Two of the Forager International Shares Fund’s largest holdings are blue chips Alphabet (Nasdaq: GOOG) and Lloyds Banking Group (LSE: LLOY). Both of these companies are well known, many tens of billions of dollars in size and covered by almost every investment bank in the world. What are they doing in a fund where the holdings mostly consist of much smaller stocks?
We are guiltier than anyone of associating ourselves with the small cap universe. In our writing and our public comments, we often stress the advantages of investing in smaller, lesser known companies. A year ago we highlighted how the Fund would reduce its exposure to large blue chips and focus on these smaller, deep value investments. We continue to believe that compelling value is far more likely at the small end of the market cap spectrum, and this remains the core of what we do.
But as the world trudges through year eight of the current economic expansion, risk management challenges have bubbled to the surface. Most stock markets have priced in aggressive expectations. Companies failing to meet those expectations have seen their share prices hammered.
Many businesses are earning in excess of our estimates of sustainable earnings, and investors are paying high prices for those earnings streams. Many of them will likely see their results deteriorate as the long arms of competition and capital eventually close around them.
Challenging capital allocation decisions
We have no insight into when any kind of market correction will occur. But as allocators of capital, we must choose which sort of risks we are willing to accept. We must also decide how much we are willing to pay to assume those risks. Large companies generally have less risk because they have more robust businesses. They have usually grown to be large because they possess some kind of advantage, and the fact that they are large gives them economies of scale advantages. Both Alphabet and Lloyds fit this description.
Our decision to own these stocks has been driven by two primary forces. Most high quality, less risky businesses command hefty premiums. Alphabet and Lloyds do not. They are unlikely to produce returns of 20% per annum, but they should deliver consistent results without taking excessive amounts of risk. Any type of downturn will impact their businesses to a lesser degree. This type of investment should be useful in an aging bull market.
Which leads to the second reason: in a frothy market, even the small caps that we would normally be attracted to trade at prices that make us flinch. The opportunities we are finding are mostly cyclical companies. Granted, they are also mostly operating in Europe, where the economic recovery has only recently begun, but there are limits to how much portfolio exposure we want to these types of businesses.
Blue chip from time to time
So there are less small cap opportunities. Those that do exist are lower quality businesses and the portfolio is already 30% cash. Owning a few high quality companies at reasonable prices makes perfect portfolio sense. In fact, a few more would be wonderful.
The International Fund has a very flexible mandate for exactly this reason. Over the long-term, you should expect most of our excess returns to come from smaller, lesser known companies. While waiting for those opportunities to arrive, expect us to allocate capital to the best risk adjusted opportunities we can find. Right now, that includes a select number of blue chips.
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