Souls’ ignores the stampede

Noted small caps stock picker Frank Villante has spent much of the past year closing his ears to the “siren call” of the ongoing commodities bull market.

Investment manager for the Souls Australian Small Companies Fund, Villante said it’s “very easy to succumb to the siren call of a late-stage bull market, but there’s almost an obsessional view here about doing what we do well”.

“We have to ensure we’re roped securely to the mast of the boat when the siren tells us to buy stocks with no earnings and spurious business models and a questionable management and board.”

He describes the small caps market as “quite stretched in terms of valuation, after four successive years of very strong returns, and with disturbing pockets of excess”.

“There are certain areas that appear to have characteristics of a bubble about them, graphically illustrated by some of the momentum investing that is occurring at the moment.”

The fund returned 40.4 per cent for the three years to December, a performance that saw it nominated in this year’s Money Management overall Fund Manager of the Year award, and also win the Australian shares — small cap category.

However, Villante described as disappointing the fund’s performance relative to the (small ordinaries) benchmark over the 12 months to March 31.

“We’re not well equipped to deal with the excessive valuations and the momentum investments characteristic of a late-stage bull market.

“People tend to invest based on thematics rather than true underlying quality of business, business model, accounts, people and valuation, which is the glue that holds us together.

“To put that in perspective,” he says, “about 10 stocks that form a significant part of the small caps sector, and some of those stocks’ valuations, have become very, very stretched.”

In addition, he says some resource stock values have increased to the point where the “earnings base and/or the quality of the asset does not in any way correspond to the valuation”.

“Some of these companies are capped at between $0.5 billion and $2 billion, when, in my opinion, they would find it difficult to get a bank overdraft for a million dollars,” he adds.

“So, there’s a significant disconnect between the cash generative qualities of those businesses at this point in time and what the market perceives to be their value.”

Souls is avoiding “like the plague those areas of stretched or extreme valuations”, Villante says, despite that “momentum in some of those stocks is still quite prevalent”, the driving force behind the siren call.

“The issue for us is that if valuations can become as stretched as they are now they can become yet further stretched, or to put it another way, if the distance from reality is as extreme as it is now it can go further.”

He said the “bottom line for us is if we are not comfortable with the quality of the accounts, people, business model and the valuation doesn’t stack up, we won’t invest in the company”.

“Essentially, this means there will be periods where the rigour of our investment process doesn’t really fit in with an aggressive momentum market.”

Steve Black, co-manager of the Pengana Emerging Companies Fund, a runner up along with MIR Investment Management, does not “share the negativity that is out there in the market”.

“With small industrials being on a PE average of 15 or 16 times, which is not too far from their long-term average, I certainly don’t think the market exhibits the normal characteristics it would over a heated market. It’s not particularly cheap, but it does not seem to be too far away from fair value either.”

Black said the manager “prefers to add value by picking the right stocks through a cycle rather that try to time short-term market movements”.

“Bear in mind that we have 700 to 800 companies in our universe from which we can pick our portfolio of 50 stocks, so at any point in time we should be able to identify 50 or 60 stocks from that universe that aren’t correctly valued.”

Winner: Souls Funds Management

Finalist: MIR

Finalist: Pengana Capital