Meet the ‘emotionless’ fundies that keep outperforming

By Joanne Tran from the AFR.

Twenty years is a long time in a market saturated with equity funds, but not only have Pengana Capital’s Ed Prendergast and Steve Black survived fickle financial markets they’re also outperforming them.

The Melbourne-based portfolio managers run the Pengana Emerging Companies Fund, which has returned 12.4 per cent per annum after fees since its inception in 2004, against the 5 per cent of the S&P/ASX Small Ordinaries Index.

In one year, it delivered 29.5 per cent after fees, exceeding the benchmark’s 26.6 per cent.

It’s the twentieth year of running the strategy, which holds about 60 stocks from a universe of 800. The over $809 million fund has a history of soft closing, as it can be harder to outperform with larger sums, particularly when buying and selling into smaller stocks, says the pair.

Prendergast and Black say discipline is a common quality they both have and attribute it as a reason for the longevity of their professional partnership.

“We don’t run on high levels of emotion, we’re structured, stable, and level-headed,” Prendergast says. “We don’t agree on everything when discussing stocks, but ultimately, we have to absolutely agree before we do invest.”

“We don’t ever have to die in a ditch over a separation of views because we’ve got so much choice. Anyone who [is] in this game needs to acknowledge that we’re in the business of hopefully getting six out of 10 decisions right.”

Finding the right companies

The pair point to one of the portfolio’s biggest holdings, ASX-listed funeral services provider Propel Funeral Partner, as an example of one of the right decisions. Year to date, the stock has rallied 12.5 per cent.

A funeral provider is as non-cyclical as it gets, a quality the team is on the hunt for when investing in companies. “We like companies that are not necessarily going to have their earnings sort of thrown around by the vagaries of the economic conditions at the time,” says Black.

“It’s got inbuilt growth, as the Baby Boomers and the population is aging, so there’s a natural increase in the rate of deaths in Australia, starting in the last two or three years. It could be volatile year to year, but the trend is definitely up,” Prendergast says.

The funeral service provider exists in a fragmented industry, where there is no single company that dominates. There’s a strong long-term upside for Propel, according to Prendergast, because it has a market share of about 8 per cent in a sector where the company could expand steadily through sensible acquisitions.

“Propel can access finance through people like us and the banks, so they’ve got scale and access to capital that they can buy private players at very favourable pricing,” he says, adding that he also likes how the management has a large stake in the business (about 14 per cent of the company).

The fund managers keep turnover in their portfolio low and tend to hold on to stocks. That’s why, Black says, they don’t spend too much time reacting to day-to-day market news or company updates.

“We’ll wait for the market to hopefully recognise what we know. In small-cap investing, it’s all about finding and then taking advantage of the mispricing in the market,” he says. “We’re all about finding companies before brokers research them, before they go in the index, and then just waiting patiently.”

Another stock the Pengana team likes is TechnologyOne, which they have owned in the portfolio for at least 15 years. “This company has shown 10 per cent to 15 percent earnings growth for 20 years or more,” Prendergast says.

And again, it’s a company that the pair says is not tied to the ups and downs of the economy, as the software company primarily serves customers in the education and government sectors. TechnologyOne shares have rocketed more than 98 percent to trade at about $30.49 apiece so far this year.

What are the ‘major red flags’

Investing in small caps means that the duo isn’t strangers to volatility or dealing with company founders who still have skin in the game.

“You’re taking a view on people,” Prendergast says.

“There’s nothing like having a conversation with the leader to nut out whether the key people behind [them] has got the capability to perform,” he says. “Are they honest about the risks? Are they honest about and pragmatic about their competition?”

There’s nothing the pair hate more than hearing from managers that their competition is “hopeless” or that “they don’t make mistakes” or “we buy a lot of businesses, and we’ve never bought one that didn’t work.”

“They’re all signs of hubris to us and are major red flags.”

Another high conviction pick for the pair is investment bonds and life insuranceprovider Generation Development. It’s a recent addition to the fund, having only been added to the portfolio about six months ago.

“It’s earnings are growing 25 per cent per annum, and we bought it on a PE of 25 times,” Black says. “For us, it’s a clear mispricing. In the time we’ve owned it, the share price has already risen 30 or 40 per cent. It’s another example where there are inefficiencies in the market.”

In June this year, Generation Development mopped up all the shares in influential investment research and consulting business Lonsec that it did not already own after having bought about 40 per cent of the company in 2020.

“We regard it as a really high-performing asset that’s delivering a lot of profit growth, which has driven the share price to where it is,” Black says.

Generation Development shares have surged 122 per cent to $3.78 this year.

Black, praises the leadership Olympics swimming legend Grant Hackett, now Generation Development’s chief executive, describing him as a “shrewd operator.” “The scoreboard says that he’s doing a great job,” he says.

The strategy the duo runs was the first fund launched by Pengana after it was founded by chief executive Russel Pillemer and former prime minister Malcolm Turnbull in 2003.

“We’re not looking to build empires. It’s only the one product we’ve ever looked to manage here. We’re not looking to build out other micro-cap funds or mid-cap funds or contribute to other Pengana products.”

Black was at JBWere and Prendergast at Citi before they teamed up at Pengana. They acknowledged from the start the biggest risk to the business was if the two of them let their egos get in the way.

So far, so good.

 

View the original AFR article HERE.