Investment Process

WaveStone Capital has a four step Investment Process which is –

  • Identify businesses which exhibit Sustainable Competitive Advantage – each company is given a score out of 15 factors which identify its Superior Corporate DNA and the Industry Dynamics in which it operates.
  • Apply Quality, Growth and Valuation Tests
  • Overlay Portfolio Risk Controls
  • Portfolio Creation

What is Superior Corporate DNA?

Corporate DNA, or a company’s ‘genetic markers’, can indicate a company’s likelihood of success. There are seven markers including a company’s track record, logical expansion plans and its research and development effort. Once we have established whether or not a company has the Superior Corporate DNA attributes we then assess whether or not a company is facing headwinds or tailwinds in its industry.

Shorting

Shorting creates a bigger “float” with which a fund manager can than reinvest into better performing companies. This is the most extreme and aggressive form of capital allocation efficiency.

The WaveStone Capital Dynamic Australian Equity Fund has the ability to short stocks. Shorting is not mandated however it does increase the opportunity set available for return enhancement. WaveStone restricts its modest short selling (max 10 stocks) largely to the top 100 companies for liquidity reasons with the investment typically having none or very few Superior Corporate DNA traits, industry headwinds and solvency concerns. Overly optimistic broker expectations are the icing on the cake as the valuation tests are applied and if found to be overvalued the stock is shorted.

Short Interest case study:

How do Shorts add value?

One of WaveStone’s all-time great calls was a short position in a ASX Top 50 company, Centro. On December 17, 2007 Centro issued a bombshell notice to say it could not roll over more than $4bn of short term debt. The stock price fell 85% in two trading days from $5.70 to 0.88c.

WaveStone held a 1% short position in its Dynamic Australian Equity Fund. The following table illustrates the impact on the two different WaveStone Capital Funds:

  Long Short Long Only
Investment decision Negative on Centro Negative on Centro
Portfolio decision 1% short position Hold 0%
Stock index weight 0.10% 0.10%
Absolute position -1.00% 0%
Position relative to index -1.10% -0.10%
2 day return -85% -85%
Excess return +0.85% absolute +0.85% relative

From an absolute return perspective, the short position in Centro added 0.85% to the overall return of the Dynamic Australian Equity Fund. Whilst the 0% holding in our Long only portfolio achieved 0% absolute return but gained 0.85% when compared to the index.