When Jonathan Wilson decided to strike out on his own after running a portfolio for Clime Investment Management last year, the sharemarket was in the grip of a bull run that had pushed equity prices to record highs.
Since then, however, equity markets have tumbled in a decline that has accelerated as the year progressed before a crescendo this month.
Australian shares have fallen sharply and in the past week and touched levels not seen since 2020. The downdraft has wiped tens of billions of dollars from the market value of the country’s listed businesses as investors grow uneasy about the risk of recession looming over developed economies.
Against this backdrop, Wilson and his business partner and fellow portfolio manager Adrian Ezquerro, who both left Clime after managing its small companies fund for years, have unveiled Elvest. The acronym is short for Emerging Leaders Investment Company, a small-cap investment house focusing on Australian companies.
“We’re already in a bear market for small caps, down over 25 per cent from last year’s peak,” says Wilson, close to double the drop for the S&P/ASX 200 from its high in August.
Shares in small companies are less liquid than listed giants like BHP or Commonwealth Bank, which placed an extra burden on their value during the past few weeks’ mayhem.
“When you have these broad sell-offs, small-caps get hit because everyone is thinking the same thing at the same time – you don’t want to be in a liquidity hole,” says Wilson.
The sharp declines offer a compelling flip side for portfolio managers with money to invest.
Attractive companies that typically trade at a premium now appear on reasonable valuations. Also, if the interest rate increase forecasts priced into the market fail to materialise, equity market valuations may enjoy a healthy rebound.
“It’s a blank canvas and we’re finding more sensible prices for quality,” says Wilson. “It’s a fantastic time to start a fund,” he adds. “We can come out the other side of this and look back at this moment as an exceptional opportunity to accumulate good quality businesses.”
Although the growing prospect of recession in the US and UK would weigh on global growth and impact Australia the focus for Wilson now is to identify attractive companies at a reasonable price.
“Our job is to pick stocks. We’re optimistic. Circumspect about what’s happening, but optimistic that we’ll find great opportunities,” he says.
“There’s been strong capital moves to large-caps and resources and away from industrials. Within that broad small industrials move you’re going to get good quality companies sold off at the same time.”
Wilson says he will wait to pick through the post-Federal Reserve rate hike rubble to find companies at sensible prices. The resulting portfolio will be highly concentrated, managing between 20 and 40 ASX-listed small-cap stocks that fall beyond the S&P/ASX 100 list of the largest blue chips.
The fund is set to own a handful of names that featured in the Clime Small Companies portfolio, including Jumbo Interactive, a lottery business, and RPMGlobal a software and training business that services the mining industry.
Shares in Jumbo soared more than 250 per cent in the year to October 2019 but have since halved in value, while RPMGlobal has tumbled by a quarter from a high late last year.
“RPM is a leader in quite a narrow niche. If you think about their customers – miners – they’re making money hand over fist with commodity prices so high,” he says.
The company’s market opportunity could be as much as 20 times its current recurring revenue base, according to Wilson, and the company has displayed discipline on costs.
Billing software firm Hansen Technologies, another stock from the Clime days, will feature in the portfolio and was the target of a failed takeover by Australian private equity group BGH Capital last year.
Wilson is also bullish on fashion jewellery and accessories retailer Lovisa. He sees it as an attractive company despite its shares almost halving in value from a peak in November as investors worry climbing interest rates will hit consumer discretionary shares.
“Lovisa has been sold off as part of the pressure on discretionary spending, but the company characteristics overwhelm the macro issues,” says Wilson. “A really capital efficient model, incredible unit economics, high gross margins and its products are at a low price point so less affected by inflation.”
The business is also rolling out its offerings in the US, which could drive a further burst of growth not currently factored into its share price.
“What gives us comfort is that it’s not trading at very high multiples on current earnings and that means that successful execution is not priced in,” says Wilson.
The fundie brings a track record from Clime that has outperformed its benchmark, although an avoidance of resources companies has hurt returns in the past year.
From the inception of the Clime Smaller Companies fund until Wilson’s departure in January, the portfolio returned 91.5 per cent net of fees compared to the 84.8 per cent return for its benchmark, according to Clime data.
In the final year Wilson worked on the portfolio, it fell 2.1 per cent while its benchmark soared 16.9 per cent, according to Clime.
The tough year partly related to the fund’s underweight holding of resources shares. The top-performing small-cap funds over one year mostly had a large overweight position in resource stocks and minimal tech exposure, Morningstar data shows.
Wilson hopes the contained size of the portfolio, in part reflecting the difference in market value of small companies compared to listed behemoths, will help focus the fund on the best ideas. This will help to juice returns in a corner of the market known for disparate single-stock performance.
The portfolio will be constrained to between $300 million and $400 million in assets, which Wilson hopes will drive performance.
“We’re small-cap specialists, it’s what we do, we’ve got one style which is based around quality companies and exploiting the inefficiencies that occur in small caps,” Wilson says.
Instances of small-cap fund bloating act as a cautionary tale. If a fund grows too big, it’s harder to build meaningful positions in smaller, less liquid companies without owning large chunks of the businesses. Larger positions also make it harder to exit stocks quickly.
Wilson and Ezquerro are treading a well-worn path in stepping away from an established fund manager to launch their own firm.
The pair joins the likes of Chris Stott and Martin Hickson, who left Wilson Asset Management to found 1851 Capital, and Tony Waters and Chris Prunty, former Ausbil and Investors Mutual portfolio managers who launched QVG Capital.
All have set out to emulate the success of boutiques like Eley Griffiths, Pengana Capital and Paradice Investment Management.
Wilson counts Michael Burry among his investing heroes, the hedge fund manager famous for predicting and profiting from the US subprime mortgage crisis, which almost brought down the world’s financial system.
Burry made billions by betting against the US housing market through the financial crisis and his exploits were profiled in The Big Short, the Michael Lewis book that traced some of the hedge funds that profited from the mayhem.
Burry also achieved mammoth returns in the early 2000s by shorting tech stocks and by 2004, his hedge fund Scion Capital was turning away money from investors, according to Lewis.
Like Scion, Elvest’s early backers are friends and family. Wilson admits that in this economic environment, flows will take time.
“People are waiting for the right opportunity to enter the market. They’re trying to time the market. We’re not trying to time the market, we’re trying to time companies. We’re looking to pick off companies at the right time for them,” he says.