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Spheria Global Microcap Fund

ARSN 627 330 287 APIR WHT6704AU

Performance as at 31st October 2021

1 Spheria Global Microcap Fund. Returns of the Fund are net of applicable fees, costs and taxes.
2 Benchmark is the MSCI World Microcap Index in AUD (Net) from 1 July 2021 and prior to that MSCI Kokusai (World Ex-Japan) Microcap Index in AUD.
3 Inception date is 1 March 2019. Past performance is not a reliable indicator of future performance. All p.a. returns are annualised.

Overall Commentary

All but the largest stocks were weaker in October. The MSCI World appreciated 1.6%, MSCI Smalls fell 0.4%, and MSCI Micros fell 2.0%. The Fund did relatively well, despite this dynamic, up 0.8% after fees.

Since its inception (1 March 2019), the Fund has delivered 23.2% p/a after fees. This return is 3.4% p/a more than its Benchmark, and 6.9% p/a more than the MSCI World of large cap stocks.

Regional Exposure

Source: Spheria Asset Management

Sector Exposure

Global Characteristics

EPS= Earnings per Share, FCF = Free Cash Flow, Negative Net Debt / EBITDA figures show a debt free, or net cash balance sheet.

Further Commentary

The chart below shows the comparison to the major MSCI Indices.

Source: MSCI, Spheria

Markets

Energy and Materials continued their march higher in October. Meanwhile, defensives in Health Care and Consumer Staples lagged considerably, down 7.4% and 4.0%, respectively. There are signs of a near term peak in growth as supply chain issues bite and Government stimulus wanes. Perhaps with the Central Bank Cartel about to begin tapering, investors are increasingly nervous about growth stocks on high multiples and what higher interest rates may mean?

We expect these concerns will evaporate in the coming months. However, the beauty of a style neutral portfolio and huge universe of opportunities is that we don’t care and can instead focus on our 3-5 year bottom-up fundamental analysis and valuation. Macro is hard; finding and analysing undiscovered companies is relatively easy if you know how and have the wherewithal to do it.

Given the outperformance of materials and energy, it was no surprise to see Canada and Australia as the two best performing microcap markets in October. On the other hand, the market wasn’t buying what Japan was selling (safety) and that country’s microcaps were down 7.7%. We continue to crawl over Japan, currently owning four stocks there and many more under analyst coverage. The balance sheets in that country are in rude health, and valuations are extremely appealing. The cherry on top is a weaker Yen of late, which provides a significant tailwind to Japanese exporters.

Source: MSCI, Spheria. World Index includes Japan, Kokusai excludes Japan.

Fund Performance

Concentric (COIC.SS)

Source: Concentric

The Fund’s best performing stock this month was Concentric.

Concentric is a Swedish based manufacturer of pumps and hydraulics. Concentric pumps are the market leader and benchmark in lubrication, cooling and fuel pumps for medium and heavy-duty diesel engines, transmission and compressors. Evolving environmental and noise regulations have meant that its truck manufacturing customers have relied increasingly on Concentric to deliver greater efficiency while ensuring the reliability critical for trucks, construction, and agricultural equipment.

The company is a classic Spheria stock. Free cash flow conversion has averaged 109% (earnings before interest and tax, or EBIT, to Free Cash Flow); returns and margins are healthy, reflecting the company’s substantial intellectual property and reputation; and the balance sheet has a pile of cash. Furthermore, the team’s thesis is that the market is not factoring in any upside from the company’s opportunity in e-pumps. E-pumps are electronically driven, rather than driven by the diesel motor. The company estimates that e-pumps could represent 20% of revenue by 2025. In the short term, stricter emission standards will drive the use of e-pumps since they are more efficient. Longer-term, truck fleets’ electrification will significantly boost growth since e-pumps will be required for shifting and lubricating transmission or cooling and lubricating the electric traction engine (depending on the powertrain used). Current diesel engines use about three pumps on average. However, electric vehicles may require more pumps (five or more), and each e-pump is more expensive than a conventional equivalent.

Recently, the company has announced that it has acquired EMP, a leading US producer of electric and mechanical water and oil pumps. Concentric is paying US$147 million for EMP but increases Concentric’s revenue by more than 50%. It also bolsters the company’s electric product capabilities. The market liked the announcement, and the stock price rose 17% as a result. Spheria’s analysis of the acquisition suggests this is more than warranted, and the Fund continues to hold the stock.

Inogen (INGN.US)

Inogen was again the Fund’s largest detractor. The company remains a victim of COVID lockdowns. However, with economies reopening and the elderly becoming increasingly mobile, the company is set for a much brighter future.

As a reminder, Inogen is the global leader in the manufacture of portable oxygen concentrators. These products can be substituted for oxygen tanks when patients require mobility. The industry continues to grow strongly, and following COVID many more patients have been prescribed oxygen. Normalised for COVID, the company’s metrics and valuation are attractive, and the company’s balance sheet includes US$220 million of net cash.

Outlook

How do we get out of this mess?

Source: FRED

Is the US ready to become a bad lender? Recall, even the UK, with all its might, was at one stage a serial defaulter to its financiers in the cities of Genoa, Venice and Florence. Following the Napoleonic Wars, the UK’s public debt was 260%. This quandary took over 40 years to work through and reduce public debt to 100%. Could today’s politicians convince the populace to accept 40 years of austerity?

A theory offered by some commentators is that Western Governments are likely to resort to financial repression. Financial repression is where the Government monopolises lending so that institutions are effectively forced to lend to them. This action suppresses nominal interest rates and allows Governments to pay down debt. Negative real interest rates work as a tax on savers and transfers money from creditors (savers) to borrowers.

While financial repression sounds radical, it has historically been quite common. As the chart below shows, working off excess public debt is not a new phenomenon.

Indeed, after World War II, financial repression was the norm for many advanced economies. The beauty is that this new type of tax works by stealth, slowly eroding savers’ assets. Much easier for politicians to get away with than income or sales tax. It can take multiple forms, including legal restrictions on interest rates and control of credit allocation or capital movements.

The IMF has written on this topic multiple times (recently here). The IMF states that “A large role for nonmarket forces in interest rate determination is a key feature of financial repression.”. Hold on that sounds familiar. The Central Bank Cartel (CBC) certainly fits the bill of nonmarket forces. Current US 10-year real interest rates are -0.92%.

Savers sure feel like they are being taxed hard, hence why equities are so popular. The problem is, the CBC has already spent a lot of its bullets. The Federal Reserve balance sheet has expanded from $4 trillion to over $8 trillion currently. The balance of outstanding US Treasuries is $21.9 trillion. How much longer can the Fed hold down rates on its own?

It may be that the CBC is simply the first part of the act. Financial repression is most successful when inflation is elevated. The CBC may be doing its best to stoke inflation before macro-prudential regulations take over the repression. As the chart from the IMF below shows, financial repression works gradually over time.

Source: IMF

Great, you may think? Low interest rates sound bullish for equities. Well, there is a twist. Whereas the CBC’s form of financial repression (QE) has allowed institutions to allocate capital freely, including equity markets, macro-prudential controls are likely to include constraints on credit allocation and restrictions on international capital movements. It may include prudential regulatory measures that require institutions (often pension funds) to hold Government debt in their portfolios. In more extreme cases, it has also included transaction taxes on equities and a prohibition on gold transactions.

Let’s take a scenario where regulators force institutions to hold more reserves, constrain the countries capital account, and implement prudential changes to ensure institutions have more Government debt. These actions will result in a switch from equities to Government Debt. The table below may help you decide which equities will suffer most under this scenario.

*Bloomberg Intelligence. Source: MSCI, Spheria, Bloomberg

Large US tech stocks have been the principal beneficiaries of the CBC’s first act of financial repression. However, are investors prepared for the second act? Once again, Global Micros serve as a valuable diversification tool. To reiterate:

  • Global Microcaps oscillate around large-cap equities depending on the economic cycle, providing diversification benefits. Adding Global Microcaps can help reduce overall equity portfolio volatility and downside risk.
  • Microcaps are less dominated by the US market with only 26% of the MSCI World represented by that country. In contrast, the MSCI World Index has a 67% allocation to the US market, and that market, in turn, is the most concentrated it has been since 2000.
  • Microcaps typically trade at an earnings multiple discount to large caps, but the rise in passive investing has stretched that gap in valuation. During the dot-com bust, smaller companies outperformed large caps materially owing to this kind of valuation discrepancy.

One thing is for sure; Governments are going to have to pull something quite spectacular to get us out of this mess. Therefore, we urge investors to consider diversifying into Global Microcaps to prepare for any scenario.

Platform Availability List

The Spheria Global Microcap Fund is available on the below Platforms. Please check with your platform for minimum investment requirements and fees.

HUB24

Macquarie Wrap

Netwealth

Praemium

Spheria Global Microcap Fund value
Benchmark MSCI World Micro Cap Index
Investment Objective Outperform the MSCI World Micro Cap Index in AUD (Net) over the long term
Investing Universe Global listed microcap equities predominantly in developed markets with a market capitalisation of US$1.0bn and below at time of purchase
Holdings Generally 30-80 stocks
Distributions Annually
Fees 1.35% p.a. management fee & 20% performance fee of the Fund’s excess return versus its benchmark, net of the management fee.
Cash Up to 20% cash
Expected Turnover 20% - 40%
Style Long only
APIR WHT6704AU
Minimum Initial Investment $25,000

Fund Ratings

Further Information

For more information, please contact Pinnacle Investment Management Limited
on 1300 010 311 or email distribution@pinnacleinvestment.com

Disclaimer

This communication is prepared by Spheria Asset Management Pty Limited (ABN 42 611 081 326, Corporate Authorised Representative No. 1240979) (‘Spheria’) as the investment manager of the Spheria Global Microcap Fund (ARSN 627 330 287) (the ‘Fund’). Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371 (‘PFSL’) is the product issuer of the Funds. PFSL is not licensed to provide financial product advice. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited (‘Pinnacle’) ABN 22 100 325 184. The Product Disclosure Statement (‘PDS’) and Target Market Determination (‘TMD’) of the Fund is available at https://spheria.com.au/funds/spheria-global-microcap-fund/. Any potential investor should consider the PDS and TMD before deciding whether to acquire, or continue to hold units in, the Fund.
This communication is for general information only. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice before doing so. Past performance is for illustrative purposes only and is not indicative of future performance. Unless otherwise specified, all amounts are in Australian Dollars (AUD).
Whilst Spheria, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Spheria, PFSL and Pinnacle disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information. This disclaimer extends to any entity that may distribute this communication.
Any opinions and forecasts reflect the judgment and assumptions of Spheria and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future. Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information contained in this communication is prohibited without obtaining prior written permission from Spheria. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication.
This may contain the trade names or trademarks of various third parties, and if so, any such use is solely for illustrative purposes only. All product and company names are trademarks™ or registered® trademarks of their respective holders. Use of them does not imply any affiliation with, endorsement by, or association of any kind between them and Spheria.
The Zenith Investment Partners (ABN 27 103 132 672, AFS Licence 226872) (“Zenith”) rating (assigned Spheria Global Microcap Fund – November 2020) referred to in this piece is limited to “General Advice” (s766B Corporations Act 2001) for Wholesale clients only. This advice has been prepared without taking into account the objectives, financial situation or needs of any individual, including target markets of financial products, where applicable, and is subject to change at any time without prior notice. It is not a specific recommendation to purchase, sell or hold the relevant product(s). Investors should seek independent financial advice before making an investment decision and should consider the appropriateness of this advice in light of their own objectives, financial situation and needs. Investors should obtain a copy of, and consider the PDS or offer document before making any decision and refer to the full Zenith Product Assessment available on the Zenith website. Past performance is not an indication of future performance. Zenith usually charges the product issuer, fund manager or related party to conduct Product Assessments. Full details regarding Zenith’s methodology, ratings definitions and regulatory compliance are available on our Product Assessments and at Fund Research Regulatory Guidelines.