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Fishing where the fish are

"The seas fringing land make up less than a tenth of the world's oceans, yet, astonishingly, 90 percent of all marine creatures live in these coastal waters." – David Attenborough

During the 2018 annual meeting for the Daily Journal, Charlie Munger, vice-chairman of Berkshire Hathaway and longtime partner of Warren Buffett, told investors: "The first rule of fishing is "fish where the fish are," and the second rule of fishing is "don't forget rule number one." And investing is the same thing. Some places have a lot of fish, and you don't have to be that good a fisherman to do pretty well. Other places are so heavily fished that no matter how good a fisherman you are, you aren't going to do very well."

If you are a fisherman, it makes sense to fish in the shallow coastal waters where the vast majority of fish are. If you are an investor, on the other hand, where should you go to find undervalued stocks? Although they can be found in many places, we believe the micro, small and mid-cap (SMid cap) universe offers a particularly high concentration of undervalued stocks.

We define micro-caps as companies capitalized below EUR 300 million, small-caps as those between EUR 300 million and EUR 2 billion, mid-caps between EUR 2 billion and EUR 10 billion, while anything over EUR 10 billion is large-cap.

By this definition, there are around 1,700 large-cap stocks globally. In contrast, there are close to 17,000 SMid cap companies. Hence, the opportunity set is ten times larger fishing in SMid cap waters than if you limit yourself to the biggest fish.

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A focus on catching fish rather than chasing whales. Photo: Yomex Owo, Unsplash.com

Mispriced opportunities

The SMid cap waters are also not as heavily fished. Investors steering funds with several billion dollars under management will have a tough time navigating the shallower SMid cap waters. Most large funds and those with a high turnover strategy need high trading liquidity in a stock to be able to invest. Hence, there's often a liquidity premium to be earned if you are willing and able to hold stocks with slightly lower liquidity.

Furthermore, SMid cap stocks receive far less research coverage from sell-side analysts than large-cap ones, increasing the likelihood of mispricing. Among large-caps, almost 90% have more than 10 analyst recommendations whereas only 4% are covered by five analysts or fewer. In contrast, only 16% of SMid cap stocks have over 10 analyst recommendations and about two thirds had five or less[1].

Of course, this does not mean that there can't be mispricing in large-cap stocks. However, we believe that they tend to be more efficiently priced and anomalies are fewer and farther between. As unconstrained contrarian value investors, we routinely invest across all company sizes, sectors and geographies. This is a great advantage as we can always cast our line where the fish are most plentiful in our pursuit of superior returns for our fellow SKAGEN Focus unit holders.

Increased exposure towards small and mid-cap stocks

We have gradually increased our emphasis on smaller companies and today about 85% of assets are invested in micro, small, mid-cap stocks. We expect this exposure to remain high in the future, although we will sometimes come across very attractive large-cap investment opportunities which we will not pass up.

It is important to note that with around EUR 150 million of assets, the fund could double in size two or three times over and remain nimble enough to take advantage of the attractive opportunities we currently see in the SMid cap space.

Over the past 12 months SKAGEN Focus has delivered very strong performance, both in absolute terms and relative to our benchmark. This has been the result of sticking to our guns, remaining true to our contrarian and price driven investment philosophy, and staying disciplined in our investing process. We have also been helped by external factors, such as value investing returning to favor and several holdings benefitting from raw materials tailwinds.

Regardless of what the future holds for the global equity market, we will continue to leverage our unconstrained mandate, stay true to our process and work diligently to find undervalued stocks, all while remembering the first and second rules of fishing.



[1] Source: Bloomberg

Historical returns are no guarantee for future returns. Future returns will depend, inter alia, on market developments, the fund manager's skill, the fund's risk profile and management fees. The return may become negative as a result of negative price developments.

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