In a follow-up to our last blog on lessons from 2020, Andrew Baume and I discuss some of the challenges for investing when everything is so expensive.

Investors find it very difficult to feel enthusiastic about deploying capital in markets that are priced well above their historical norms and away from the investor's measure of value. Compounding this unease are periods where the outlook seems so uncertain. If anything, 2020 taught us that this is no reason not to deploy that capital.

It also told us that an explicit expense such as a manager fee is very persuasive compared to the more subtle question of paying for a manager with a value or risk adjusted return focus.

Keynes is often quoted as saying "markets can stay irrational longer than you can stay solvent", but the current asset inflation is by no means irrational.

It is the only possible response to liquidity injections designed to combat the most scary of diseases - deflation - at a time when the global savings pool is bigger than at any time in human history, not only by amount but also per capita in the Developed World.

In March 2020 the immediate response to a global shutdown was market action presuming significant slowing of world GDP with concurrent massive unemployment and dissaving. Governments and central banks who have discovered the joy of free money responded incredibly quickly, pulling asset prices off the floor. The German DAX had dropped 35% and the UK FTSE lost 30% by the time COVID shocks were fully priced. Ultimately GDP fell nearly 10% in the UK and Europe. Though prices have now recovered faster than economies with the DAX comfortably above Feb 2020 highs and the FTSE just below.

So, the fundamental analysis that has been the backbone of the investment process for a hundred or more years is giving us signals that the weight of money seems to completely ignore. The deluge of liquidity means that most assets are now extremely exposed to the risk-free interest rate which drives the dividend discount model of valuation. Despite this, 2020 shows us we need to remain invested, the option of waiting for a 'buying opportunity' is loaded against those allocated to zero rate cash.

Many allocators have been disappointed by the performance of their "liquid alternatives" allocations, partly because there had been a presumption that they would not behave in step with equities when there was a significant price pullback. This proved not always to be the case, some managers allowing the view they were un- or negatively correlated with equities in times of stress to persist even if not stating it explicitly.

In fact a symptom of the new low rates case is for the markets to tend towards a positive correlation (even towards 1) in both down and up markets. The sense that many "alpha" strategies were actually correlated with beta was borne out by performance.

Assets that were less liquid and tended not to be marked to market fared much better in March 2020 as new buyers vanished in the most liquid markets. Central banks managed the crisis via liquidity, bringing buyers back in to markets and evening out the performance gap between the liquid and less liquid. As the liquidity crisis was so short lived it is difficult to estimate how the less liquid asset classes would have performed under longer term redemption pressure.

Human nature is often seen in corporate behaviour as well. As people we often conflate familiarity with understanding, in fact it is much easier to act on our familiar triggers than to delve into the true nature of an event. Daniel Kahneman is a psychologist who won a Nobel Prize in Economics by recognizing this trait.

A couple of easy but potentially dangerous learnings from 2020 may be to remove liquid alternative sources of returns from portfolios and focus more on illiquid ones. Both courses of action are understandable responses but need to be taken in the context of all scenarios, not merely the one we have just witnessed.

So disappointment needs to be viewed in context. We all fall into the common trap of analysing the performance of each component of a portfolio when the outcome of all of the components working together was within expectations. Disappointment should be confined to when the overall portfolio performed outside expectations (given every portfolio has layers of risk, this expectation needs to be realistic). Secondly disappointment with a particular allocation needs to be seen in the prism of how the allocation was designed to behave and whether the execution failed the design. It is no good complaining about a liquid alternatives not being negatively correlated with equities when the underlying design did not include that characteristic for example.

One of the hot topics in Equity and to an extent Fixed Income investing is the cost benefit of indexing rather than active management. The design of that strategy is to outsource your return to the momentum of everyone else in the market. It will be interesting to see whether the mooted return of the value investor puts a spotlight on that design feature.

The next article will cover diversification as it relates to whole of cycle investing.

Recently I sat down with my colleague Andrew Baume to reflect on 2020 and what lessons can be drawn. As he says, with the dubious benefit of over 35 years in Financial Markets, "I have grown weary of commentators who do not accept that this time it is different." The fact that market prices move from one day to the next is evidence that not only this time, but every day in markets is different, otherwise, we could crystal ball gaze and live the simple life.

The era of "democratisation of information" may be a new phenomenon, but as any student of history will know, change is a constant. 

When Sir Thomas More walked across the iced-over Thames into the Tower of London he contemplated how cold London had become. In the early 1980s, Paul Volcker decided to massively manipulate the overnight cash rate and money supply. Mao Zedong was accused by Khrushchev of ruling via a "cult of personality". Mark Twain famously said history does not repeat itself, but it rhymes.

The past 12 months of investment markets have rhymed in an often clanging disharmony with elements of times past, but they are clearly also different. George Soros took a view against the Bank of England in 1992 that was a blueprint for the Reddit warriors to take on hedge fund shorted stocks as a cause célèbre. Soros was backed by deep research and a conviction that the level of the GBP was wrong, but it was might and a squeeze that won the day for him. GameStop was just might and weight of numbers, so soon reversed leading to massive losses for the warriors who bought at either of the tops (so far).

The COVID-19 asset pricing crisis of March 2020 was another driven more by weight of numbers than by deep research or analysis of the future case given the events playing out. Once the liquidity picture became clearer, and the stance of central banks doing "whatever it takes" (rhyming with Draghi) prices responded.

Investment textbooks teach that there is an "optimisation" process that over time will lead to smoother and ultimately better outcomes. Academic investing has a tendency to argue away the times when correlations break down, referring to the long term nature of the ideal investment portfolio. The danger of that approach is shown with the more common incidences of increased correlations between many markets over the last 20 years or so.

Managers have sometimes found it convenient to be seen as having negative correlations to other asset classes (usually equities) and found that in times of stress that is hard to sustain. Not only does that idea get more regularly tested than historically, by allowing that implication to be held the sector as a whole suffers crises in confidence. How we long for an investment that looks the same once the can is opened as the picture on the label. Optimisation when measured in hindsight can look anything but optimal.

Despite that, innovative methods of investing are an essential response to the constant change in conditions. One example of truly uncharted waters is a global middle class saving for their own retirement (rather than receiving a government or employer pension). According to the OECD, the global retirement pool is over US$49 trillion and growing. Once added to the bottomless pit of liquidity being provided by governments globally, it is little wonder markets are staying well bid and commentators call for another crash (they have predicted 27 of the last 3 pullbacks).

It is certainly not the first time investors feel impelled to buy assets that feel expensive. FOMO is real as asset prices stay frothy and cash rates are below inflation. Bond rates have already reflected the policy of massive stimulation, the capacity for them to provide relief in the event of an equity selloff has diminished compared to times past. Most asset valuations have benefitted from low discount rates, and assets like bonds that may have a veneer of negative correlation lose that relationship in stress. There is an ongoing need to be invested when being in cash is so penalising. 

In the midst of this, central banks tempt us with rhetoric that rates are not going anywhere for at least a couple of years. Investors can't rely on an optimisation strategy that worked when interest rates were higher. Diversification of sources of return that don't rely on low-interest rates is a difficult task, one that will improve portfolio outcomes particularly from a risk concentration standpoint. It was not just fixed interest that felt a shiver as US bond rates rose by 66% in the last two months.

There is no guarantee that any strategy is negatively correlated with any other during times of stress. Investors have to stay invested but perhaps the rhymes of history can be harnessed to build a more resilient dynamic asset allocation that reflects the way markets are behaving, not just reflecting expectations or hopes. Diversification through relatively static asset allocations needs "time in the market" to generate the academic outcome but can lead to wild rides in the interim. A 70/30 equity/others split works as the tide rises all boats, but clearly, the inverse is also true.

Diversification of return sources and an ability to dynamically reallocate has attractive characteristics because as Keynes said, "the market can remain irrational for longer than you can remain solvent". There is no option to be out of the market waiting for a time for assets to "cheapen."

Lastly, when markets move in ways that weren't expected, history is clear; more money is lost selling at the lows that made by timing the entry point. 2020's price action where the collapse and subsequent recovery of asset pricing on relatively low volume suggests participants are hearing the rhymes. 

"Needing" to sell assets in the dip was painful. Funds that had large amounts of illiquid assets had the light shined on them when an externality such as government allowing access to the hitherto always growing superannuation balance of millions of members tested liquidity policies. Illiquidity is not a bad thing at all as it usually comes with a premium and investors with long term horizons can bank that. Strong inflows had a dampening effect on the liquidity drain, but there is a lingering question of equity between the members who withdrew for super at a very small discount to pre-Covid pricing (and potentially reinvested into markets down 20-30%) and those who remained in the fund with even lower liquidity and an asset that might well not have been realisable at the holding price. Access to higher liquidity assets also allow funds to make bigger strategic rebalancing decisions.

Although timing the market is hard, there are big events where the need to do that is clear. Entities that seek to maintain fixed weight allocations also need to find flows to do that and top up the allocations for the sector that has fallen most. Some interesting thought bubbles for allocators to ponder.

In summary, lessons we can glean from knowing our history and looking for rhymes (not rules) are multiple, but some are straightforward:

• Crises are inevitable but their manifestation will often be unique,
• No matter how "expensive" market conditions may be, an investor has to deploy funds,
• Correlation and dispersion in practice can be quite different to the textbook,
• Abandoning alternative sources of return as the traditional ones get more and more expensive seems brave,
• The human element (irrational exuberance or negative bias) can weaken our investment outcome, but many have rejected quantitative over discretionary investing,
• Stabilising strategies are more reliable than tactical (over)trading, but Fixed Income is losing its ability to stabilise, and
• Investors often conflate familiarity with understanding - they can be much more at risk with a "vanilla" 70:30 allocation strategy than one that has dynamic and dispersed sources of return.

This is the first of several pieces that will explore these lessons of 2020 while recognising the environment of 2021. The outcome will rhyme with the past, but history will not repeat.

• The ANZ, NAB and WBC results for the March half-year demonstrated comfortable provisioning, strong balance sheets, improving margins, and prudent funding. What was missing was organic growth.
• The banks' loan write-downs in the next two years will be less than the provisions they made last year, but provision write-backs are no substitute for growth.
• We continue to believe that, although the banks will track Australia's post-coronavirus recovery, they will underperform the market in the longer term.

Last November we said that the big four banks were on the road to recovery, and recommended that investors hang onto the banks as a leveraged play on Australian growth in 2021. Over the last six months the banks' share prices rose by 35% or more: now the question is, can they keep on out-performing?

Australian investors have come around to the belief that our economy is on a smooth path to recovery, so they expect bank earnings to recover in line with the economy. Consensus forecasts imply that, after their FY21 rebound, bank earnings per share will grow by less than 10% in each of the next two years. Dividend payouts will not return to their pre-pandemic levels of 75%-plus, so dividend yields will grow very slowly from their FY21 levels of 4.5% to 5.0%.

The banks are simply not as profitable as they used to be, because of higher capital requirements and increased competition in key areas. A decade ago, 20% returns on equity were common; by contrast, in the next couple of years CBA will earn about 12% and ANZ, NAB and Westpac 9% to 10%.

The changed environment is reflected in the banks' dismal share price performance from 2015 to 2020 as seen in the graph below. CBA alone has just beaten its 2015 share price peak; the other three are still about 30% below their 2015 peaks. The "new normal" after COVID-19 will not be much better for the banks than the old normal before the pandemic.

Australian "Big Four" Banks share prices indexed to Base 100 = March 2015

Source: FACTSET

In the longer term, the banks still face the four strategic threats described on our 22 July 2019 paper (available on the Arminius website): higher standards, cryptocurrencies and payment systems, fintechs and neobanks, and ultra-low interest rates. The pandemic diverted attention from these threats, but the threats are still there.

We believe that the combined effects of these threats will erode the banks' growth rates over the next five years, with the result that their total returns will be about 1%pa below the 10.2%pa long-term return of the Australian share market.

The banks have already remediated almost all of their customers and updated their systems to cope with higher regulatory standards. Their CEOs have begun to lay out their post-pandemic strategies, and it is clear that they are based on very different visions of the future of banking.

We do not regard cryptocurrencies as a threat to the standard banking model, partly because acceptance is limited to the true believers, and partly because the regulators have barely started to supervise the sector. Payment systems, however, are undergoing dramatic changes which could change the banking model over the next five years. In particular, all of the major central banks are now looking at issuing their own digital currencies, and some of them may copy the Chinese model.

The pandemic killed off some of the weaker neobanks and fintechs, but the stronger players (e.g. Judo) have survived and are winning market share. Ultimately, their owners will probably succumb to the temptation to sell out to the big banks, but over the next few years they will nibble away at the incumbents' margins, in the same sort of process that we have seen in other disrupted sectors such as airlines and telecommunications.

Ultra-low interest rates are not a permanent feature of the Australian financial landscape, and the Reserve Bank's response to the pandemic included assistance to the banks. It is likely that the strength of the recovery, the jump in house prices, and the emerging inflationary pressures will encourage the Reserve Bank to begin raising official interest rates sooner than the market is expecting.

In addition, there is the challenge issued by the Reserve Bank of New Zealand. During the GFC, the Kiwi regulators could hardly fail to notice that the Australian banks operating in NZ made decisions to suit their Australian regulators and shareholders, without regard to their Kiwi stakeholders. The RBNZ has told the banks that it wants much higher capital ratios in their NZ businesses, ring-fenced so that Kiwi stakeholders come first. The Aussie banks must either comply, and see their Kiwi return on equity drop, or they must divest their NZ businesses.

Most importantly, the big four Australian banks are no longer cheap. In terms of price-earnings ratios and price-to-book ratios, they are more expensive than most banks in the developed world, even their much stronger US counterparts.

All data is in local currency terms. Blue data points are country level section averages, with the exception of Mkt Cap which is a sum total.

Source: FACTSET

They are also slightly expensive relative to their own history. Relative to the Australian market, however, they are still slightly cheap, and their strong capital positions leave room for share buybacks. Therefore we recommend that investors maintain their bank holdings, at least until the next set of results in November.

When the Australian Investment Council, the peak investment body for private asset managers, released the performance highlights for the most recent financial year it was shown yet again that Australian Private Equity outperformed listed markets over a 5, 10 and 20 year period by between 2.0% and 8.9% p.a. net of all fees:

These results are consistent with findings overseas and makes intuitive sense given investors should be rewarded with an "illiquidity premium" for investing in private assets.

But what is less understood is what drives these consistently superior returns.  We set out in this article to examine some of the key factors that contribute to Private Equity's outperformance.

GREATER OPPORTUNITY SET

Illion, in a recent report on SME business opportunities estimated that there are around 14,000 private companies in Australia which could be classed as small-medium (revenues of $20-150m).  This contrasts with the number of larger private businesses (~2,000) and the typical public fund universe of 200-300 securities.  It can even be argued that the real investable universe for public equity large cap managers is even smaller as many managers are restricted to primarily dealing in the top 30-50 securities given their mandate and liquidity constraints.

But how accessible are these private companies to PE managers?  In a report published in 2017 by PricewaterhouseCoopers, over two thirds of founders or family business owners indicated they will sell their business or pass it on to the next generation in the next five years providing ample acquisition opportunities for private equity managers.

The existence of a greater number of companies being competed for by a fewer number of purchasers leads to more opportunity to find "undiscovered gems" at prices that don't necessarily find equilibrium through normal market discovery processes.

Number of Australian private companies by sector activity and by size of revenues: 

Source: Illion | Services: Trade, Accommodation and Food Services, Transport, Postal and Warehousing, Information Media and Telecommunications, Financial and Insurance Services, Professional, Scientific and Technical Services, Administrative and Support Services, Public Administration and Safety, Education and Training, Health Care and Social Assistance, Arts and Recreation Services and Other Services. Industrials: Mining, Manufacturing, Electricity, Gas, Water and Waste Services and Construction.

LOWER ENTRY MULTIPLES

The entry multiples, that is the measure of the price paid for a business as a multiple of EBITDA, are lower for private businesses than they are for public ones.  This is a natural outcome from greater public company information availability combined with the fact that the price that purchasers are willing to pay being lower for private assets.

In turn, multiples paid for small to medium private businesses are on average lower than those paid for larger businesses due to those businesses being perceived as being more risky.  The table below shows that multiples for small-mid sized private businesses in Australia generally fall between 6-8x EBITDA whereas larger businesses fall into the 10-12x range.

The price that a purchaser pays for an investee company is critical in determining the return an investor achieves.

Multiples of completed Australian company transactions grouped by Enterprise Value

Source: Dealtracker 2020; Grant Thornton

VALUE CREATED THROUGH INTERVENTION

With larger listed businesses it is often the case that they are able to afford to employ the expertise to enable operations and strategy excellence to create efficiencies that enhance overall company performance.  This is rarely the case with private businesses and particularly with smaller businesses which are family or founder owned.

For family or founder owned companies and start-ups with less management capability, significant value can be created by leveraging the expertise provided by private equity firms. Company efficiencies are improved, growth is accelerated through customer expansion, M&A activity initiated, managing cash, reducing costs, attracting talent and improving IT systems.

Often these businesses see private equity as a valuable way of accessing industry experts who can assist with benchmarking, accessing new markets and generally providing expertise that is not easily accessible otherwise.

Adams Street Partners, a global private markets specialist,  quantified the sources from value creation in the US LBO Private Equity market from revenue growth being at 38% and multiple arbitrage (which is often a by-product of revenue growth) at 33% meaning the managers they studied brought meaningful value to private investments primarily through the enhancements they made to private businesses.

LESS RED TAPE

It can be argued that the focus of boards on corporate governance related to shareholder requirements and oversight can stifle entrepreneurial spirit.  Listed company boards spend large amounts of time concerned with control-related topics and shareholder reporting as opposed to matters concerning expanding the business.  Private equity managers are often able to strike a balance between governance and growth to deliver on their investment thesis and increase the value of their portfolio companies.​

There are a multitude of other reasons that private equity may result in better company performance that public ownership.  These include:

• Release of capital constraints: An injection of capital under private ownership may enable improvements and/or financing of growth opportunities that may have been limited where capital sourcing opportunities were inhibited through public ownership restrictions
• Patient capital.  Private equity managers can choose when to deploy capital based on opportunities available, economic conditions and price.  The evidence that timing when to invest can make meaningful differences to performance outcomes is evidenced by the fact that Private Equity funds that invested during and following significant economic downturns have significantly outperformed other vintage years.
• Lack of analyst coverage: For some smaller listed businesses, their lack of size means less company analyst coverage which can inhibit a companies ability to raise capital for growth opportunities.  This issue goes away with private ownership focussed on investing for growth.​

In conclusion: Private Equity has been shown to outperform public equity over long periods across numerous markets, for a number of reasons.  Institutional investors have known this for decades and have allocated meaningful amounts to the asset class.  Through Vantage Private Equity individual investors now have the opportunity to participate in these institutional, private opportunities and access the significant returns that the Private Equity asset class delivers.

• Not all areas of the market that are benefiting from the recent shift in market sentiment are good places to invest.
• A balanced view that includes assessment of value and quality in addition to sentiment points us to six sectors that are particularly attractive in this environment.

In recent weeks, market sentiment has undeniably shifted away from relatively expensive, high-risk, low-quality stocks. To illustrate the magnitude of this aggregate shift, it's helpful to compare our measures of sentiment with our assessments of value, quality, and risk.

The correlation between sentiment and value has shifted from negative to positive over the past two months; the already positive correlation between sentiment and quality has become higher over the same period. At the same time, the correlation between sentiment and high risk has plummeted. Figure 1 shows the extent to which investors recently have been turning their attention toward more reasonably valued, higher-quality, lower-risk stocks.

Figure 1

Correlation of Active Quantitative Equity's Proprietary Sentiment Scores with Proprietary Scores for Value, Quality, and Risk

That said, in our view not every area of the market with improving sentiment is a good place to invest, and not every segment with deteriorating sentiment should be avoided. Consumer Services and Real Estate both remain unattractive on our measures, despite their improvement in sentiment in recent months. In general, Consumer Services firms still represent very poor value (when taking quality considerations into account). And although many Real Estate companies continue to be of high quality, our signals - which quantitatively analyze the language used in earnings conference calls and in the explanatory notes of financial reports - are concerning.

The six market segments we most favor in this environment of shifting sentiment (in no particular order) are Health Care Equipment, Banks, Insurance, Technology Hardware, Autos, and Semiconductors. Our preferences are not always based on improvement in sentiment (see Figure 2). For example, although the broader Health Care sector has experienced heavy deterioration in market sentiment, we still like Health Care Equipment and Services, especially in the US. The language signals from Health Care Equipment and Services companies' conference call transcripts and financial reports are very strong, valuations are reasonable, and quality is high.

Figure 2

 AQE's Current Most-Favored and Least-Favored Sectors

Banks have benefited from improving sentiment in recent weeks. While we favor banks overall, that improvement in sentiment is not the sole source of that positive assessment. Drilling down to examine banks by region reveals some important distinctions. European banks have seen a much larger improvement in sentiment than their North American counterparts, but we view European banks as only neutral in attractiveness compared with cheaper North American banks.

The same multi-dimensional view informs our negative assessments as well. Sentiment toward real estate stocks across the developed world has improved a lot in recent weeks, but in Europe sentiment toward real estate stocks has actually gotten worse. Our language signals for European real estate names are also very poor.

Bottom Line

Sentiment has turned to favor attributes we like, including high quality and cheaper valuation. When choosing stocks, however, it's important to weigh all important attributes, including value, quality, and risk - as well as sentiment - in order to avoid simply riding the latest sentiment trends.

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Richard Ivers, portfolio manager for the Prime Value Emerging Opportunities Fund, has notched up his first three years in charge of the small caps investment fund.

Markets have thrown just about everything at investment managers during this time: from flat spots to record highs, and the 'fastest bear market in history', which happened as COVID-19 panicked investment markets.

Ivers steered the Prime Value Emerging Opportunities Fund to several key milestones, including being the second best performing Australian equities fund for the 2020 calendar year.

He has delivered returns well above the market by prioritising capital protection. "Protecting capital is the most important step for us because if we minimise losses we maximise opportunities.

"Every market event creates opportunities. The volatility we have seen in small caps across COVID has provided us with excellent chances to invest in quality companies poised to do well during the recovery and beyond.

"But it all starts with a commitment to preserving capital, which means avoiding the speculative stocks and looking through the hype to find real quality."

Key numbers for the Prime Value Emerging Opportunities Fund:

For the last three years the Prime Value Emerging Opportunities Fund has delivered 20.7% per annum to investors while the index returned 9.1% per annum - this means the Fund has outperformed the index by 11.6% per annum net of fees.

During this three years:

• The Fund has outperformed 87% of months when the index has fallen (13 months out of 15)
• Outperformed 52% of months when the index has risen (11 months out of 21)
• Outperformed 67% in total of all months (24 months out of 36).

The last time the Prime Value Emerging Opportunities Fund underperformed in a falling month was December 2018 - over two years ago.

For the year to 30 April 2021 the PVEOF has delivered 54.91%, outperforming the small ordinaries accumulation index by 15.14%, outperforming strongly during 12 months of rising markets.

The Fund has delivered 13 consecutive months of positive returns, while the index has had three negative months during that 13.

The Prime Value Emerging Opportunities Fund's last negative returning month was March 2020 (during the COVID crash).

Performance has been achieved at a lower level of volatility than the market: risk, as measured by volatility, (standard deviation) has been 13.8% below the index. This results in a far superior Sharpe ratio, which measures risk-adjusted returns.

Most articles we read are about hot stock tips to buy. Occasionally there are articles about "shorting" opportunities, albeit most are directed to sophisticated investors given the risks around shorting (i.e. a potential loss that exceeds your initial investment). Very few articles talk about when to sell.

However, it can be just as important to know when to sell as when and what to buy, a key skill in active management.

The Redbubble thesis revisited

Last year, we highlighted Redbubble as a COVID winner with global aspirations. The business was a significant beneficiary of lockdowns and stimulus payments - with their years and dollars of investment in the artist platform, logistics and supply chains - paying dividends during the global e-commerce boom, especially in their key US markets.

The company's execution during this period was stellar as it managed the significant spike in sales volume during the COVID work-from-home period. It was quick to take advantage of the boom in facemask demand - an entirely new product category - which immediately became a major contributor to revenue.

The marketplace platform also demonstrated the power of operating leverage, as 96 per cent growth in Revenue delivered 1,028 per cent growth in EBITDA (albeit off a low base) in the December 2020 half. Incremental margins of 25-30 per cent helped drive improved profitability. The Redbubble flywheel helped generate interest during lockdowns, with significant social media interest on Tik Tok and Twitter as well as more mainstream media articles drive users.

With all these positive tailwinds, why did we sell out of our holding in Redbubble?

In my previous article, the empirical paper "Selling Fast, Buying Slow" referred to three discrepancies between the buying and selling performance of investors:

• Investors displayed clear skill in buying - positions added to the portfolio outperformed both the benchmark and a strategy which randomly bought more shares of assets already held in the portfolio;

• Selling decisions failed to beat a no-skill strategy of selling randomly chosen positions - the level of underperformance was observed to be significant, such that it dragged down performance by 50 to 100 basis points; and

• Selling decisions coinciding with releases of portfolio-relevant information outperform - for example, following the release of company earnings announcements.

It is the final point which is relevant in our decision to sell our remaining holding.

Assessing earnings risk

At Montgomery, we not only focus on the price vs valuation of our investments but also the earnings risks - either higher or lower than market estimates. In many cases, it is these earnings risks that provide significant upside or downside potential relative to the current share price - especially for less mature businesses - as they drive the growth trajectory of future earnings.

For Redbubble, the share price faced its first significant road-bump following its DecH20 result released in February. The update revealed some additional costs related to paid acquisition and shipping, as well as reduced gross margins related to promotional activity in the December quarter. Some of these took the market by surprise, and the share price sold off ~15 per cent in the weeks following the release as it too caught up in the broader "rotation" out of e-commerce winners.

Earnings risk assessed for March quarter underpins exit thesis

The next stock-specific catalyst was the March quarter sales update. With the share price re-based to $5-6/sh after some margin-related earnings downgrades, it was important to assess the likely trajectory of earnings for the June half of FY21.

There were two key areas that underpinned our decision to sell prior to Redbubble's March quarter earnings release:

Contribution of face masks to revenue

While many investors were aware of facemasks being a significant contributor to revenue growth, there were few estimates of the quantum of revenue contribution.

After peaking at ~25 per cent of revenue in July, we assessed facemasks had declined to ~5-7 per cent of revenue exiting December. This has a significant impact not only for Redbubble's revenue for March, but also the difficulty in "comping" elevated face-masks sales that were unlikely to be repeated in the September quarter 2021.

We also assumed even if COVID did not recede, facemasks were unlikely to be a significant repeat contributor in the key US market due to i) greater competition in masks; and ii) warmer months in the northern hemisphere in conjunction with vaccine roll-out.

Impact of currency on revenue growth

Given the volatile moves in currency and the US' contribution to revenue, this represented a significant swing factor in our estimates of Redbubble's revenue trajectory.

With >70 per cent of Redbubble's revenue from North America and the strength of the AUD vs USD, this represented ~15 per cent headwind to its top line versus the prior comparative period, which we assessed had yet to be fully factored in market earnings estimates.

Where we could have been wrong

While the decision to sell ahead of its April earnings release may appear to be obvious in hindsight, there were factors which we had to consider where we may be wrong:

• The market may have looked through currency impacted growth - our assessment of 80 per cent top-line is still impressive;

• An accretive, complementary transaction given its extremely strong balance sheet - which we deemed lower risk given RBL's organic growth opportunities and relatively new CEO;

• Potential recovery in gross profit and EBITDA margins;

• Our sales estimates are wrong, and the company could deliver higher than expected.

All of these factors (and other unexpected positive developments) may have resulted in a higher share price. Despite this, we deemed the risk skew to the earnings and subsequent share price impact was to the downside.

Where to given sell-off?

With the Redbubble share price having re-based once again (more significantly than we had anticipated) - and with incremental new future sales targets, earnings and profit margins and investment focus areas, it may be worth re-assessing the shares once again as an investment opportunity.

Many of the aspects which initially attracted us to the Redbubble business - the flywheel, operating leverage, investment in supply chains, global reach and aspirations - remains intact.

There is also increased awareness of the Redbubble brand given the spike in website viewer traffic and new customers acquired during COVID.

It is also clearly a much more valuable company coming out of COVID than it was going in, and should new CEO Michael Ilczynski and the Redbubble team start delivering on its aspirational targets, will likely become more valuable over time.