By Graham Hand, Managing Editor, Cuffelinks
Introduction: Sebastian Evans is Chief Investment Officer and Managing Director of NAOS Asset Management. NAOS manages three listed investment companies (LICs) with concentrated exposures to Australian listed industrial companies outside of the ASX-50. The LICs are in micro-cap stocks (ASX:NCC), small caps (ASX:NSC) and mid-caps (ASX:NAC).
GH: In the micro investing universe with more than 1,000 companies on the ASX, where do you even start to look?
SE: Sometimes we are criticised for having too few positions but we have strong company screens. We use ESG checks and we don’t invest in resources, oil and gas companies, exploration companies and anything smaller than $10 million in market cap. That rules out most companies.
Then by the time we meet credible managers who can deliver on expectations and run public companies under pressure and meet goals and objectives, we’re quickly down to about 50.
GH: Do you meet the management of every company before you invest?
SE: Yes. In some of our investments, we might own 25% of a company, so we’re intimate with them – board, directors, senior executives, unlisted competitors, ex-employees … all the war stories. That’s where I spend most of my time, with the investments. We’re not traders, we’ve had some investments for seven years, which is essentially the length of our business.
GH: Given that management have continuous disclosure obligations, what sort of things do you get from them?
SE: The biggest is consistency of the message and that they deliver what they say they’re going to do. In small businesses, as soon as something’s not consistent or the messaging becomes loose, it tends to show there’s something a little wrong. And then it can become seriously wrong quickly.
GH: Are you looking more at the person or the business or both?
SE: I learned the hard way that backing people in small business is almost everything. Good people are driven, they can manage teams, they have to run a listed company, and there are few people who can do all that well.
But if you invest in an industry that’s struggling, you’re not doing yourself any favours. You want to operate in an industry that has growth prospects today and for 30 or 40 years.
GH: After the success of growth stocks versus value in the last five years, do you feel the decision to restrict to industrial stocks has limited your performance?
SE: From an investment and performance point of view, it’s definitely hurt. But from a company brand and business point of view, it hasn’t hurt as we’re consistent with our messaging. We’re very transparent, people understand what we invest in.
Sometimes, the best managers in the world go through periods where they are in the lowest quartile of performance. And unfortunately, although I don’t look at tables, I’m sure we’re in the bottom quartile in the past 12 months. Would I change it? No, because it’s what we feel comfortable with and the team has invested in. There’s no point in me managing other people’s money and trying to invest in businesses that I can’t understand and don’t feel comfortable with.
GH: Why have you chosen the LIC structure, given it’s a double-edged sword? You raise committed capital but you have to manage problems such as trading at a discount.
SE: We used to run two small managed funds, but we’d spend a lot of time on ratings, getting on platforms, generating advice demand. You know, all the conflicted gatekeepers. The real growth was never going to happen. We were the first LIC to list after the success of MFF (Magellan) but of course the market has come a long way since then.
Using the LIC structure was the smartest thing we did in the Australian micro-cap sector. I heard a prominent fund manager interviewed last week about his unlisted fund and he said, “Never invest in illiquid stocks.”
GH: Because of redemptions, which force you to sell.
SE: Yes, and you can’t recover your losses. If something goes wrong, the fund can kill you. We take a very different view. We operate in a LIC format. We don’t suffer from redemptions and we can invest in illiquid businesses that might be better than liquid businesses. Often it’s illiquid because the founder has a large stake. The benefit of a LIC is you’re not forced out of some of these businesses today. You can wait for them to become successful businesses.
GH: In the micro space, do you find sometimes you’re the only professional analyst?
SE: Yes, sometimes we’re the only fund manager on the register. If look at all the positions in our micro-cap fund, there might be two that are covered by brokers with one or two other fund managers there.
GH: And you see that as a comparative advantage?
SE: I do, but people will have their own views. I can get on my mobile phone now and I could call any managing director of stocks we own and they would pick up and talk for an hour and a half about the business. I could ask them for referrals from customers, old employees, whatever. We might not make money on them in the first six months, or even the first 12 months, but I feel we benefit from that level of understanding. A lot of bigger fund managers don’t waste their time on a $10 million investment.
For example, we have a big position in a company called MNF Group. It’s a voice-over-internet telco capped at about $300 million, where the founder owns 40%. Also, Lifestyle Communities, a retirement village operator capped at $500 million. We understand these businesses, especially when some of them are unloved.
GH: We’ve talked about the upside of the LIC structure. What about managing the downside? Most LICs trade at a discount to NTA, and a couple of yours are at decent discounts.
SE: Yes, it’s frustrating. The LIC that we acquired (Ed, now ASX:NSC, formerly Contango Microcap Limited) was a lot harder than I thought it was going to be, as it trades at a big discount. When a LIC doesn’t perform, it can fall out of favour quickly, and that’s had more sellers than buyers. But I believe if you pay a good dividend, it puts a floor under your share price as long as you’ve got the reserves for the dividend. Our dividends have gone up every year for seven years.
NAOS spends a lot of time and money on messaging and marketing, even though we’re not a profitable business. Our biggest investors are in places like Rockhampton and Adelaide, not Sydney or Melbourne, so for us to find the people who actually invest in LICs is very time-consuming. It’s about developing their relationship with us as their fund manager.
GH: It’s difficult for anyone to corral SMSFs, with 1.1 million trustees who are hard to identify and pin down.
SE: Exactly. It’s a borderline nightmare. You need to find advisers who are not aligned or pitch to individuals on why we can invest in a market better than someone else. While in our space, there’s not a huge amount of competition but our performance has been poor. The key is consistency of message but it’s definitely not a get-rich-quick scheme.
GH: Given the size of your dividends, are you surprised it hasn’t led to more support? Many claim retirees are interested in income and not overly fussed about what’s happening with the share price.
SE: I don’t think there’s a lot of new money coming into equity LICs at the moment due to the uncertainty about franked dividends. They’re looking for debt funds and offshore funds. NSC is the one we acquired (Ed, current discount to NTA 20%) with 6,000 shareholders, and we added 900 new ones to that but we lost 1,900.
GH: Would you like to name a stock in each of your funds that you’re most confident about?
SE: In NAC, our biggest holding is MNF Group, and a lot of products offered by companies like Google and Facebook are voice-over-internet. Uber and Carsales use MNF. In NSC, we like another telco called Over The Wire. It’s a one-stop-shop for telecommunication services, cloud services, security services, things like that. And finally, a small one in NCC is a business called Wingarra. They export oaten hay and red meat to China and other places in Asia.
GH: Okay, to finish up, what skill are you most proud of that makes NAOS a better fund manager?
SE: Being able to stick to what we have always said we will do. I’ve been doing this for 11 years and it’s getting harder. Look at all the fund managers that have closed recently, and the competition from ETFs and index funds. I appreciate you’ve got to understand when something’s not going right and you need to adapt to the times. But I think you need to stick to your core philosophy and we’ve been able to do that. And hopefully, it’ll bear fruit at some stage.
Graham Hand is Managing Editor of Cuffelinks. This article is general information and does not consider the circumstances of any investor. Disclosures: NAOS Asset Management is a sponsor of Cuffelinks, and Graham Hand’s SMSF owns shares in ASX:NSC.
Cuffelinks: Published 02 May 2019