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Building active portfolios, building conviction levels

Octagon looks to enhance the returns for our customers by being an active manager in the markets we invest in. This means, by definition and style, we are not passive investors who simply buy the index or the sector, rather we apply a disciplined process that allows the Octagon portfolio managers to identify when and why an asset is mispriced, and take advantage for our clients.

Tuesday, April 30th 2024, 6:01AM

by Octagon Asset Management

“Mispriced” is how a portfolio manager describes an asset whose market price today is different to their analysis of what fair price for that asset should be. There are numerous reasons why a market price today might not reflect the fair value of an asset; limited market knowledge, excessive focus on short term earnings; market dislocations and liquidity events and simply irrational investor behaviour can all be reasons an asset is mispriced. Where an asset has multiple indicators of being mispriced, the conviction of a portfolio manager lifts and this flows into how they build them into a portfolio of securities.

Portfolio construction

Creating an investment portfolio may seem intuitively simple – buy lots of the assets that are mispriced by being too cheap, and don’t own any of the ones that are too expensive. Lots of things people do in all walks of life can be described as simple, but not easy. As we dig deeper into the portfolio construction process we find we need to make trade-offs, primarily balancing the return we expect against the risks we are taking.

The team of Portfolio Managers and analysts at Octagon spend days (and sometimes nights!) trying to understand and value listed companies. A key objective is to improve the confidence, or conviction, in our views on each company’s valuation. It is that conviction in our view that finds its way into how the final portfolio is built.

To gain conviction, Octagon forms its views across five dimensions.

Quantitative value is just the beginning

There are many mathematical ways to describe a company, including its profitability, its growth rate, and its dividend yield. You can then rank each company’s attractiveness using these metrics, and combine them in many different ways. For Octagon this is just the start of the process. We use mathematical descriptors to identify companies that might be mispriced and then we dig deeper to try and understand why that might be so.

Management: How good for how long?

Running a business is not easy. Understanding how the company makes money, how cash flow has trended over time and how it compares to similar companies (sometimes, but not always in New Zealand) is an important way to analyse the future prospects of a business. Management teams which have been realistic about their prospects – because they have a strong understanding of how their business makes money and the environment they operate in – are a key factor for investment success, in our opinion.

Overly sensitive valuations need not apply

We believe that valuing businesses is impossible without forming a view of the future. The assumptions around profitability, the level of investment required to grow and the competitive backdrop need to be reasonable. Niels Bohr, a Nobel laureate physicist, famously quipped “Predicting is very difficult, especially if it’s about the future.” So once we have a set of assumptions, we run scenarios around our view of the most likely operating environment. If a small move in one assumption changes the valuation by a lot, it signals greater valuation risk.

It’s only a surprise if you don’t expect it

Having worked out how we think a business operates and its financial metrics, there is a fourth step. Test and learn. How is the company doing against our prior expectations? Are we constantly being surprised by the level of profitability, the level of investment required, the way competitors are behaving? These surprises could be positive or negative relative to our expectations, but if there are a lot of them, it implies we, and probably management, haven’t yet truly worked out the way the business sustainably makes money. 

Experience supports judgement calls

After all of that, we apply judgement based on years of following a company, the industry it operates in and the market backdrop. We consider the overall risk of the portfolio in this step. We want to retain diversification, to ensure we are not too exposed to stocks that all rely on the same factor and to ensure the expected volatility of the portfolio is reasonable.

Building conviction

When all of the first four variables reinforce each other, we are much more likely to have a high conviction view and rely on our combined experience to make the judgement calls. That conviction view will mean a bigger difference in the portfolio’s holding of a company, relative to the benchmark weighting in the company. Where the variables conflict with each other, our conviction will be lower. The judgement step will very rarely, if ever, over-rule the recommendation of the other four factors, but we’re only too aware of our own human biases to temper or exaggerate the recommendation. That why we believe in the rigour and repeatability of our processes as we build conviction in our actively manage portfolios.

 

 


Launched in November 2021, Octagon Asset Management is a boutique funds management company with a team based in Wellington, Auckland, and Queenstown. We are committed to an active fund management approach and believe that outstanding fund managers, supported by best-in-class research, will deliver the best performance in the long-term. Forsyth Barr Investment Management Limited is the issuer and Octagon Asset Management Limited the investment manager of the Octagon Investment Funds. Find out more at https://www.octagonasset.co.nz/about-us/

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