Katana Asset Management Limited - Investment Philosophy

"It is a socialist idea that making profits is a vice. I consider that the real vice is making losses." Winston Churchill

 

Approach

As an ‘All Opportunities’ fund, the underlying goal is to assess the risk adjusted return of every potential opportunity. The Manager is happy to selectively and modestly initiate higher-risk positions, provided that the potential return significantly exceeds the additional risk – preferably in terms of both value and time.

Whilst The Manager intends to combine the best principles of value, fundamental and technical analysis, the manager do not wish to be constrained by the constructs of any one approach. The key to the long-term success of the fund is seen as the capacity to integrate the best principles of each discipline with the extensive and varied experiences of the investment strategy committee. This is achieved by encouraging flexibility and adaptability, but within the confines of an overall framework that controls risk.

Inherent in this framework, is the broad classification of purchases as either ‘Investments’ or ‘Market Opportunities/Trading Positions’: In general terms, the Manager has a pre-disposition towards viewing:

• Larger capitalised companies as either INVESTMENTS or TRADING positions
 

• Emerging companies as primarily INVESTMENT positions; ie the Manager is less inclined to consider an emerging company as a potential trading/market opportunity, and almost totally against doing so where there is an absence of liquidity.
  

Investments

‘The game of professional investing, is intolerably boring and over exacting to anyone who is not entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.’ Keynes

In the terminology adopted by The Manager, an ‘investment’ is considered to be a purchase in a company where the underlying (intrinsic) value ;

a) Can be quantified, and
 

b) Is materially above the current market price

Investments are considered to be of a static, longer duration.

Trading / Market Opportunities

The Manager defines ‘market opportunities’ as purchases that ;

a) Potentially may not meet all of the criteria for ‘investments’

b) May need to be assessed in a short period of time
 

c) Are only intended to be held for a short duration.

There are literally dozens of ‘market opportunities’ at any given point in time and they are constantly arising and evolving.

 Personal Qualities

‘With time and patience, the mulberry leaf becomes a silk gown.”
Chinese proverb

Patience, confidence and self-belief in the face of short term panic are critical pre-requisites to long-term investment success. However one must always recognise that either the data, or analysis of the data or both, may be in error. This hence requires a unique capacity to process and act on these competing demands.

Equally important is the ability to switch frequently between the ‘big picture’ and the detail, to identify the macro moves and then be able to act on them with specific selections.

Another critical trait is the ability to think independently. If the ‘minority are wealthy’, then by definition the masses are wrong, or perhaps less harshly – not ‘as right’. The potential to outperform the market can only be achieved if something is transacted that is different to ‘the market’.

The market is the same and yet it is constantly evolving. Therefore our understanding must also evolve. Mistakes are inevitable, but recognition, control and learning from mistakes, are essential.

 Investment Strategy

The strategy of some of the great modern era investors may be summarised as follows:

1. Assess stocks that are in one’s ‘circle of competence’ -ie that the Manager understands.

2. Look for a long term sustainable moat or competitive advantage

3. Only invest where management is trustworthy and competent
 

4. Ensure the price is sensible.

In maintaining an investment strategy, these points are ignored at great peril.

The Manager strives to respect this framework, and to pay attention to the following in determining and assessing investment strategy:

1. ‘Be fearful when others are greedy and greedy when others are fearful;’ (Warren Buffet); the best value is to be found at times of extreme fear : Commonly this fear is restricted to a particular company. At times this fear is less discriminating. Similarly, stock prices both singularly and as a group overshoot to the upside as ‘irrational exuberance’ or misplaced optimism leap to the fore Identifying and assessing potentially oversold stocks is an intrinsic part of the day to day function of the Manager.Similarly, in every investment decision, the Manager is focussed on comparative and absolute valuation metrics, as well as momentum (read sentiment) indicators that point to overbought stocks and markets.

2. Knowing how much to bet is as important as knowing what to bet on; building a diversified, well-risked portfolio is a relatively more simple task. The true challenge is to have the capacity and conviction to take a (substantially) overweight position when the rare fat pitch arrives. To maintain discipline and risk management, the maximum weighting that the portfolio may attain in a stock is on a sliding scale commensurate with the number of supporting PMs and relative market capitalisation of the company.Our goal is to ‘bet heavy when we have the odds, and the rest of the time to abstain’.

3. Large asset dislocations are rare and may only occur every few years The Manager is focussed on making large investments at stock and market extremes.

4. Never forget Risk; it will return (read ‘when the market ignores risk it is only a question of ’when’ not ‘if’) Risk always reverts to the mean; sell assets when risk premiums evaporate. Buy assets as the cycle bottoms and risk appetite is on the rise – eg when high interest rates are moving lower, large risk premiums are declining and credit spreads are narrowing.

5. Mispriced stocks exist in all markets; the challenge is to identify them ahead of the market There is no substitute for turning over stones. Work, work, work. Read the commentary. Make the phone calls. Visit the companies.

6. Emotional Quotient (EQ) is as important as Intelligence Quotient (IQ) Test and re-test objectivity. Allow time to distil emotion. Strive for calmness and balance. Only make (investment) decisions through the Investment Committee.

7. One of the key questions is What’s going to Change?’Share prices change as earnings change. Determine both at a macro and micro level, what it is that is likely to change and hence drive markets and share prices.

8. Today, a substantial amount of money is being managed on a short term horizon The opportunity is to take a different time horizon. In assessing an investment, the Manager is prepared to take a 2-5 year view and will seek to take as long an investment horizon as is permitted.

9. Avoiding a loss is superior to making a gain; from a loss of 50%, a return of 100% must be achieved with the remaining capital to return to par. Safety takes precedent over potential gain.

10. The market is not a zero sum game; the share market is unitised pieces of a country’s economy. A growing economy translates into a growing stock market – a positive sum game. In a growing economy, the odds are stacked in favour of an investor. Accordingly, equities are the investment of choice over options, futures and other zero sum investments where no margin is afforded by a growing asset.

11. The best investors know how to be wrong. Document key company risks and review these risks against company newsflow and management updates, to identify problems as early as possible.Additionally, it is useful to record what ‘we would not want to see’ when investing.

12. Investors derive confidence from other investors; a shareholder selling with conviction can lead other shareholders to sell  and indeed aggressive selling / buying, is not accepted as valid in itself. Look beyond market moves and assess the rationale.

13. The Market reverts to its long term mean over time Take larger bets the further the market deviates from the mean: like an elastic band, its return will be greater and swifter, the further it is stretched.

14. Investing is one part maths, one part economics and one part psychology; unless this is recognised and embraced, decisions will be negatively impacted. PMs recognise and embrace the blend of skills and strive to consciously adjust for sub-conscious bias and strengthen weaknesses.

15. There is no perfect company; only inadequate research and analysis will fail to uncover risks and flaws. We accept that we must purchase imperfect companies and hence turn the focus from trying to locate perfect companies to trying to identify the best stocks on a comparative basis.

16. Decision making is based on imperfect information; the available information is never complete, possibly inaccurate and constantly changing The focus is to aggressively filter companies at the front end, to restrict the number of stocks that we intimately research and monitor. Whilst it is acknowledged that information is imperfect, the goal is to nonetheless have an information advantage – to ‘know more’ on the companies in which we invest.

 Investment Style

"A man who wants to lead the orchestra must turn his back on the crowd."
Max Lucado

Fundamental Analysis vs. Technical Analysis

Underlying (intrinsic) value drives the long term share price, but sentiment is the primary driver in the short-medium term. Therefore at the broadest level, every investment decision has two components : what to buy and (then) when. Another way to state this, is that price = value + sentiment. It is not sufficient to simply identify extraordinary opportunities, it is also necessary to transact at the right time. A stock that is ‘cheap’ can always ‘get cheaper’!

This is at the heart of the superficially paradoxical statement :

Think independently, but act in unison with the market.

By this, The Manager’s objective is to :

identify undervalued stocks, by focussing on those companies that are out of favour due to either their sector, size, category (growth vs. value vs. cyclical vs. defensive etc) or company-specific event BUT act only once the sentiment within the wider investment community is beginning to turn.

Fundamental and value analysis is at the heart of the first part of this equation.

Technical analysis offers considerable insight into timing decisions.

Market experience and observation can assist in both areas.

Value Investing (ie Revert to the Mean) vs. Growth

At the outset, it should be appreciated that historical (profit) data is of incidental value, and useful only insomuch as it assists in the evaluation of the credibility of the forecast data. Hence the success of our analysis is inextricably linked to the quality of forecasts, of which by definition we cannot be certain.

There has been considerable discussion of the merits of funds that invest in value and others that seek growth. The return premiums from value and growth styles are similar over time, but value and growth stocks outperform at different times in the business cycle. More specifically, value investments tend to outperform growth stocks in periods of slow growth or recession. whilst growth stocks typically outperform value stocks in periods of reasonable or strong growth.

For Growth investing, preoccupation is with unexpected success – ie unexpected earnings growth; either unexpected in the sense that the growth ;

• Is not forecast / anticipated

• Is not believed

For Value Investing: ‘Value is about the anxiety of the sellers, who because they feel that way, have an urgent need to sell these shares at a very depressed price.’ (Lewis Sanders, AllianceBernstein)

Therefore growth investing is about ongoing success and durability. Value investing is about failure (or perceived failure) and whether it is transitory or permanent!

The biggest risk to a value investor, is the ‘value trap’ – ie buying a company on a low PER and high yield that:

• Is in structural decline
 

• Has (perceived) static but in reality declining earnings

• May have large, unidentified issues that are recognised and understood by those closest to the company/sector.

Top Down/Thematic vs. Bottom Up

To initially identify potential investments, various individual and thematic models are constantly developed, incorporating both top-down and bottom-up analysis ;

- Major themes are played mainly with the big caps (not exclusively but mainly); they are safe, more liquid and will move first/more with a theme - ie the big caps are TOP DOWN DRIVEN

- small caps are really about value/niche opportunities, management etc - ie they are BOTTOM UP DRIVEN

Cyclical vs. Defensive

Similarly, the distinction is often made between cyclical companies and defensive stocks.

Cyclical stocks’ earnings are tied intimately to the level of economic activity, and hence move strongly in periods of economic growth.

Defensive stocks include companies such as banks, utilities, infrastructure companies and property trusts. Profitability may be reasonably predictable and Defensive companies often have reasonably high dividend pay-out ratios. Their share prices are often inversely linked to bond rates, so that if bond rates increase, the share price of defensive stocks will typically decrease because investors may switch into bonds if they find their yields to be more attractive than those of Defensive stocks.

 
Approach

The Manager has a style neutral approach because it aims to outperform the index and maximise returns to shareholders throughout the economic and market cycle.

However, the Manager’s natural inclination towards capital preservation, makes it difficult to not at least maintain a cursory eye upon the value proposition on offer at all times.