On an average day Commonwealth Bank (CBA) shares worth $250m change hands. A $10bn fund manager can buy a 1% position simply and easily. Without influencing the price, it would take one or two days. The same manager, wanting to buy the same 1%, will take a month to reach their target weight in food and liquor distributor Metcash (MTS).
What about Enero (EGG), one of the Australian Fund’s holdings? Forget the $10bn manager. A percent of funds under management would buy the whole company. Even a $1bn manager, trying to get a 1% position, will have to own 11% of the company. Trading in the open market would take close to two years.
A month, let alone two years, is a long time. Even trying to buy a stock can frighten sellers off. The stock can rise quickly with few shares trading, reducing any expected gain.
And then you need to get out. Selling many shares in a small stock can be easy when things are going well; excitement and higher prices will lead to more shares changing hands. But when the business is performing badly the stock will fall as fewer shares trade. Any attempt to sell may cause further falls.
None of this should be news to investors in the Forager Australian Shares Fund. It is the reason we have restricted the amount of money we manage in Australia. It’s also one of the main reasons we listed the Fund on the ASX. But it is worth reiterating.
First, today’s size is already impeding our ability to replicate the strategy that generated our historical performance. There isn’t much point us looking at companies with a market capitalisation of less than $50m. Remember that Service Stream (SSM), the Fund’s most successful historical investment, had a market cap of about $60m at the time we were buying it.
It isn’t just the number of potential opportunities, but the price at which you can execute and the portfolio weighting you are ultimately able to achieve. Take contractor Decmil (DCG). After a downgrade of earnings expectations last July, the Fund was a keen buyer. Not much volume changed hands at prices we were prepared to pay though. Stuck owning a tiny 0.2% position, the Fund sold the stock for a small gain.
Or newer portfolio holding 3P Learning (3PL). The Fund was able to invest in the company prior to the price shooting up—the current portfolio weighting is 1.7%. Had we had our way, it would have been at least 5% and probably higher. Our current number of shares would have achieved that when our funds under management was one third of the size.
There will be plenty of opportunities to deploy the money. Participating in capital raisings and helping a large shareholder exit the company are good ways of buying into smaller companies. Freedom Insurance (FIG) is a good recent example. Providing capital when others don’t want to can be rewarding. And in distressed times larger stocks become cheap. Faffing about at the smaller end of the market actually impeded our ability to buy larger mining services companies like Monadelphous (MND) and WorleyParsons (WOR) when they eventually got caught up in the pessimism.
But the issue remains: smaller stock fund managers must consider not only what to buy, but when and how to build a position. We have yet to see anyone investing $500m plus in Australian small and micro caps materially outperform over the long run.
This blog post is an extract from the Forager March 2018 Quarterly Report. If you would like to be added to the report distribution list, please sign up here.
2 thoughts on “Size Kills in Funds Management”
A good honest post Alex to acknowledge that today your opportunity set can be more limited than from 5 years ago.
Others in the industry could easily leave these issues in the background and raise more capital off good performance numbers.
It’s not all bad as you point out though. Reaching a 5% ownership of a company may make exiting the stock difficult in the future but can help to exert influence on running the company if necessary.
I would be interested if in the future you see the fund significantly increasing the number of stocks held in the portfolio? One hand I could see you getting filled on more positions for less than your desired weight. On the other hand, I could see that large block trades or raisings may still bias you to some concentrated bets. Perhaps the direction of markets will be the key. I haven’t been a holder in the Australian fund yet, just recently invested in the international fund where fund size is less of an issue.
I assume these sorts of pains are far more significant if you are managing $200m compared to $100m. So i am wondering why you would grow to $200. The incremental funds under management is probably only worth a bit more than a million pa in revenue to forager? Hence why not keep funds under management at $100million and increase your performance fee to 30 % (or some other number) of earnings over 8%?