ABSOLUTE RETURN FOCUS

At Watermark, our strategy is not reliant on a rising market to supplement returns. We focus on the absolute gain or loss that may result from each investment opportunity rather than the return relative to the broader share market. Similarly, we view risk as the prospect of losing capital rather than of under-performing the market. This is a true ‘uncorrelated’ strategy.

“When the bull market does after 12 years eventually become a bear, our strategy has the potential to continue advancing. Given we have the potential to be fully hedged, our portfolio can continue to perform in both up and down markets”

Click on the links below to learn more about our approach.

PHILOSOPHY

We aim to maximise returns with minimal market risk

INVESTMENT PROCESS

We are an active fundamental investor with a nimble and decisive operating culture

WHAT IS SHORT SELLING?

How we generate returns from a falling share price

ALIGNMENT

Our ‘Co-Investment policy’ brings directors’ interests firmly inline with investor s in the fund

Investment Philosophy

At Watermark we believe successful investing requires the following skills:

  • An ability to evaluate the true worth of a business and the capability of management charged with running it;
  • An understanding of how and why a company’s shares come to be mis-priced; and
  • An appreciation of the risks that can undermine the investment case.

Employing these skills, the best investment opportunities arise when shares in strong, well managed companies can be purchased on attractive terms. These companies typically exhibit the following characteristics:

  • A history of superior returns through the economic cycle;
  • Management with a track record of creating and distributing value to shareholders; and
  • Businesses with a capacity to grow.

Consistent with the basic principles above, when selecting the best securities to short sell, we look to sell the shares of companies with weak fundamentals and that rank poorly on these metrics. 

While the market is generally efficient at valuing companies, it is by no means perfect. From time to time mis-pricing of shares occurs, providing opportunities to acquire good companies below their fair value, or to sell short the shares of weaker companies above their value. By conducting deep fundamental research on companies and industries, our investment process looks to identify mis-priced securities by taking advantage of some important shortcomings of the share market:

  • Investors are often myopic looking for short-term rewards. The value of a business on the other hand should be considered in the context of its longer term potential;
  • Investors are unduly influenced by sentiment, overreacting to good or bad news. This often causes the price of shares to deviate from fair value;
  • While the price of shares generally reflects the conventional thinking of investors, experience suggests conventional wisdom is often wrong; and
  • The likelihood of mispricing is greatest during periods of significant change as investors are often slow to interpret the full consequences of transformational events.

Investment Process

Watermark employs a fundamental research process in identifying investment ideas from our investment universe. Investment ideas come from monitoring economic and industry trends as well as extensive contact with company management and industry sources.

Once identified, investment opportunities are screened to ensure they are of an investment grade. A full qualitative assessment of the proposed investment is completed to establish whether the business is of a suitable quality and attractively priced. We discuss in more detail below:

Investment Ideas and Opportunities

Investment opportunities emerge from close examination of industry trends. These developments may include economic, political or legislative changes that impact the structure and competitive environment in which a company operates. Investors in many instances are slow to identify and price these changes.

The best investment ideas present a unique view, are relevant to the value of the business and are not currently reflected in the share price.

Qualitative Review

Once a suitable investment opportunity has been identified, a full review of financial performance will be completed. This is usually followed by meetings with management to further develop an understanding of the business and the management philosophy. Where possible, members of the investment team will also meet with suppliers, regulators, competitors and customers to gauge the competitive environment.

Short Selling

To identify short selling opportunities Watermark employs a similar security selection process as outlined above, but is looking for the opposite qualities in companies. We believe the best “shorting” opportunities are found in companies with weak fundamentals that can be sold for more than they are worth. For a more detailed explanation of the Short Selling process, refer to the dedicated section below.

When targeting companies to borrow and sell (short), we look for the following:

  • A history of inferior returns
  • Management with a poor track record.
  • Businesses that are highly competitive and struggling to grow
  • Securities that are expensive on a range of valuation measures

Portfolio Construction

Unlike a traditional fund, Watermark constructs two portfolios, a long and a short portfolio with the weighting of each investment in each portfolio loosely correlated with the level of conviction around individual investment ideas.

This process ensures we construct portfolios around the best individual investment ideas, with the highest conviction, while retaining a bias in favour of good, well managed companies to buy (long), and weaker businesses to sell (short).

The relative size of the two portfolios is a consequence of the quantity and quality of investment ideas we can identify to buy and sell. Macroeconomic and sector research along with a full range of risk metrics, will influence the overall weighting of each investment.

The relative size of the long and short portfolios will determine the net market exposure. The larger the short portfolio relative to the long portfolio the lower will be the net market exposure and the higher the cash weighting. If the portfolios are of equal size the fund is market neutral with no net market exposure.

Short Selling

Short selling provides Watermark with an additional means of expressing investment ideas while hedging market risk. In a long/short strategy, profits are made when the long portfolio outperforms the short, irrespective of movements in the broader share market. Shorts have historically contributed strongly to total returns for Watermark funds, demonstrating well-honed capabilities in this area.

Investors benefit from long/short investing in three ways:

  1. They access a further source of alpha in mispriced shorts (so, access to both rising and falling share prices).
  2. They leverage their exposure to the stock picker while increasing diversification.
  3. They benefit from the natural hedge against market fluctuations.

In summary, this allows the manager to take full advantage of mispricing opportunities across the value spectrum while retaining less market risk.

How do we short sell?

It is self-explanatory how profits are made from a rising share price, but how can we profit if we expect the price to fall? At Watermark we look to take advantage of both opportunities.

We can borrow the shares of companies we expect to perform poorly from other institutional investors, for a fee. We then sell these shares on market, collecting the sale proceeds. Selling shares that have been borrowed is called short selling. If we are successful and the price falls, we can then re-purchase the shares at the lower price and return them to the beneficial owner, profiting to the extent the value of the shares have fallen.

A simple example:

Investor ‘A’ expects the price of ABC Limited shares trading at $1/share to fall and the price of XYZ Limited shares also trading $1/share to rise.

He borrows 100 shares from investor ‘B’ a long-term holder, for a small fee. He immediately sells those shares, raising $100 in cash. If the price falls to 75c as expected, investor ‘A’ can then re-purchase the shares for $75. He would return the shares to the beneficial owner ‘B’ and keep the difference of $25.

This is only one side of the transaction however. Short selling is often misunderstood because investors fail to consider the investment of the short sale proceeds. Looking at a short sale in isolation is akin to looking at the cost of a loan without also considering the investment of the loan proceeds. ‘Shorts’ are first and foremost a source of additional funds for an investor, so we also need to consider the purpose of raising the funds.

As with any investment proposal we need to consider both the return on investment which is funded by the short proceeds and the cost of funding that investment via the short sale.

The cash proceeds from short sales can be either retained in cash or reinvested in other assets, the outcome is very different:

When the short proceeds are reinvested in other long positions leverage is introduced into the structure with the investor benefiting from any outperformance of the asset over the liability (short). If the proceeds are retained in cash, the investor will benefit to the extent the liability falls in value. If this position is held in a share portfolio, the short becomes a hedge for the fund’s other share investments.

Returning to our example above:

If the short proceeds from selling the ABC shares were retained in cash then ‘A’ would also earn interest on the $100 deposited. At 5% the overall profit on the transaction increases to $30.

Alternatively, if investor ‘A’ were to reinvest the short proceeds in 100 XYZ Limited shares which he expects to increase in value, he would do even better. If the shares rise to his target price of $1.25/share, he can then sell the XYZ shares for $125, with a $25 gain.

If he added that to the gain from short selling ABC Limited, the investor pockets a total return of $50 on $100 invested.

In this example the investor has profited from both sides of the transaction. Of course it can go the other way as well. A less successful investor may lose on both sides of the transaction.

In long/short investing, it does not matter whether the value of shares that have been sold short increase or fall in value, the investor is always ahead so long as the short proceeds are invested in an asset (or retained in cash) that outperforms the shares that have been sold short.

Investor Alignment

Our Co-Investment Policy

Watermark manages funds on behalf of investors in one unlisted trust. Directors and the Investment Team of Watermark Funds Management are amongst the largest individual investors in this strategy. This long-standing policy of co-investment brings directors’ interests firmly into line with investors in the funds.

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