Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Tiger Cub prowls the peaks
With markets as frothy as they are, you need to find the misfits – and play your cards close to the chest. It helps to be away from the pack.
It often takes an outsider to reveal the idiosyncrasies of Australian society. The same can be true of its financial services. Adam Leitzes, founder and chief investment officer of hedge fund Karst Peak Capital, spends most of his time in Hong Kong, well outside the cloistered Australian funds management scene – and is happy about it.
“I’ve been a little bit away from the pack; there’s good and bad things to that, but the benefit is that I find Australia to be a very close-knit community – it’s very broker driven, there’s a lot of gossip… all the funds are in Sydney and they’re all meeting at the same pubs and talking about the same people,” Leitzes says.
“It’s hard to be contrarian in that environment, and it’s hard to think differently, and it’s hard to hold on to something you might own when it’s going against you – if it’s down 30 per cent and everybody around you is telling you why they have problems and why they sold the stock. That can be damaging, psychologically.”
Once a Forbes journalist, Leitzes looked to apply the same investigative techniques in his work as an analyst at Tiger Management, the family office of Tiger Management founder Julian Robertson. He soon homed in on Asia – both he and Robertson were interested in exploring a less efficient market with fewer funds on the ground – and launched Tiger’s Shanghai outpost in 2010, before Robertson offered him seed funding for his own venture: Karst Peak, another of the “Tiger Cubs” the legendary hedge fund has spawned over its 20-year history. Australia has proved a lucrative hunting ground.
“You’re seeing these ecosystems explode, particularly in the technology and healthcare space where a few early successes and big companies that have been built over the last ten years – Atlassian and Xero and Afterpay and Canva – are breeding the next stage of entrepreneurs and great companies,” Leitzes says. “I think we’re just getting started.”
One of the historical picks that Leitzes is most proud of – and which encapsulates his contrarian philosophy – has a relatively simple thesis behind it: nobody likes their skin being forced through a cheese grater. But that’s essentially how skin grafts for burn victims are harvested. Avita Healthcare had developed a form of “spray on skin” made with small amounts of a patient’s cells that made the process both easier and faster. Undervalued and unloved to the extent that nobody had even initiated research coverage despite it being listed for more than 15 years, Avita had seen limited success in commercialising the product and cracking the big US markets.
“It was one of the first major advancements in treating burns in decades, but nonetheless the company had languished for a long period of time,” Leitzes says. “… Investors were disillusioned by it because the share price vacillated for over a decade in the market with broken promises and never really got off the ground.
“We kind of like those things – things that are unloved, misunderstood, out of favour, and complicated.”
Leitzes ears perked up when the company announced new management in 2017, and commenced analysing the applications of its flagship product. Karst Peak conducted surveys of surgeons to gauge how likely they were to use the product and hired a third-party investigative firm to explore the background of the new CEO. Everything pointed to Avita being a buy. Karst Peak was about a year early to the party – but when it finally did get started with the product’s US launch, the bet paid off.
“It was only when the company started generating some real revenue that the stock started to take off,” Leitzes says. “Australian investors do like revenue generating companies… a lot of investors, both retail and institutional, avoid money-losing companies. We actually like that stage of a company because there’s not as many people picking it apart.”
Then there are those companies that, far from being unloved, are loved a little too much. Leitzes is reluctant to talk about Karst Peak’s shorts for two reasons: one, because they make most of their money on the longs; and two, because of the now infamous GameStop “short squeeze”. Nobody wants to wind up on the other end of an army of frenzied Reddit day traders.
Still, Karst Peak is always searching for “exaggeration, manipulation, and obfuscation”. Some high-profile Australian companies generate a significant amount of their revenue overseas, where their products sell at a premium, while the vast majority of the share registry and coverage is local – meaning a fundamental lack of visibility over sales and demand. Others rely on growth through acquisitions, creating a bloated network of businesses funded by debt, and take advantage of lax accounting standards to account for most of the acquisition price as goodwill.
“Companies in Australia can look artificially profitable compared to a very similar business overseas because of the way the accounting is treated,” Leitzes says. “That’s incentivised companies to be highly acquisitive, and it’s an interesting area where you’ve seen a lot of huge blowups if you can time them correctly.”
On Wall Street, where Leitzes started his career, hedge funds are a tripping hazard. By contrast, the total FUM of Australia and New Zealand’s hedge funds (about $40 billion) amounts to just one of America’s largest. Leitzes puts that down to a lack of mid-size pools of capital, such as those commanded by university endowments, foundations, and family offices. And Australia’s biggest investors – the titanic super funds – are highly fee sensitive. On top of that, the hedge funds that are around tend to be focused on higher turnover strategies rather than “deep fundamental research”.
“There’s not that many funds that are incentivised to do really deep work because most of them are not holding investments for many, many years,” Leitzes says. “That makes Australia quite unique and interesting, because it’s one of the few places in the world where this basic getting your hands dirty and channel checking can help generate alpha.”
Karst Peak has one analyst in Australia – Hashan De Silva, who studied medicine and covers the healthcare sector – and is looking to expand its team with a dedicated technology analyst in the next few months. The team doesn’t pay much attention to the macro picture, but Leitzes concedes that markets are frothy with soaring interest in cryptocurrencies and non-fungible tokens and says that “he feels particularly comfortable and sleeps better being only 35 per cent net long the market”.
One thing he is concerned about is the increasing interest in private investment at a time when the environment may not be as supportive of IPOs – admittedly not a systemic risk, but one that’s worth worrying about.
“If people became really concerned about inflation or interest rates really jumped significantly, you could see the markets really seize up… And then you could have people who are stuck in these pre-IPOs,” Leitzes says. “I don’t think all of them are structured very well to support being an illiquid private company.”
“It’s something that gives us pause, and makes us pretty cautious about the terms of these investments. We don’t just want to bank on these things going public. We want to think about what happens if they don’t.”
