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Spatium’s Secret Small Cap Sauce
Four years ago, old high-school buddies Nicholas Quinn and Jesse Moors were taking in the sunshine at a café on Melbourne’s Southbank, when they decided to take their mutual interest in stock market investment to the next level.
Quinn, a former PwC global tax specialist, and Moors, formerly a business development manager at CPA Australia, had talked often about the idea that would become their investment strategy, a short-term, relative-valuation-driven, high-turnover approach, designed to capture under-valued opportunities in the small-cap space.
It was an approach that Quinn had been honing, in practice, since 2013, consulting to a group of Singapore-based fund managers. “In the first three years of our discussions, I worked an original thesis that was a long-short strategy, but fast-forward seven years, Jessie and I are running effectively what is the long side of that strategy.”
The pair established a company, Spatium Capital, and their strategy was backed by a seed investor in July 2018 through a separately managed account (SMA). Moors and Quinn launched the unregistered managed investment scheme to wholesale Australian investors and their Singaporean equivalent, “accredited investors,” in March 2020, in the form of an Australian unit trust, the Spatium Small Companies Fund (SSCF).
The SSCF is a long-only approach, but a short-term one: the entire portfolio is turned over, on average, every 30 to 45 days, with the occasional outlier being held for approximately 90 days. Quinn and Moors will hold, on average, 25 to 40 positions across the S&P/ASX 300 index: the primary goal is to grow investors’ capital through exceeding the return achieved by the S&P/ASX Small Ordinaries Index – the fund’s benchmark – over the long term.
Moors describes the approach as follows. “We look at the top 300 companies on the Australian market – the S&P/ASX 300 index – and we use five filters to isolate the companies that we think are probably fairly valued. We use a macro filter, an industry filter, a small companies filter, the decay rate and then the hurdle filter as well, and we’re trying to say, right, there’s 200 or 250 stocks that we’re not going to look at any further. The number that’s left is the group of stocks that we want to investigate further.”
The pair applies a relative valuation model to assess the remaining companies, and from that group comes the portfolio, of up to 40 positions.
“We are stock pickers,” says Quinn. “We don’t try to be industry- or sector-weighted, or to have an economic forecast of where we think an individual sector may be going. We are purely focused on stock selection at the company level.
“We don’t want companies that might be lagging the overall market, but relative to their industry they’re doing quite well. We don’t want companies where the rate of decay of value is probably indicating a more systemic shift. The final filter for us is working out, OK, we’ve got this ideal entry price of, say, $3, and an exit price of $3.30 – we’re targeting a 10% return for this position.
“It’s not always that large, of course, but making sure that once we account for transaction costs – and the fact that we’re not going to get these calls right every single time – there’s still going to enough of a return there for the investors. This helps us build a portfolio and that has flowed through to the result base we’ve had in the last two-and-a-bit years.”
The fund is benchmarked to the S&P/ASX Small Ordinaries index, which is where Spatium finds most of its value. “By operational design, we’re locked-into the top 300. We can’t trade outside the S&P/ASX 300, even if we wanted to,” says Quinn. “That said, we would trade approximately 85%, sometimes 90% of our portfolio within the stocks ranked 101-300, the S&P/ASX Small Ordinaries index.
“We will ‘spend’ approximately 10 to 15% of the portfolio on companies within the Top 100, but only when we feel that they’re extremely under-valued – and that doesn’t come up too often, due to the Top 100 being so heavily analysed. We find almost all of our value outside the Top 100, which is obviously why we’re running a small-cap fund,” he says.
“If we do see an absolute bargain in the Top 100, we’re not going to exclude it just because we’re small-cap managers – if we think there’s value there, we’ll pounce on it. And we have, we have over the last 18 to 24 months now. But again, they don’t happen as often. And they also tend to realise that little bit quicker because they are getting scrutinised more heavily than companies outside the top 100. They tend to bounce back that little bit faster than the smaller companies,” Quinn says.
At the end of September, the fund had returned as follows:
The fund’s top-performing positions so far this year have been IDP Education, Austal, and Monadelphous Group, Moors says.
Quinn says the client base is driven by the structure. “It’s obviously going to have tax implications for investors that invest with us – depending on how you’re structured, obviously we’re going to be more tailored towards self-managed super funds (SMSFs) that are only going to pay a top marginal tax rate of 15%, and we might be less beneficial to a high-net-wealth investor who’s going to pay the full marginal tax rate.
“The strategy chooses the clients – the high-turnover approach simply suits lower-tax-rate investors, such as SMSFs, charitable organisations, as well as corporates who want to invest. We have also had several high-net-wealth investors get on board, to diversify their portfolios,” says Quinn.
And that goes to the heart of how this fund is probably best used.
“Morningstar describes us as a ‘small-cap strategy blend’ fund, and that is how we are mostly used,” says Moors. “It’s an actively traded value-based approach – we’re not growth investors or holding for the longer term – but if you’re looking for Australian small-cap exposure and you already have two or three small-cap managers in your portfolio, you could add this as potentially a third or fourth allocation.
“The benefit that it gives you first and foremost is that liquidity; there’s no lock-up, and monthly redemptions are available. Further, it doesn’t have the same correlation to many other small-cap managers; it’s been validated a few times by Morningstar and others, we’re the only small-cap manager with such a significantly high turnover rate. It’s certainly a differentiating factor,” says Moors.
Quinn describes Spatium as “actually quite a defensive manager,” which makes the SSCF a good blend with more aggressive managers. “Our upside capture ratio is approximately 108%, but our downside capture ratio is around 47%. March was a good example of that: the market fell 23%, but we only fell 11%. We’re quite proud of the downside protection we’ve afforded investors, especially during COVID. We’ve done so with a beta of 0.81, and with a lower standard portfolio variance than the benchmark. You have had less of a roller-coaster with us: that’s pretty attractive to investors who are a bit more conservative.”
The target performance is 5%-6% a year above the performance of the S&P/ASX Small Ordinaries index. “Over a monthly cycle, we’d be looking to add about 50-75 basis points to the index, notwithstanding that with the recent volatility off the back of COVID, we’ve been able to deliver outperformance of 18% per annum over the last two years,” says Moors.
The fund presently managed just over $5.7 million. “Because it’s a short-term approach, we believe this strategy caps out at anywhere between $130 million-$160 million,” says Quinn. “That’s just so that we can remain agile and flexible to move relatively frequently and not run into a situation where we might be trading against ourselves. The goal of the SSCF is performance, not asset gathering.”
The fund is managed for 1.25% a year, with a 15% performance fee that kicks in if the absolute return is positive, the relative return against benchmark is positive, and the high watermark is exceeded.
The fund is majority invested at all times, with a target cash holding of less than 3%. Redemptions are monthly. The trust is forced to distribute its income annually: almost all of the annual distribution will be income. For the June 2020 financial year, the fund provided a 16.5% distribution
