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The Eley Griffiths Group Small Companies Fund

The fund invests in shares of ASX-listed Australian and New Zealand companies that fall outside S&P/ASX 100 index, plus some cash. The cash weight may range from 0-20% of the portfolio valuation at different points in time.

Eley Griffiths Group has evolved an investment philosophy that combines market experience and analytical rigour with a disciplined stock selection process. This coupling has long been our differentiator in a market active with investors looking to take advantage of mispriced opportunities.

The manager assesses risk at the company level (via detailed modeling of publically available accounts and management discussions) as well as at the portfolio level. At the portfolio construction stage a number of limits apply to any given investment or allocation. A practical minimum and safe maximum bet size are adhered to as are limits on the % of a company’s issued capital that can be held. This addresses the importance of tradable liquidity when investing in this class of equity.

Investee companies must be quit within 2 years of their inclusion in the S&P/ASX 100 index, ensuring the portfolio is recycled and focused on other listed small companies. The allocated cash weighting will also reflect the managers view of prevailing valuations and market health at a particular point in time.

 


 

  • We believe that markets do not always price small companies efficiently and that these inefficiencies can be exploited using market experience, intelligence and disciplined research & stock selection processes. We believe that the performance of a stock is driven by the relative strength of its management, industry structure, earnings profile and its valuation. The investment case can only be assessed through ongoing rigorous qualitative and quantitative analysis on a company-by-company basis. This occurs against the backdrop of a live equities market.

    We recognise that the performance of each individual security is inherently uncertain and that the application of a sound investment process and risk discipline is key to adding value at the portfolio level.

  • EGG is an active manager of small companies. EGG operates a score-based assessment of companies factoring in such attributes as management quality and track record, industry growth rate, industry structure, company specific growth rate and company valuation relative to the market.

    Our fundamental assessment of a company’s management, industry structure and valuation tends to bias our investments towards well managed companies with good industry structures that are attractively priced relative to the market. We believe that companies exhibiting these characteristics will deliver above average returns over the medium term. Simplistically, EGG would apportion its process value-added as below:

    Source of Value Added

    Contribution to Performance (%)

    Sector Selection

    0

    Stock Selection

    75

    Factor Tilts

    0

    Cash Allocation

    5

    Other [Portfolio Weighting]

    20

    TOTAL

    100

    EGG also rates the level of influence each of the following in our stock selection process:

    Factor

    Contribution to Performance (%)

    Value (e.g. P/E, dividend yield etc)

    25

    Past Growth (exhibited in dividends, earnings or free cash flow)

    5

    Projected Growth (e.g. Dividends, earnings or free cash flow)

    20

    Technical Analysis

    0

    Quality of Management

    30

    Quantitative methods (e.g. Dividend discount models)

    0

    Index Weights

    0

    Other [Industry structure]

    20

    TOTAL

    100

  • EGG’s stock selection centres on the following key areas:

    • Qualitative assessment of industry structure & management quality, using a Porter-style analysis; and
    • Quantitative assessment of company valuation.

    These two areas of focus are complementary & inter-related. Valuations are updated as new information becomes available either as a financial report or in a form that might impact upon industry structure and management.

    Research

    Approximately 90% of EGG’s research is conducted by the portfolio managers, with external research comprising 10%. Internal research is based on an extensive company visitation programme, review of publicly available information, financial modelling and score-based assessment. External research includes information from stockbrokers, industry reports and data from government agencies. Real-time data is sourced from IRESS Market Technologies. This information is incorporated in company and industry research notes and centrally located on our electronic database.

    EGG’s universe consists of all Australian listed stocks outside of the S&P/ASX 100 Index (around 1100 stocks). This universe is screened, with the primary screening criterion being market capitalisation. EGG will focus on stocks with a market capitalisation of at least $50 million, plus selected other stocks that our market intelligence suggests to be worthy of consideration, such as IPO candidates. This becomes the active list, which currently comprises around 220 stocks.

    Qualitative Assessment -Assessing Industry Structure

    To develop a detailed understanding of the quality of the industry structure, our analysis considers both the outlook for a business sector and a company’s relative position within its sector. This assessment focuses on the following factors:

    • Long-term growth outlook for the industry relative to GDP
    • Barriers to entry
    • Risk of changes in the regulatory environment
    • Actual & potential competition
    • Substitutes available to customers
    • Supply & demand outlook
    • Depth & breadth of customer base
    • Pricing power

    Qualitative Assessment – Management Quality

    EGG’s assessment of management quality is based on five key criteria:

    • track record of management execution in improving the value of the business and generating returns for shareholders
    • ability to articulate and execute existing business strategies
    • ability to appropriately manage the capital within the business
    • clarity of the strategic planning process (e.g. our confidence in the company’s communication of business strategy and operating conditions)
    • degree of management alignment with shareholders interests.

    EGG places a great deal of emphasis on regular dialogue with company management and industry participants, to ensure information is current. Also important is regular contact with the company’s competitors as well as its suppliers, customers and a wide range of other industry participants in a position to contribute other views.

    The investment team at Eley Griffiths Group take part in excess of 500 field trips and company briefings per annum.

    Qualitative Assessment – Output

    A qualitative score is assigned to each stock by rating industry structure and management quality on a relative basis.

    Quantitative Assessment – Valuation

    EGG has developed a comprehensive valuation methodology, which is based on specific financial data from the company’s annual report and appendix 4E/D statements. EGG has generated a comprehensive library of financial models for Australian small companies. The base data, which the models use, is in a format prescribed by the ASX and is thus consistent across companies. The financial models have in-built integrity checks, which include reconciliation of the company’s profit & loss, balance sheet and cash flows, thus ensuring consistency across income and capital items.

    Key assumptions on revenue streams and margins are input into the model, based on our extensive research. The models project the balance sheet, earnings per share (EPS) and cash flow generation for the next three reporting periods. From this, the model derives a time-weighted EPS growth rate and the forecast price earnings ratio in the current year for each company. These models are then factored into a database, which then derives a relative valuation score for each stock based on the following two factors:

    • earnings per share growth profile
    • price earnings ratio.

    The financial models are updated promptly when interim & yearly results are announced and are also updated throughout the year based on insights from our qualitative research. The models are dynamically linked to market pricing and they produce quantitative valuation scores on a real time basis.

    Overall Scoring of Securities

    The quantitative & qualitative scores assigned to each stock are equally weighted to derive an overall score, which is the key input to our portfolio construction process.

    This scoring system promotes consistency and transparency in the research process.

  • An algorithm is used to assist in the portfolio construction process. The algorithm is called “SCOPE” standing for “Small Companies Optimal Portfolio Evaluation”. SCOPE translates stock scores into recommended active portfolio positions. It ensures consistency between the scores & recommended positions while taking account of practical requirements in constructing active portfolios (relating to minimum absolute and relative position sizes) and adhering to the predetermined risk limits (including maximum active bet size, liquidity and maximum percentage ownership levels of any one stock).

    The process explicitly contemplates limited discretion for tactical deviations from the positions recommended by SCOPE, subject to not breaching the risk limits. Such tactical deviations are limited to 100 basis points per stock and are based on short-term issues, which cannot be satisfactorily incorporated into our core research such as corporate actions, M&A activity and short-term cyclical influences. Manager justification is required in implementing tactical deviations, which in practice tend only to be reserved for a small number of stocks at any one time.

    Schematic of Portfolio Construction

    Below is a schematic chart of the Eley Griffiths Group model portfolio as at July 2003. The chart maps the stock score on the X-axis to the recommended active bet on the Y-axis. As can be seen, the higher the score the higher the active bet. The portolio cut-off score is approximately 1.10, and therefore stocks with a score of less than 1.10 are not included in the portfolio. As such, they comprise a negative active bet.

    Stocks whose scores are between 0 and 1.10 represent the most fertile area for further investigation. These are the stocks that are most likely to be included in the portfolio at some future point should their scores improve.

    Number of stocks held; Style bias

    The portfolio will typically contain between 35 and 55 stocks. The research and portfolio construction process incorporates a growth at a reasonable price (GARP) methodology, with a qualitative factor overlay.

    The style bias may vary at different times as the quantitative scoring process is based on individual stock outcomes relative to market. However, the portfolio is not expected to show either strong value or growth characteristics at any point in time.

    Buy & Sell Disciplines

    The Buy/Sell decision is the logical outcome of changes in each individual stock ranking, relative to the universe of available stock choices. These rankings will change as the underlying scores change. Changes in scores will be driven by:

    • Valuation – stock pricing affects stock scores, as do earnings forecasts
    • News Flow or research which changes the management or industry structure score
    • Selection Effect – overall rankings are relative to the universe so for example stocks whose parameters stay the same whilst all others are improving will suffer a deterioration in their overall scores

    SCOPE suggests a portfolio weight for an individual stock, which is directly correlated to its score. Therefore improving or deteriorating scores are immediately processed to a new appropriate portfolio weighting. Normal “portfolio drift” is accommodated in the process to avoid over-trading. Therefore the Buy/Sell process is an integral and logical part of the investment process, and affords the manager a tool to effect a proportionate response to a change in a company’s situation.

    Transaction Strategy

    In order to gain best execution for clients and unit holders, EGG will use a wide range of brokers that can add value to trading positions. EGG will take a very hands-on role in the dealing strategy, giving brokers specific instructions regarding size, timing and price of purchases and sales. Performance against these instructions will be monitored on a daily basis. The benchmark used to rate stock execution is the Volume Weighted Average Price. This index measures the average traded price of major stocks each day and EGG will expect stockbrokers to match or better this outcome for “at market” orders.

    Portfolio Risk Management Policy

    EGG seeks to manage risk both at the stock level and the portfolio level. At the stock level EGG constructs financial models (where possible) and forecasts financial performance for the next three reporting periods. The models contemplate profit & loss, balance sheet and cash flow performance, and are internally reconciled. The detailed qualitative assessment and company visitation programme is also a risk management tool at the stock level.

    At the portfolio level, the EGG small company portfolios will be managed with reference to the following predetermined risk limits, relative to the S&P/ASX Small Ordinaries Index:

    • min/max stock position relative to index: +/- 5%
    • maximum holding in any stock: 10% of the market capitalisation of that stock
    • liquidity constraint: a maximum stock position of 100% of turnover over a rolling 6 week period
    • if a stock held within the portfolio becomes part of the S&P/ASX 100 Index, then it must be sold out of the portfolio within a maximum of two years.
    • no short selling

    While not a hard risk limit, portfolios will generally be managed with an ex-ante (forward looking) tracking error of between 6% p.a. and 12% p.a.

    *Unless otherwise agreed with a client and detailed in the relevant IMA.

 
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