THE SUPERVISED SYSTEM
The investment teams seeks to construct a portfolio which provides investors with an annual return that outperforms other assets with similar riskiness whilst minimising permanent loss of capital. The investment team will invest on a global basis but have a natural tendency to focus on the Australian market. Capital can be allocated to equities, option contracts, foreign exchange derivatives, debt securities and commodities. However at least 85% of capital is allocated to cash and listed equity investments at any given time. The net assets of the fund will not be geared. While the fund may be hold leveraged positions in commodities and foreign exchange contracts from time to time for hedging purposes.
The Portfolio Manager is responsible for sourcing and managing investments. The Portfolio Manager reports to and is guided by the Investment Committee. The Fund can only invest in a security if the Investment Committee has provided a written approval.
We believe that equity markets are inefficient and, therefore offer excellent investment opportunities over time. The inefficiencies arise due to excesses in investor emotion, short term investment horizons and disproportionate focus on one of the least important aspects of a company’s financial health – a single year’s profit and loss statement.
Conventional thinking is that holding more stocks reduces stock specific risk. Research however shows that 93% of stock specific risk can be eliminated by holding 20 stocks; basically each stock added to a portfolio beyond 20, is likely to have a decreasing impact on risk reduction (Elton and Gruber 2002). This means, effective diversification can be achieved in concentrated portfolios.
Adding investments to a portfolio requires rigorous risk identification analyses, a manger has a greater chance of finding 20 great investments than 100 great investments and each additional investment brings in new risks. Focussing on fewer positions enables for a greater understanding of each thesis and allows for increased expected return on the portfolio; it is for these reasons we construct a concentrated portfolio with 15-25 core positions.
The investment style would be considered ‘bottom up’ analysis rather than ‘top down’. Being a ‘bottom up’ investor does not mean that we don’t need to take a view on the market or the economy – the big picture impacts the probability of different investment cases playing out. In selecting positions we apply a six step process:
1. Fundamental Valuation
The Investment team conducts rigorous analysis on a potential investment opportunity. This may typically include meeting management, competitors, customers and other interested stakeholders. We will only consider investing if managements and other shareholders interests are aligned with ours and expected to stay so for the foreseeable future- we ask ourselves is the company being run for the shareholders or the employees? The investment team will then form a view on the sustainable level of annual cash generation of the equity claim and its longer term intrinsic value under a variety of scenarios.
2. Macro-Economic considerations
The investment team will identify key macroeconomic factors that may impact the intrinsic value of the company, analyse how sensitive valuation is to a change in these factors, and form a view on the risk to any such change in these factors.
3. Catalyst Identification
Pivotal to the process is catalyst identification, this ensures we maximise our time weighted return on capital. The investment team view catalyst events as important facilitators of moving the price of a company towards intrinsic value within a shorter time frame. Sometimes we will seek to induce the realisation of a catalyst.
4. Downside stress testing
The investment team seek to understand exactly how much unitholder capital is being risked with each position. Typically we subject the balance sheet to a hypothetical severe downside event. We look at whether tangible net assets as a percentage of total assets is sufficient to satisfy this material disruption and need to be confident there is a low probability of us losing more than we are willing to risk – we specifically report on how much we believe we are risking with each position.
We believe we spend more time on downside analysis than most other market participants. In reality the upside scenario is easy to determine – a stockbroker or CEO will tell you what the stock could be worth in a best case scenario- the hard part is determining the valuation probability distribution and understanding the correlation matrix of all portfolio holdings.
5. Investment edge
In order to invest, we need to understand why the opportunity exists and believe we have a sizable analytical edge over the person on the other side of the trade. We remind ourselves that the seller of the stock has most probably been associated with the story for a greater period of time and try to understand why they are selling.
6. Portfolio Positioning
Given we run quite concentrated portfolios we need to ask ourselves whether the position fits appropriately with our portfolio holdings. We conduct qualitative analyses with respect to expected correlation to existing holdings and whether the position increases or decreases the overall risk carried within the portfolio.
PRUDENTIAL LIMITS AND GUIDELINES
SIAL will endeavour to work within the investment, allocation and other limits set out in this Information Memorandum. However, these should be viewed as objectives only, not as absolute limits. Where they are exceeded for any reason SIAL will endeavour to address the excess and effect adjustment as necessary to meet the limits set out in this Information Memorandum.
Portfolio Weighting Rules:
- No more than 15% of net assets invested in a single position (by cost value).
- At least 85% of the portfolio must be invested in listed equities and cash.
- Maximum cash weighting of 30% of net assets.
- Minimum cash weighting of 5% of net assets.
- No leverage within the portfolio – ie no gearing of equity positions.
- No more than 10% of capital allocated (at cost) to hedging activities, this capital is inclusive of any hedge deposits required.