In our Investment Strategy Note we discuss how even the best long-term performing fund managers always have shorter term periods of underperformance - it's not a bug, it's a feature of the best.

Summary:

• The goal of equity fund investors is generally to be with the top performing managers over the long term (5-10+ years).
• Data shows that virtually all long-term top performing managers have shorter term periods (1-3 years) where they underperform their benchmark.
• Ditching long term top performing managers at the first sign of underperformance is likely to be a suboptimal strategy.
• To be with long term top performing managers you should expect you will have to endure short term periods of underperformance.

The financial media love to laud or lament short-term investment performance, both good and bad. As an investor, it's easy to get drawn in, as you mentally extrapolate out recent trends across your portfolio.

But to capture superior long-term results, which is what most of us ultimately aim for, we must first be willing to tolerate periods of short-term pain.

These short-term swings can be difficult to stomach and will often tempt investors to bail out of the market. However, without being able to accept periods of underperformance, investors may miss out on the market's inevitable rebound and fail to harvest the long-term superior returns of equities.

If investors can develop a deeper understanding of how top funds perform over time, they will more confidently weather the inevitable periods of short-term volatility in performance, and be more likely to reach their long-term investment goals.

Don't be alarmed

The evidence is clear: virtually every top-performing fund has instances where it underperforms its benchmark and its peers, particularly over time periods of three years or less.

A study by independent US investment bank, Baird, looked at a group of more than 1,500 funds with 10-year track records. They then narrowed the list to 600 funds that outperformed their respective benchmarks by one percentage point or more, on an annualized basis, over the 10-year period. The list was further narrowed to include only those funds that both outperformed and exhibited less volatility than the market benchmark.

Despite their impressive long-term performance, 85% of these top managers had at least one three-year period in which they underperformed their benchmark by one percentage point or more. About half of them lagged their benchmarks by three percentage points, and one-quarter of them fell five or more percentage points below the benchmark for at least one three-year period.

Depending on which of the three-year periods investors looked at, they could have been highly alarmed by these periods of underperformance. Yet in the long-run investors profited: all these managers were top performers over the full 10-year time span.

It pays to be patient

When looking at shorter periods, the results were even more telling. All the top managers dropped below their benchmark at least once. Moreover, one-quarter of them went through at least one 12-month period where they underperformed their benchmark by 15 percentage points or more.

By these measures, it looks as though all fund managers, including even the best ones, will go through periods of underperformance. For investors, it can be particularly challenging knowing what to do when your fund is in the midst of one of these tough periods.

The evidence suggests that rather than leaving a top-performing manager during difficult times, it pays to be patient through periods of underperformance. Indeed, the longer an investor can wait, the better their funds' chances of beating its benchmark become.

Time diversification

One of the major factors affecting fund performance is the cyclical relationship between asset prices and the business cycle. In the short term, investments can fluctuate in value for a number of reasons, including changes in the economy, volatility, political uncertainty, business failures, interest rate changes, fluctuations in currency values, and company earnings. In an economic downturn, GDP growth slows, and business earnings decline, which leads to less optimistic outlooks for companies and lower stock prices. In an economic expansion, the reverse tends to happen.

But time is an investor's best ally.

As investor holding periods lengthen, short-term risks tend to become less relevant, partly because many short-term price movements tend to offset each other over a complete business cycle. This means that, as an investment's holding period increases (e.g., 20 years vs. 5 years), investment risk due to market volatility (i.e., ups and downs of prices) will decrease.  Because of this relationship, both the frequency and magnitude of underperformance become less dramatic over more extended periods.

A more wholistic view

Investors who buy into an equity fund based solely on a few quarters of strong returns are quite likely to reverse course and sell out of the fund when returns fall short. In our opinion, this churn benefits no one, and hence at Ophir we seek investors who agree with our investment philosophy and appreciate our process. We expect our portfolios to have negative years or underperform their benchmarks on occasions and understand that investors can start feeling nervous and uncomfortable through these periods. As seen below, our Ophir Opportunities Fund, which has the longest track record of any Ophir fund at nearly 9 years, has had two periods of 1-year underperformance and one period of 3-year underperformance (albeit briefly), yet is ranked no.1* over the long term, generating 24.6% p.a. (net) since its inception in August 2012.

We strongly believe investors should remain focused on their long-term financial plan and avoid knee-jerk reactions during times of negative absolute or relative performance. All equity fund managers have short term periods of underperformance. A more wholistic view of managers needs to be taken. This includes factors such as long-term track record (if it exists), people, investment process, levels of alignment and adherence to capacity constraints, amongst others. In this way, investors who take a more wholistic view are more likely to set themselves up for long-term success.

Source: Ophir Asset Management. *FE fundinfo data, Australian Small/Mid Caps, Aug 2012- March 2021

One year on from the 'fastest bear market in history' we can see the benefits in keeping calm and staying invested in the Australian stock market.

Prime Value Emerging Opportunities Fund portfolio manager, Richard Ivers, shares his views below on where the market is currently at. But first, let's rewind 12 months:

During February and March 2020 markets plummeted. In the USA, the S&P 500 fell 30 per cent in just 22 trading days after reaching a record high on 19 February 2020 - the fastest drop of its magnitude ever.

Likewise, the ASX 200 entered its fastest bear market, shedding 20.5% in just 14 days.

As economies globally shut down, the question seemed to be how far could markets fall?

What happened next surprised many investing experts and emphasised the virtues of the words: DON'T PANIC.

The fastest bear market in history turned out to be the shortest bear market. One year on, the recovery has been remarkable.

Prime Value Asset Management's Australian equities funds show the benefits in keeping a steady hand.

Looking through the market

As Prime Value fund managers Richard Ivers and ST Wong often say, their job is to "look through" short-term market fluctuations when making investment decisions.

When markets were spiralling one year ago, Richard and ST sought to turn crisis into opportunity.

The savage sell-off meant many good quality companies were suddenly available at better value, in line with Prime Value's 'Growth at a Reasonable Price' approach.

For the Prime Value Emerging Opportunities Fund, the volatility among small cap stocks has provided many opportunities during the shutdowns and on through the recovery.

Investing during this uncertainty - always with an eye on 'protecting the downside' - allowed the Prime Value Emerging Opportunities Fund to be the best performing Australian small caps fund for the year to 30 June 2020, the second best performing Australian equities fund in any category for the calendar year to 31 December 2020 (Morningstar), and currently the best among funds who blend value and growth styles for the year to 31 March 2021 (Morningstar).

Current state of play

Richard Ivers, portfolio manager for the fund, says the market continues to create opportunities. "The small caps market is still choppy, there is more takeover activity, and there are some good buying opportunities at present.

"The volatility has created the opportunity to buy some quality companies relatively cheaply."

He says looking through the COVID-19 market recovery continues to be key. "We see some big fluctuations in stocks which may be perceived as winners or losers from the recovery. By looking through the short-term issues and analysing the strength of the business we can find some real gems.

"But the economy is changing, and investors need to look through the market swings. A key current question is how will the COVID winners and losers from last year fare during 2021

"Many people are trying to trade the re-opening, but it always has to come back to growth at a reasonable price.

"For example, some of the travel stocks are now over-priced. But there are other ways to benefit from economies re-opening which are less obvious, via really good businesses."

Right here right now - the biggest themes driving markets are electrification and decarbonisation - which are really 2 sides of the same coin.  And with the global resolve now clearly past the inflection point, these 2 themes are likely to be the dominant drivers for most of this decade.

So far, in an effort to gain exposure, Aussie investors have stumbled from graphite to cobalt to lithium to nickel and then back to lithium again.   However, there is an emerging viewpoint that copper could be the surest way to gain exposure to the enormous electrification opportunity.  For example, Goldman Sachs recently released a piece of research titled: Green Metals: Copper is the New Oil.

Given that the Australian market is renowned as one of 2 global resources hubs, it would be reasonable to assume that there would be a host of copper producers listed on the ASX    However that is not the case. If we exclude BHP and RIO - whose main earnings come from iron ore - there are only 4 ASX listed copper producers. Over the past decade, a combination of corporate activity, low copper price, increased fiscal discipline and depleted ore bodies has left us with just FOUR ASX listed copper producers. This is extraordinary for the most widely used base metal on our planet.

Of the 4 producers, OZL and C6C are both trading on PERs in the mid20's.  SFR would appear superficially cheap, however the DeGrussa mine is scheduled to be depleted sometime during 2022. 

This leaves Aeris, which our funds have been steadily accumulating on a PER of <3x.

Aeries recently came to life on the well-timed and equally well priced purchase of the Cracow gold mine from Evolution in 2020.   In fact so well timed and priced was the acquisition, that in the space of 12 months they have been able to completely pay off their debt and are now generating strong surplus cashflow. But it is the Tritton Copper mine near Cobar in western NSW that has piqued our interest. 

The Tritton min has been producing copper since 2005.   During this time it has produced over 320,000 tonnes of contained metal.   Over the past decade, it has produced between 23,000 and 30,000 tonnes every year.   It is forecast to produce around that amount - ~23,000t - this current financial year, at an AISC of $3.75 per lb.   Yet despite this long term record, the stock is trading on a consensus average PER of 3x over 2021FY to 2023FY.  

Clearly the market has concerns.  From our analysis, there are 2 major investor issues: mine life and hedging

Mine Life

The last stated reserve of 86t contained metal equates to a little under 4 years.  So on the surface this would appear an issue.   However, there are important factors that make it highly likely that the mine will be operating for many years to come.

The first of these is highlighted by existing resources (as opposed to reserves).  At 250,000 tonnes of contained copper, this is equates to more than 10 years at the current production rate.   At the current high copper price, we would expect a solid and ongoing conversion of resources into reserves    But there is an even more important point.   Reserve definition drilling requires a much higher level of saturation.   Most mines of this nature drill the ore body to sustain mine plans (only) several years out.  As the mine goes deeper, infill drilling of known resources will continue to add to reserves.   The best demonstration of this is to review past reserve statements.   In 2013, total cu reserves were 126,000 tonnes.  Since then the Tritton mine has produced nearly 190,000 tonnes and counting.

The second factor that adds to our confidence is that Aeris has reported strong exploration success over the past 12 months.  In the coming years we are likely to see additional tonnes from 3 sources:

• Life of mine extensions via mineralisation at depth, South Wing, Budgerygar and the corridor between Tritton and Budgerygar
• Brownfields exploration at Murrawombie, where >5 metre intersections as high as 4% have been recorded
• Greenfields exploration via the Constellation target where the first drill hole spectacularly intersected 20m at 2.4% Cu.

It's important to recognise that for much of the past decade, Aeris has been struggling with low Cu and gold prices and hence has not had the dollars to spend on exploration.  This has changed in the past 12 months, and we would expect a steady stream of positive drill results.

Hedging

Like a lot of companies, when the Cu price rallied hard, Aeris prudently put in place some hedging in the event that the move faulted.   Clearly in hindsight this has capped their short term benefit.  

However the hedging currently in place is modest.   Aeris has locked in 78% for the current quarter (which has only 7 weeks to run) and 26% for the September quarter, both at an average of $4.57 per pound. 

This will still see a strong cash build, whilst also allowing the company to sell part production into the decade high price.    Beyond the September quarter, Aeris is unhedged and will be able to sell 100% of its production at spot, which at the time of writing had pushed through $6.30 per pound.  

Strong Risk-Return Proposition

If prices hold anywhere near the current level, this will see Aeris generate 'super profits'.   If the emerging consensus view is correct, then a combination of 'super profits and limited cu producers may see investors clamour for stock. 

On past earnings, a PER of 9x would equate to a share price north of 30c.   If we flow through the current spot price for copper, then the 'theoretical' valuation is multiples thereof.   .   If the market is being overly cautious, then this is a rare opportunity in a sector that has the strongest of tailwinds.

Recently I attended a UBS hosted virtual China Commodity Tour. In light of the observations that I had made back in a research note to you all in December 2020, I thought it would be useful to provide an update to those views given recent positive trends.

China is not only the world's second largest economy, it is also Australia's and New Zealand's largest trading partner (c. 30-40% of both countries' exports) and its economic performance influences investor sentiment in both economies. In recent times navigating a more assertive China under President Xi Jinping has been a key factor to monitor for investors in Australasian equities. China in particular has proven itself to be very effective at managing COVID-19, which allowed a strong recovery to develop. More recently the pace of vaccinations in China has picked up reaching 200 million shots with the government targeting 40% of the population by July. In terms of macro developments, Q1 2021 GDP growth jumped 18.3% (relative to a year earlier) whilst sequential growth slowed, as expected, to about 2% (quarter-on-quarter). UBS expect this to stay at around 6% for the balance of the year, resulting in a full-year GDP growth forecast of 9%. This mirrors a strong growth recovery in the US being driven by policy stimulus and progress towards a normalization of activity- Goldman Sachs is forecasting over 7% US GDP growth for 2021. Other growth metrics in China remain robust; Fixed Asset Investment rebounded 25.6% in the first quarter, Industrial Production grew by 28% and Retail Sales rebounded 34% (8.5% higher than the first quarter of 2019). Similar trends were evident in property with sales up 64% from where we were this time last year. With Chinese stimulus beginning to recede, growth rates will moderate but real consumption growth should remain robust in the period ahead.  

Key presenters in the UBS tour highlighted a broadly positive demand backdrop but one where the authorities are focused on moderating any excesses. The government is tightening credit availability to property developers to avoid overheating with forecasts of lower housing starts in 2021, although Infrastructure is expected to grow by 6.5-7%. This combination suggests positive steel demand this year (a recent CLSA survey estimated more than 3% growth). Policy makers in China are increasingly focused on restricting steel exports and limiting production due to pollution in a number of key regions, in particular Tangshan. During the past week China removed steel export tax rebates for 146 types of steel products and will increase the export tax on certain steel products from 15% to 20%. With steel exports in China currently annualizing over 60 million tonnes, the government is now clearly signaling a new direction in this area. China produced 271 million tonnes of crude steel in the first quarter of 2021, up 15.6% year-on-year. On an annualised basis this equates to 1.08 billion tonnes. If China maintained this level of steel output for the rest of the year, expectations were that annual production would therefore increase by around 4%. However, following the tour and recent news flow around the removal of export rebates, our base case has now been revised lower and assumes that China will reduce their exports through the balance of this year resulting in steel output growth of only 1.5%.

On the face of it this is a negative for iron ore demand in China with over 80% of output being produced from blast furnaces (a process that requires iron ore at a ratio of 1.7 tonnes of ore to produce a tonne of steel). However, with China withdrawing tonnage from the steel export market we expect other regions to increase blast furnace capacity utilization to make up the difference. Principally this will be evident in Japan, South Korea, Taiwan and to a lesser extent Europe. This shift in productive locations will help offset the lost tonnage of iron ore demand from China. In addition, it is worth noting that China's focus on pollution is resulting in a higher demand for the best quality iron ore (lump and pellets). This works in favour of the large Australian miners, BHP and Rio Tinto.

The iron ore supply side remains relatively constrained but production from Brazil is gradually improving, as their COVID challenges improve. We forecast that major producer Vale will increase volumes by 30 million tonnes this year from their mines in Brazil. India remains a major uncertainty with rampant COVID infections potentially reducing last year's level of exports. Overall the market still appears tight this year but particularly in the first-half of 2021.

Despite the iron ore demand / supply backdrop continuing in a state of flux, in late April its price hit a new record high of close to US$200/t. This ultimately demonstrated that with the world progressing through its recovery phase, and with massive amounts of development occurring in property and infrastructure, the scales are tilted in this commodity's favour. 

As we look forward there remains uncertainty across market commentators as to where the iron ore price will move to. Our central view is that the spot price will weaken over the course of this year to average US$165/t in 2021 and US$120/t in 2022. This appears to be a negative forecast, but such a price would still result in material earnings upside for the mining sector relative to consensus expectations and would also support substantial capital return opportunities. On the basis of the current iron ore price the sector is generating a free-cashflow yield of almost 20%. On our base case of a declining price, the free cashflow yield ranges from 10-19% in FY21 and 10-13% in FY22.  Our top pick in the sector is Rio Tinto - we estimate Rio can return 35% of its market capitalization over the next three years and remain debt free. If it were to raise even a small amount of debt the potential size of a capital return increases materially. Both BHP and Rio Tinto are more diversified commodity exposures than Fortescue and with better quality iron ore, so this is our least preferred exposure in the sector.

Our core insight from the UBS-hosted event was that while the overall backdrop remains supportive for iron ore, there are a myriad of factors which need to be carefully navigated at an individual country and stock level. We believe this backdrop remains supportive for our active investment approach.