Richard Ivers, portfolio manager for the Prime Value Emerging Opportunities Fund, has notched up his first three years in charge of the small caps investment fund.

Markets have thrown just about everything at investment managers during this time: from flat spots to record highs, and the 'fastest bear market in history', which happened as COVID-19 panicked investment markets.

Ivers steered the Prime Value Emerging Opportunities Fund to several key milestones, including being the second best performing Australian equities fund for the 2020 calendar year.

He has delivered returns well above the market by prioritising capital protection. "Protecting capital is the most important step for us because if we minimise losses we maximise opportunities.

"Every market event creates opportunities. The volatility we have seen in small caps across COVID has provided us with excellent chances to invest in quality companies poised to do well during the recovery and beyond.

"But it all starts with a commitment to preserving capital, which means avoiding the speculative stocks and looking through the hype to find real quality."

Key numbers for the Prime Value Emerging Opportunities Fund:

For the last three years the Prime Value Emerging Opportunities Fund has delivered 20.7% per annum to investors while the index returned 9.1% per annum - this means the Fund has outperformed the index by 11.6% per annum net of fees.

During this three years:

• The Fund has outperformed 87% of months when the index has fallen (13 months out of 15)
• Outperformed 52% of months when the index has risen (11 months out of 21)
• Outperformed 67% in total of all months (24 months out of 36).

The last time the Prime Value Emerging Opportunities Fund underperformed in a falling month was December 2018 - over two years ago.

For the year to 30 April 2021 the PVEOF has delivered 54.91%, outperforming the small ordinaries accumulation index by 15.14%, outperforming strongly during 12 months of rising markets.

The Fund has delivered 13 consecutive months of positive returns, while the index has had three negative months during that 13.

The Prime Value Emerging Opportunities Fund's last negative returning month was March 2020 (during the COVID crash).

Performance has been achieved at a lower level of volatility than the market: risk, as measured by volatility, (standard deviation) has been 13.8% below the index. This results in a far superior Sharpe ratio, which measures risk-adjusted returns.

Most articles we read are about hot stock tips to buy. Occasionally there are articles about "shorting" opportunities, albeit most are directed to sophisticated investors given the risks around shorting (i.e. a potential loss that exceeds your initial investment). Very few articles talk about when to sell.

However, it can be just as important to know when to sell as when and what to buy, a key skill in active management.

The Redbubble thesis revisited

Last year, we highlighted Redbubble as a COVID winner with global aspirations. The business was a significant beneficiary of lockdowns and stimulus payments - with their years and dollars of investment in the artist platform, logistics and supply chains - paying dividends during the global e-commerce boom, especially in their key US markets.

The company's execution during this period was stellar as it managed the significant spike in sales volume during the COVID work-from-home period. It was quick to take advantage of the boom in facemask demand - an entirely new product category - which immediately became a major contributor to revenue.

The marketplace platform also demonstrated the power of operating leverage, as 96 per cent growth in Revenue delivered 1,028 per cent growth in EBITDA (albeit off a low base) in the December 2020 half. Incremental margins of 25-30 per cent helped drive improved profitability. The Redbubble flywheel helped generate interest during lockdowns, with significant social media interest on Tik Tok and Twitter as well as more mainstream media articles drive users.

With all these positive tailwinds, why did we sell out of our holding in Redbubble?

In my previous article, the empirical paper "Selling Fast, Buying Slow" referred to three discrepancies between the buying and selling performance of investors:

• Investors displayed clear skill in buying - positions added to the portfolio outperformed both the benchmark and a strategy which randomly bought more shares of assets already held in the portfolio;

• Selling decisions failed to beat a no-skill strategy of selling randomly chosen positions - the level of underperformance was observed to be significant, such that it dragged down performance by 50 to 100 basis points; and

• Selling decisions coinciding with releases of portfolio-relevant information outperform - for example, following the release of company earnings announcements.

It is the final point which is relevant in our decision to sell our remaining holding.

Assessing earnings risk

At Montgomery, we not only focus on the price vs valuation of our investments but also the earnings risks - either higher or lower than market estimates. In many cases, it is these earnings risks that provide significant upside or downside potential relative to the current share price - especially for less mature businesses - as they drive the growth trajectory of future earnings.

For Redbubble, the share price faced its first significant road-bump following its DecH20 result released in February. The update revealed some additional costs related to paid acquisition and shipping, as well as reduced gross margins related to promotional activity in the December quarter. Some of these took the market by surprise, and the share price sold off ~15 per cent in the weeks following the release as it too caught up in the broader "rotation" out of e-commerce winners.

Earnings risk assessed for March quarter underpins exit thesis

The next stock-specific catalyst was the March quarter sales update. With the share price re-based to $5-6/sh after some margin-related earnings downgrades, it was important to assess the likely trajectory of earnings for the June half of FY21.

There were two key areas that underpinned our decision to sell prior to Redbubble's March quarter earnings release:

Contribution of face masks to revenue

While many investors were aware of facemasks being a significant contributor to revenue growth, there were few estimates of the quantum of revenue contribution.

After peaking at ~25 per cent of revenue in July, we assessed facemasks had declined to ~5-7 per cent of revenue exiting December. This has a significant impact not only for Redbubble's revenue for March, but also the difficulty in "comping" elevated face-masks sales that were unlikely to be repeated in the September quarter 2021.

We also assumed even if COVID did not recede, facemasks were unlikely to be a significant repeat contributor in the key US market due to i) greater competition in masks; and ii) warmer months in the northern hemisphere in conjunction with vaccine roll-out.

Impact of currency on revenue growth

Given the volatile moves in currency and the US' contribution to revenue, this represented a significant swing factor in our estimates of Redbubble's revenue trajectory.

With >70 per cent of Redbubble's revenue from North America and the strength of the AUD vs USD, this represented ~15 per cent headwind to its top line versus the prior comparative period, which we assessed had yet to be fully factored in market earnings estimates.

Where we could have been wrong

While the decision to sell ahead of its April earnings release may appear to be obvious in hindsight, there were factors which we had to consider where we may be wrong:

• The market may have looked through currency impacted growth - our assessment of 80 per cent top-line is still impressive;

• An accretive, complementary transaction given its extremely strong balance sheet - which we deemed lower risk given RBL's organic growth opportunities and relatively new CEO;

• Potential recovery in gross profit and EBITDA margins;

• Our sales estimates are wrong, and the company could deliver higher than expected.

All of these factors (and other unexpected positive developments) may have resulted in a higher share price. Despite this, we deemed the risk skew to the earnings and subsequent share price impact was to the downside.

Where to given sell-off?

With the Redbubble share price having re-based once again (more significantly than we had anticipated) - and with incremental new future sales targets, earnings and profit margins and investment focus areas, it may be worth re-assessing the shares once again as an investment opportunity.

Many of the aspects which initially attracted us to the Redbubble business - the flywheel, operating leverage, investment in supply chains, global reach and aspirations - remains intact.

There is also increased awareness of the Redbubble brand given the spike in website viewer traffic and new customers acquired during COVID.

It is also clearly a much more valuable company coming out of COVID than it was going in, and should new CEO Michael Ilczynski and the Redbubble team start delivering on its aspirational targets, will likely become more valuable over time.

With Australia now emerging from its first recession in 29 years as a result of the slowing economy caused by the COVID-19 restrictions in 2020, it is timely to compare the historical performance of the Australian & New Zealand Private Equity market across all time frames, to the performance of those Private Equity funds that were established during, or otherwise invested across, previous recessionary periods.

Summary statistics provided by AVCAL & Cambridge Associates reveal that the median and upper quartile net returns from Private Equity funds formed in Australia and New Zealand, between 1997 and 2018, focused on the later expansion and buyout financing stage, in which Vantage funds invest, was 11.1% p.a. and 20.3% p.a. respectively. These robust returns demonstrate Private Equity's ability to consistently outperform public markets as the return on the S&P ASX 200 Accumulation Index over the corresponding period was only 8.4% p.a.1.

However, during periods of economic contraction, the performance of Private Equity was even more pronounced. Utilising data provided by Preqin (2020) 2, Vantage conducted an analysis of the investment returns delivered by Private Equity Funds during the recessionary periods following the "dot-com crash" in 2000 and the Global Financial Crisis (GFC) of 2008 to 2010. Australian and New Zealand Private Equity funds, focused on investing in the lower to mid-market segment, investing during and up to 2 years following these events generated median and upper quartile net returns of 19.6% p.a. and 45.0% p.a. respectively, significantly outperforming the public market comparables during these periods.

WEIGHTED AVERAGE NET IRR % PERFORMANCE OF AUSTRALIAN & NEW ZEALAND PRIVATE EQUITY FUNDS

The reason for this outperformance is due to a number of factors which include an increase in opportunities, less competition from listed and  trade purchasers and an ultimate decrease in purchase multiples. Vantage's underlying managers' report that purchase multiples have followed a similar downward trajectory to that seen following the dot-com crash and the GFC, providing an increase in the number of attractive investment opportunities. As a result, it is likely that Private Equity funds investing during and following this recessionary period of 2020 - 2023 will more likely outperform historical returns, due to lower purchase multiples combined with the low interest rate environment and ample deployable capital available to be invested.

A number of academic papers have analysed and reported on Private Equity's resilience versus non-Private Equity backed peers during past economic downturns. Research conducted by Wilson et la. (2012) 3, from a data set of 14 million financial records, found that Private Equity backed businesses in the United Kingdom during the period 1995 - 2010, experienced significantly positive growth, relative to peers that were non-Private Equity backed throughout the 2008 crisis. Further highlighting Private Equity's resilience during the GFC period, A recent Stanford Business School study, titled "Private Equity and Financial Fragility During the Crisis" by Bernstein, Lerner & Mezzanotti (2017) 4, confirmed that Private Equity backed companies are significantly more resilient and can act as an economic stabiliser during a recession. In the study, Private Equity lead companies were found to be less likely to face financial constraints during an economic downturn such as the GFC, allowing them to grow and increase market share versus their peers throughout the same period.

Arguably the current economic contraction has signified the beginning of a new cycle in financial markets and the end of a prolonged period of asset inflation and increasing acquisition multiples. As a result, there will be an increase in attractive investment opportunities for Vantage's underlying Private Equity managers to invest capital at lower than historical valuation multiples, throughout the second half of the calendar year 2020 and into 2021. This re-rating of asset prices and Private Equity's ability to consistently outperform during and following recessionary periods, will ultimately deliver Vantage Fund investors with superior risk adjusted returns over the term of each Vantage Fund.

References

1. Private Equity data source; Australia Private Equity Summary Statistics, AVCAL & Cambridge Associates 30 September 2018. Measured across 72 private equity funds formed between 1997 & 2018, net to investor returns as at 30 September 2018. S&P ASX 200 Accumulation index data from September 1997 to September 2018, source www.rba.gov.au/statistics/tables/pdf/f07.pdf.
2. Preqin - Alternative Assets Data and Intelligence - Databases, Publications and Research. (2020). Retrieved 25 June 2020, from https://pro.preqin.com/dashboard/watchList
3. Wilson, N., Wright, M., Siegel, D., & Scholes, L. (2012). Private equity portfolio company performance during the global recession. Journal Of Corporate Finance, 18(1), 193-205. doi: 10.1016/j.jcorpfin.2011.11.008
4. Bernstein, S., Lerner, J., & Mezzanotti, F. (2017). Private Equity and Financial Fragility During the Crisis. SSRN Electronic Journal. doi: 10.2139/ssrn.3004594

Past performance is not necessarily indicative of future performance.