13 Apr 2023
Any fund manager knows that you can be a rooster; and then very quickly, a feather-duster.
Especially when you work in the unforgiving world of ASX-listed small-cap and micro-cap companies, and your proposition as a manager is that you will scour the market at a capitalisation level between $50 million and $200 million, and put together a portfolio of 20 to 40 stocks that you believe have the best potential for long-term share price growth; companies that have a commercially proven business, but which have not, as yet, been discovered by the broader investment community.
This is where Dean Fergie and Graeme Carson, founders and co-managers of the Cyan 3G Fund, find themselves.
With an inception date of July 2014, the 3G Fund was running at an average annual FY return of 16.6 per cent a year by FY 2020/21, when it returned 31.8 per cent.
But in late 2021, things started to slip.
Taking a beating
In hindsight, stocks were exposed early in 2022, when the first US inflation report of the year showed a 7 per cent annual rise. Russia’s February invasion of Ukraine further rattled global markets. The Federal Reserve began raising interest rates in March 2022 to fight inflation – and hasn’t stopped.
But it has been a more difficult road for the Cyan 3G Fund than most.
In 2021/22 the fund lost 35.8 per cent, falling by 16.8 per cent in June 2022 alone. For 2022/23, so far, it’s down 9.6 per cent, having fallen by 7.7 per cent in February 2023.
Had you invested $100,000 in the Cyan 3G Fund at inception in July 2014, by November 2021, your investment had almost tripled to $295,729.
But by end-February 2023 it was worth $150,407 – down 49.1 per cent from the peak.
After a bruising February, in which the fund lost 7.7 per cent, The Inside Investor sits down with Fergie to ask the obvious question – how does it feel when the market gives out such a beating?
“It’s been really difficult,” Fergie says. “When you are a professional investor, and you run a fund like ours, people give you money because they want to invest in the smaller and micro-cap end of the market, in companies that are moving through the growth phase.
“Graeme and I aren’t second-guessing our process; we don’t sit around saying, ‘Oh, we need to change our whole investment philosophy.’ We’ve got complete faith in our process and what we’re targeting. But you do have a lot of frustration, emotionally, because you’re not achieving the results that you expect and have promised your investors…”
“That’s a sector of the market where, if you get it right, in the right cycle of the market, you can make some extremely good returns; and even if as a private investor, you’ve only got a small portion of your wealth there, it can really move the dial on your overall investment. But conversely, it can also be incrementally harmful when it doesn’t work very well.”
The manager’s responsibility, he says, is to not talk things up too much when things are going really well.
“We had three or four years where our average returns were in the range of 20 to 25 per cent a year. When that’s happening you may have some investors looking at that over the medium term and thinking, ‘Oh, I’ll just extrapolate that, and if I give these guys $100,000, it’ll be 200,000 in three or four years.’
“We can’t control that; in fact, as a manager you’ve got a responsibility to say, ‘Look, that’s not likely.’ We’ve certainly never said that people should extrapolate our returns, in fact, we’ve always said, ‘be well aware of the risks.’
The upside of the stock market, Fergie says, is that there is a lot of liquidity and investors are not locked-into an investment; but the downside is that everything has to be marked-to-market every day, depending on the vagaries of liquidity and what private investors want to do.
“The sector where we invest is very heavily influenced by general market sentiment, and the fact that liquidity for our kinds of stocks can fall away at times.”
Fergie is well aware of John Maynard Keynes’ famous adage that “Markets can stay irrational longer than you can stay solvent.” And while he does feel that much of the market behaviour is completely irrational, “you have to play what’s in front of you,” he says.
A case in point is the fund’s largest holding (7 per cent of the portfolio), Melbourne-based software company Alcidion, which is an emerging player in the field of healthcare informatics.
Since June 2021, Alcidion shares have fallen 73 per cent to 12 cents; despite, Fergie says, an almost-constant flow of good news. Alcidion is successfully rolling-out its product suite in the UK health market – specifically NHS system hospitals – and recently saw its biggest Australian contract extended for five years.
“For us, Alcidion really sums up the market. If you go back through their recent announcements, they’re constantly winning new contracts, all their metrics are going in the right direction, and yet the share price has just continued going south. It mystifies us.”
There are plenty of such conundrums. The 3G Fund was an early investor in Melbourne-based video game developer PlaySide Studios, which rocketed from its 20-cent initial public offering (IPO) in December 2020 to a peak of $1.19 in February 2022, only to subside to 33 cents at present. PlaySide is a world-renowned company in its field, but life as a listed stock has been tough, Fergie says.
“I wouldn’t say it’s been a victim of its own success, but everything went its way early on, which saw some very strong revenue growth, and some very big international clients coming onboard. But there was a confluence of events that made the story unwind a little bit.”
Yet PlaySide Studios will stay in the portfolio. “Yes, it’s languishing,” he says. “They’re likely to be close to profitable; and they’re operating on global scale. So, I think there’s a lot of merit there, and that it’s a business that could rebound and become valuable as a very scalable business model.”
It’s a similar situation with micro-investment fintech company Raiz.
“Clearly, the funds management industry has been going through a difficult time,” he says. You’ve seen the Magellans and Platinums and Pinnacles all unwind. Raiz is a business that is obviously very retail-focused: but its FUM is exactly what it was 12 months ago, in a very, very difficult market, and with a stable customer base, they’ve reduced their cash burn. Granted, there have been some issues with the board and management, which they’ve resolved. But from our perspective, we think it’s a great buy at these levels around 40 cents — but I probably would’ve said that at 60 cents.”
Staying the course
Being so disappointed in individual stocks, Fergie says he “understands perfectly” how investors must feel. “It goes back to what I said, people give us money because they want to invest in the smaller micro-cap end of the market. If you’re a private investor seeing a stock drop 5 per cent or 10 per cent every day, you would lose patience.”
Is a fall like this unnerving, professionally?
“I don’t think that’s the right word,” Fergie says. “Graeme and I aren’t second-guessing our process; we don’t sit around saying, ‘Oh, we need to change our whole investment philosophy.’ We’ve got complete faith in our process and what we’re targeting. But you do have a lot of frustration, emotionally, because you’re not achieving the results that you expect and have promised your investors, certainly in the short term.”
Investors, largely, are staying the course, he says.
“We’re lucky in that we built Cyan from personal relationships with high-net-wealth investors and small family offices. We’ve got around 150 individual clients. If ever they were going to panic and take all their money out, they would’ve done it by now. We don’t rely on one or two big mandates, that might account for half or two-thirds of the business of some smaller managers, and you can be in real trouble if one of those mandates walks. But we’re not in that situation. We’re a low-cost business. We’re big holders ourselves, and we’re not going anywhere.”
Fergie likens it to a 95:5 rule. “Maybe 5 per cent of our investors get really panicked; they’re calling us every couple of weeks to ask how things are going. But 95 per cent of them are thinking, ‘I put my money in Cyan for five years, I know there’ll be volatility, I’ve got a diversified portfolio and I’m comfortable riding it out.’”
It comes down to relationships, he says. “It took us a long time, with a lot of personal relationships to build up our client base. It’s hard to build a really sticky relationship, but it’s a lot easier to keep a very sticky relationship. So, from that perspective, it’s not really an existential worry – it’s just emotionally and professionally difficult when you’re not always achieving the results that you’d like to be posting for your clients.
“It’s very rewarding when you’re doing it well and all your investors are really happy, but at the moment they’re probably a bit frustrated or disappointed, like we are,” Fergie continues. “I’m quite confident that at some stage we’ll have a period where things will tick upward – probably after we touch peak despair in the small-cap world – and after that, they’ll be glad we’re part of their portfolio.”