives, situation or needs of any particular investor. Before deciding whether to acquire, hold or dispose of a product, an investor should refer to the current Product Disclosure Statement (PDS). A copy of the PDS can be obtained by calling 1800 649 033 or 13 29 39 or visiting www.australianunityinvestments.com.au. The information provided here was current at the time of publication only. Past performance is not a reliable indicator of future performance.
This article is not a recommendation to buy or dispose of any of the stocks noted. Any examples or information provided in this article are for illustrative and discussion purposes only and do not represent a recommendation or Acorn Capital’s view on future events, and in no way bind Acorn Capital.
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