Broad investment mandates are common: single stock positions of 10 per cent of portfolios, no constraints pertaining to industry segments, and the ability to let cash accumulate to 10 per cent or 20 per cent of the fund. Such loosely constrained stock and sector limits give managers the opportunity to build portfolios using their best investment ideas, and in a number of cases this has paid off. Gorman says all the micro-cap managers rated by S&P have the flexibility in their mandates to hold large cash positions – sometimes up to 40 per cent – which was exploited by managers seeking safe havens during the global financial crisis (GFC). Contango is a lone wolf in the micro-cap space because it does not have an open-ended fund for the retail market due to the sector’s volatility, says chairman David Stevens. The company only offers a closed-end listed investment company, Contango MicroCap Ltd (CTN), which has more than $320 million under management in the micro-cap space, which Stevens loosely defines as ex-ASX 300.
He argues that open-ended funds in illiquid asset classes have inherent problems because such funds can become “extremely popular and then unpopular with investors”, making wholesale bolts for the exit difficult to facilitate. Accordingly, Contango chose to offer only the closed-end CTN in 2004 as “a business decision, understanding the nature of investors,” he says. “We’re exceedingly happy with the performance of our micro-cap capability and the way CTN rode out the storm of the GFC.” Since its March 2004 inception, the microcap investment fund returned 24.3 per cent and 15.4 per cent above the small ordinaries index and 14.9 per cent above the All Ordinaries index, he says. Despite the asset class’s ability to generate returns significantly above bonds on a risk-adjusted basis over time, Stevens says microcaps are “consistently undervalued” and recommends that long-term holders be constantly overweight in the sector and force themselves to accept its volatility. However, Contango does “actively time markets with our industry overweights and cash allocations,” he adds.
“During 2008, we held 40 per cent cash and reinvested this in March-April 2009. We recommend that clients don’t second-guess their investment managers.” The micro-cap sector, which is not covered comprehensively by brokers, provides managers with the opportunity to unearth new information about companies, says Jack Callopy, portfolio manager of Perpetual’s smaller companies fund. “Investing in smaller companies gives greater alpha opportunities as these companies are often under-researched and undervalued compared to their larger peers,” he says. He concurs with S&P’s Gorman that three crucial skills for managers in this space are: understanding the industry in which a company operates, the company’s business model and management’s ability to source and use capital. Callopy says Perpetual has “an exceptionally well-resourced team of analysts who spend a lot of time out of the office meeting companies of all sizes, both listed and unlisted”.