This is my last post at Eighth Wonder Funds.
I created the Eighth Wonder growth fund on July 1st, 2014. My plan was to use the fund to establish an audited record of investment performance. I also hoped that sharing ideas would make me a better investor.
It has been a successful journey.
I am proud to say that the fund has achieved a return of 25.3% p.a. from inception to today. The ASX/S&P small ordinaries accumulation index increased by 7.6% p.a over this period, so this represents outperformance of 17.7% p.a.
Sharing ideas also put me in touch with some great minds. I am very thankful for the people I have met and the lessons I have learned along the way.
The ultimate goal of the fund was to improve my prospects of managing funds in a professional setting. That day has now come, and this is the main reason why I am shutting up shop.
I have been appointed co-manager of Intelligent Investor’s newly created small cap portfolio. We kicked off on Feb 1st, 2017 as a wholesale fund with seed funding from the parent company, InvestSMART. We hope to open the fund up to retail investors eventually.
I strongly believe that a fund manager’s interests should be closely aligned with the investors. So, after closing Eighth Wonder, I will be transitioning my assets to the Intelligent Investor small cap fund. My primary focus is now increasing the fund’s unit price, with luck, for many years to come.
I will be sharing my thoughts on the Intelligent Investor blog, and I’ll still post with the same twitter account (@ASX8thWonder).
But before I go, here are some of my highlights over the last 3 years.
Hidden gems do exist
With all the talk of efficient markets these days, you could be forgiven for thinking that hidden gems no longer exist. But they do, they really do. You just need to know where to look.
A profitable global leader like Cyclopharm, with strong potential to multiply in size, shouldn’t trade on 5 times earnings. But it was when I found it in July, 2014. You will struggle to find an analyst that wouldn’t have drooled over it at the time. They just weren’t looking. I made stupid returns from this position, and it took relatively little analytical effort to achieve. The returns mostly came from looking in the right place.
This cemented the lesson of carefully allocating your research time to the most productive areas. Instead of looking at Telstra for the umpteenth time, broaden your horizons and look through some unknown companies. You only need to find one.
Risking it to get the spoils
RungePincockMinarco has been a good investment for the fund. Few people know this, but to make the investment, I took a pretty decent risk. But probably not one you might think.
I had been following this obscure mining software company for a few years. My interest was initially contrarian in nature. With mining deteriorating I thought there might be an opportunity to buy it cheaply, so I kept close tabs on it.
In mid-2016, it began to sell off heavily. It looked like a big shareholder was selling and I sensed that this was my window. I needed to act quick, but I was constrained because I felt I didn’t understand the business well enough to take a meaningful position.
As luck would have it, I got a chance meeting with CEO Richard Matthews, who happened to be in Sydney at the time. Anyone who has tried to meet with management, especially a stranger like I was at short notice, will know that it doesn’t always work out.
The trouble was that I was off work studying for my level 3 CFA exam at the time. I should have been focusing on that, as it’s a difficult exam that claims many scalps, but I just couldn’t stop thinking about Runge and mining software. It was a decent personal risk, as if I failed the exam, I would have had to wait another year to re-sit it, as well as having to spend more hours reading boring finance theory.
Richard was generous with his time. He even invited me to a follow up meeting the following morning to show the software in action. It sounds corny, but I felt like a young Buffett having insurance explained to him by Lorimer Davidson of Geico.
As luck would have it, the risk was worth it. I passed my exam, and the investment has played out nicely.
Learning at the school of hard knocks
Corum Group has been the best investment for the fund.
Performance wise, it was a shocker. But because of this significant loss, I was forced to take a long, hard look at myself and my investment process. I think I have become a much better investor because of it.
My investment was based on the view that Corum’s multiple was low enough to offset its challenges. This depended on my assessment of Corum’s cash generating capacity.
Oh, how I was wrong.
Shortly after my investment, news emerged that showed many flaws in my thinking. The biggest was my misinterpretation of Corum’s cash generating capacity. To explain my mistake, we have to go back to investing 101.
For most investments, we are buying part interests in the free cash flow capacity of a business. This capacity can be displayed, and it can also be masked. Sometimes the best investments are when this capacity is being masked by temporary factors.
The opposite also exists. Unprofitable companies can also look profitable due to temporary factors, and this was Corum.
To repay its debt, Corum cut its expenses to the bone under the management of Geoffrey Broomhead. R&D was zero for many years. It allowed Corum to generate cash flow in the years leading up to my investment.
To be clear, I don’t blame management for this. It was a rational decision required to stave off bankruptcy. The blame rests squarely on my shoulders. I overlooked the unsustainably low expenses and made the mistake of expecting unsustainable cash flow into the future.
In the evolving world of software, cutting R&D is not a viable solution long term. Especially when the main competitor is backed by Telstra and its prepared to sustain low profits to dominate the industry. If a business doesn’t keep up, it will eventually result in lost market share, or higher expenses if the company eventually responds. Both factors lead to lower free cash flow.
I should have recognised this, and expected much lower free cash flow from Corum, but I didn’t. I made other mistakes too but I will spare you from them for now.
After some soul searching I made numerous changes to my process. Without going into detail, contrast Corum: which had reported profits, virtually no R&D and a lack of software expertise within the business, to Runge: which doesn’t have reported profits (yet), invests a lot in R&D and has management that “gets” software.
It’s fair to say my investing has evolved, hopefully for the better.
My main focus has always been to avoid losers. I am happy to say that, even with losses like Corum, we have been pretty successful in this endeavour. Since inception, I have made 20 investments. 13 have made money.
In addition to a reasonable strike rate, I am proud of how losses have also been contained in magnitude too.