What makes a top performer
Money Magazine Australia|August 2021
Picking the promising stocks, rather than following an index, is paying off for small-cap managers
DAVID THORNTON

Actively managed funds are facing stiff competition from passive exchange-traded funds (ETFs), with the latter consistently outperforming the former. But that doesn’t mean that actively managed funds can’t outperform. So, what sets apart the funds that do generate returns consistently above the market?

Fund managers and their critics consistently measure performance against benchmark indices, but getting overly caught up in performance relative to an index might be what holds many fundies back from achieving consistent outperformance.

Australian Ethical and Cyan Investment Management are two small-cap fund managers that consistently outperform the index.

Australian Ethical’s emerging companies fund has averaged a return of 19.5%pa since inception compared with the S&P/ASX Small Ordinaries Industrials index’s 10.9%, while Cyan’s C3G fund has returned 15.4%pa since inception compared with the Small Industrials’ 9.6% over the same period.

But in terms of how they invest, the index means very little. “We completely benchmark unaware,” says David Macri, Australian Ethical’s chief investment officer. “And that’s genuine. Because of our ethical guidelines, we have to be different to the market.”

Instead, Australian Ethical focuses on stock picking, not trying to replicate an index. “We think these companies have a competitive advantage – they’re undervalued, so we’ll hold a position.”

Graeme Carson, a director, and portfolio manager at Cyan, has much the same mantra. “We don’t benchmark against an index because that’s not how we think. We’re bottom-up – we want to find businesses that are growing or about to reach an inflection point to clear growth.”

Up close and personal

Investing in companies at the smaller end of the capitalization spectrum poses a range of opportunities and challenges.

Carson takes a more holistic approach to pick companies, based on a broader understanding of the business model and the people who execute it. “You need to meet the business, meet the management, have a holistic view of the numbers now and find out what they can look like if all the other pieces of the puzzle fall into place,” he says.

After that, Cyan looks at the financials, in particular: the return on investment capital.

This means dividend-paying companies are out of the question. “People want to chase yields because they think yields are good, but we don’t think they are,” says Carson. “Yield means that the profits are getting paid out rather than reinvested back into the company to grow it.”

It comes back to getting to know the business and the management to then be comfortable that they are going to reinvest the capital in a prudent way. “If they do that, the valuation is going to grow much more than a company paying out dividends.”

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