QVG Capital's long-short strategy proves a winner

Tony Waters is the Principal and Portfolio Manager at QVG Capital. Now why we're talking to Tony today, is because just recently, the QVG Long Short Fund was named by asset manager Mercer as the top-performing fund investing in Australian shares, returning 29.3 per cent in the 2020 financial year. I asked Tony how he's navigated through all the volatility caused by COVID and discussed the methods QVG uses to identify which companies to take a long position on and which ones to short.

Here's Tony Waters, Principal and Portfolio Manager at QVG Capital.

Table of contents:
Long short strategy
Strategy throughout COVID
View on buy now pay later stocks
Long Short fund details (timeframe, fees, funds under management)
Filters used to pick stocks
Views on the broader market
Is the market overpriced?
Comparison to the GFC
Opportunities fund

Thanks for joining us, Tony, your Long Short fund had an impressive 2020 financial year topping Mercer's list of funds investing in the ASX with a return of 29.3 per cent before tax and fees. Could you start off by explaining what the long short strategy involves and why you chose it?

Yeah, well, it's an extension of what we've done over a long period of time with our small-cap offering, where it's very much a stock picking focus. You know, we have a process where on that long side, we're focusing on trying to find stocks that beat earnings consensus in the market, by looking at a number of fundamental criteria. Primarily things like, you know, balance sheet strength, high return on invested capital and a confidence that will continue with the management incentives and their decision making that will continue to reward shareholders.

Conversely, we saw the opportunity on the Long Short fund where a lot of our time is spent in meetings where you know, it was never really investment grade from us, but we thought, well, that would be a great short opportunity. The Long Short is very much along the same strain as a stock pickers fund. The short component of the fund is very much on the inverse of what we look for in the longs, you know, which is balance sheets, which we think are becoming impaired, earnings that are unlikely to meet expectations in the market. It’s very much catalyst driven where we think the market will start to recognise that in terms of the timing of those shorts.

Just looking at the fund's performance, like most of the market, you had a bit of a rough March with about a 10 per cent decline, but since then it's been all positive. Were you quite active in picking up some discounts in that March crash, or what was the strategy? I'm just trying to get an idea of how you've navigated through COVID.

Yeah. Well, if you take a philosophy of trying to find stocks that beat earnings expectations, COVID changed everything. A couple of cases in point there, for example, we were very favourably disposed towards stocks like IDP Education, which was probably one of the best results in February half year reporting season, fantastic outlook. But if you know that business, where it's English language testing and in international student placement business, COVID, of course, changed everything.

That's just a case in point, there are a few other examples I can give. We could've stuck our heads in the sand and continued with that, or we really changed up the portfolio towards the new environment. We're starting to see that with the early results in August and what that looks like, and who are the winners in the post-COVID environment. The news flow focuses on the significant losers and there are plenty of those also, but it's really a matter of changing up that portfolio to suit the new world environment that we live in. In March, we did have quite a high churn in our portfolio in both our Small Cap and our Long Short portfolio and the results post that change up in March, have worked so far.

Just prior to that March crash, did you have a typical type of company in terms of size or industry you were looking at investing in, and then how much did that change in terms of your shift in your view of the market and what opportunities there were?

Yeah, well, Long Short is an all cap strategy. We look at opportunities irrespective of where they are on the market capitalisation range. The Long Short fund currently sits in the mid-50s in terms of funds under management, so there's plenty of flexibility to go down the spectrum in terms of both long and short opportunities. In the current world where a significant chunk of the market is passive money and the growth in ETFs, there's plenty of opportunity to borrow stock and short across the spectrum. The answer is we haven't really changed in terms of size of company, pre or post COVID it's just the sectors and the type of company that are going to be winners in the new world have changed.

On the shorting side of things, what type of companies did you see straight away as being negatively impacted by COVID? Were you straight onto those sort of travel stocks, or what were some of your better picks?

Yeah. Generally speaking, what's happened in the COVID world is themes that we were seeing in the market have effectively fast forwarded two to three years. Flexible workforce, the mobility of the workforce, the conversion of the physical stores to online retailing. These sorts of trends have effectively sped up and, you know, sectors such as the media sector, for example, which has been structurally impacted for some time have been worse affected. Obviously, travel is a component, but there wasn't really so much an immediate short on travel. It was really more coming on some of the rebound in those stocks coming out of some of the capital raisings that were done. We felt the valuations were way too optimistic on the outlook that we saw for that sector. Yes, there has been some benefit in that sector, but it wasn't so much in March, it was really subsequent on the initial rebound.

And just on the long side of things, did you have strong positions on the tech industry and buy now pay later stocks, or what's been driving your performance on that side?

We've had a long term position in Afterpay and continue to hold that name and that's been a position pretty much since the inception of QVG. We started in mid-2017. Afterpay has been a beneficiary of COVID, despite the initial prognosis given the shift to online and if you have a look at Afterpay’s transactional volume, you know, it is 90 per cent online even going into COVID. The increase in that spend has proven to be beneficial for them.

What's your perspective of the buy now pay later sector? Afterpay is obviously the biggest example, but there's an increasing amount of other companies coming into competition with it. Do you feel as though it's going to be a winner takes all situation, or do you feel they can all co-survive and all be profitable going forward?

No, definitely the former, my view on it is it's definitely the ultimate economies of scale business model and Afterpay could survive and prosper on reduced margin and that will make it very hard for the competition. We're certainly not of the view that we own the sector. It's very much specifically focused on Afterpay and a lot of the other players have effectively had other consumer finance businesses and given the success of Afterpay, have increased their focus on the buy now pay later space. But if I can call it this, it's effectively a bastardised model in terms of their business model, whether it's a Flexigroup or Zip, for that matter, to give two examples. And then the other, smaller more recent examples, it's going to be a big question mark, whether they have achieved the scale to be able to compete successfully long term.

Do you mind quickly running us through for that Long Short fund, what's the expectation in terms of returns in the timeframe investors should be looking at with that fund?

Yeah, look, you know, it's been a great first year, but the reality is, it doesn't matter what your process is. There will be periods in the market where you won't get the performance. I think anything less than a three to five year view, I would consider very short term. That's the focus for us. Having said that, with the funds under management size, that the Long Short fund is at the moment, we can be quite flexible about positions and it'd be very quick on opportunities in the market.

What is the number for funds under management at the moment?

It's currently sitting in the mid-50s. Yeah, around $55 million as we speak.

Could you just take us through the fees for that as well?

Yeah, sure. We do have a performance-based incentive and given it's an absolute return fund, that's the over and above the cash rate on 20 per cent of profits. Then there is a base fee as well, which again, is very much in line with what we see with peer funds in the market which is sitting at 1.5 per cent.

You briefly mentioned earlier the filters you use when you're picking stocks to either take a long or short position on, could you delve a little bit more deeply into that? What do you look for in terms of, I think you mentioned balance sheet strength and things like that. What filters do you use to pick these stocks?

Yeah, sure. Well maybe we start off with the shorts, a perfect short for us is a company that's structurally challenged, has a highly geared balance sheet and structurally challenged, meaning they're facing, you know, the world is shifting away from their business model and there’s significant competition coming in the space where they're likely to not make earnings expectations in the market. Probably the end result of all that, is a capital raise, or if the market does not have confidence enough in the business for that to happen. We've got a couple of stocks in our short portfolio that have been long-term suspended. For example, SpeedCast, iSignthis are two examples of that. That's, I guess, the prognosis of the perfect short.

A perfect long is the exact opposite of that, where it has balance sheet strength, there's high returns on invested capital. That's the stocks we focus on where they've got a much higher probability of beating earnings consensus in the market based on those fundamentals. And you'll typically see the long side of our portfolio will have far better than market average balance sheet strength, far better than market average returns on its capital base. And not necessarily the case, but typically, as a result, they’ll have higher earnings growth than in the market overall.

And just on a broader level, how are you viewing the COVID-19 situation in regard to the Long Short fund? Because obviously there's still quite a bit of volatility in the market, so how will you be mitigating the risk moving forward?

Well we find there's a huge demarcation line between winners and losers, and post the unfortunate situation in Victoria, where prior to that, where Australia was handling the COVID situation better than expectation, you know, the market as a whole was rising. Now, you're seeing very much a demarcation line between those that – we now know the stocks from trading updates that are working in a COVID environment and those that aren't. We’d think of a sector basis, you know, travel's an obvious one but a lot of the cyclicals as well will be struggling, particularly media is another very good example of that. And retailers that have a high physical store presence and very little online presence. Of course, the opposite is true, and we're seeing results just today from Adairs, and a Kogan trading update that have done extremely well on the retail space, in a post-COVID world.

And beyond that, there is still some physical stores that are working well in what I call big box retailers. Whether it's Bunnings with Wesfarmers or stocks like a Super Group, which is typically big box format, where you can drive up in your car, have very little contact with other people, get what you need to get and get out of the store. You know, those stores have held up very well. Nick Scali had a terrific result last week. There's some sectors that are actually working. That points to a very good result with Harvey Norman coming up in reporting season as well, particularly as they sell in categories that have proven to be very buoyant, in furniture and electronics.

How are you viewing the market overall at the moment? Are you seeing that it’s overpriced or do you still feel like there’s still opportunity to buy at the moment?

Yeah, well, it's important to know, what you see in news flow versus what the market is focused on, is two different things. The news flow is, of course, quite negative at the moment, whereas the market is looking at where we're going to be, you know, effectively in 18 months’ time and looking into FY21, FY22 numbers. If this flu situation goes on where we have Victorian type situations pop up to the extent that it has, then clearly there's a good case for the market to be overvalued. But where we see it at the moment, we don't focus so much on the market, which, we think the rebound was justified. Now it's becoming a lot more difficult to suggest the market still has a long way to go on that. It's really a matter of focusing on the stocks within the current environment that will work and there are significant winners still in a post COVID world.

And could you give me a bit of background about yourself, Tony? Because I understand you've got quite a long history in small and microcap investing, is that correct?

Yeah, that's correct. Yeah, the business is owned by myself and Chris Prunty and in more recent times, Josh Clark, who worked with us at Ausbil, in the Ausbil Microcap fund, we were there for seven years. And then we started up QVG capital, as I mentioned, in 2017. Josh is actually the portfolio manager of the Long Short fund, so credit to Josh for his performance to date. I was sell-side research, institutional sell-side small-cap research you know, going back to the late 90s and then went to the buy-side and then started up the Ausbil Microcap fund. And Chris came along to join the ride with me there in 2010 and that's the history.

You were involved in the GFC and investing throughout that. How has that experience, I guess, helped you through this current market crash? Is there anything you're able to take from your previous experience?

There's some similarities, but it's worth stating from the outset that this environment is very different to the GFC insofar as a typical economic downturn is predicated by a credit crunch or certainly, a tightening in money conditions typically, whether it's inflation getting out of control, or a misallocation of capital, which the case of the GFC into a certain sector of the market. This is completely different. You know, the economy in either Australia or globally wasn't particularly buoyant, but certainly, there was no indication of significant credit tightening. It’s very much borne out by the flu and forced lockdown. And conversely, I can see a scenario that if, and when we get a vaccine, that you could have a significant uplift as a result.

Having said that, the cure or the way governments have handled the current crisis, does have some significant similarity to the GFC where we've felt we've seen this movie play out before to a factor of, really this time around given, the stimulus post the GFC, through quantitative easing and the like, didn't result in significant inflationary outcome.

There’s a number of reasons, we could do a whole podcast about that. I'm not an economist, but there's a number of theories as to why that's happened. And given the result of that, it was, you know, very likely that the governments wouldn't hold back in terms of stimulatory response. And that’s certainly happened, it's actually a factor of, over and above what was seen during the GFC. What we saw during the GFC when that happened was commodities, particularly precious metal commodities in particular, had a significant run and we felt that was going to play out this time around. We have upweighted our exposure to gold, in particular.

How much of this investor confidence that we're seeing reflected in the market is due to that stimulus and the confidence that central banks are going to keep being flexible with monetary policy? Do you think the way that people are valuing companies has differed?

Look, I think, stimulatory response by governments in terms of what's happening in the market, is everything. It is absolutely why we've had the recovery in the market that we have. It's worth noting again, in terms of looking at the economy that, you know, you're looking at the listed market, you're quite often looking at a very different beast to what the man on the street sees. You know, if you're a restauranteur, or running a gym or a hairdressing salon, you know, you’re experiencing significant pain at the moment. Whereas, you take it to the market capitalisation level of your typical listed stocks, certainly in the ASX 200, where a lot of those stocks came cap in hand to the market, raised money, shored up their balance sheet and then kept on keeping on. Which is a very different environment to your small business person. That doesn't mean to say there's not significant hurt in some listed companies as well, which we've just talked about previously, but it's a very different environment.

I wanted to get on to QVG’s other fund that we haven't discussed that much, but the Opportunities Fund, which I think you're the portfolio manager for that. How's that been performing?

Yeah, I mean, we’re 800 basis points ahead of the Small Ords over the last 12 months. We're pleased with that. We're pretty much at the same level in terms of where we were 12 months ago with the market significantly down on that basis. And there is some overlap in terms of our long exposure to the Long Short fund. It's been similar where we've changed up the portfolio very much during late February and March and then had a good rebound in performance since then.

Yeah, so obviously there was that big hit in March, which I think, you were quite a bit more exposed to that crash in this fund, as opposed to the Long Short one judging by the results. But what were some of the better performing positions you had throughout that period? Were there any differences from positions you took in the Long Short one?

Yeah, I mean, a little bit different in terms of the weighting. Of course, Long Short had the benefit of being able to short during that period. In the long portfolio, it was in many cases, sticking with companies that we think would get through the crisis and come out the other side, looking better. We had a decent position in Afterpay, for example, and that's performed very well out of a bad March. Tyro Payments is another business where we think will be structurally better off post COVID, given a percentage of transactions in cash in the small business space will be significantly reduced and have been significantly reduced during the course of this virus. And there's been stocks that have benefited very well as well in the telecommunication space, for example, like MyNetFone, Unity Wireless, OptiComm which is now merging with Unity Wireless, which is a decent position for us. And stocks, which are somewhat immune to the virus. Elders, for example in the agricultural space with a good retail distribution and trading business throughout the country, has had a great result and we think there's more to come from that company.

Could you just quickly take us through the fees for that Opportunities fund as well?

Yeah, so the base fee is a little bit lower, it’s 1.2 per cent base, and performance of 20 per cent over and above the Small Ords Accumulation Index.

Great. Thanks very much for your time, Tony. Good luck with everything.

Not a problem. Thanks for the opportunity to talk about QVG.

That was Tony Waters, the Principal and Portfolio Manager at QVG Capital.