This article was originally published on on March 8th, 2023

When searching for an investment manager, there are typically two or three dimensions that investors use to frame their decisions.
The first is usually always performance. The second is usually cost. And then some savvy investors will look at the length of a manager’s track record.

It is rare to find a manager and fund that ticks all those boxes – good returns, over a long period, with a relatively low cost.

The Elston Australian Large Companies Fund fits the bill. What makes it even more compelling is that it is based on a simple yet elegant strategy that focuses solely on the ASX top 100.

Make no mistake, the strategy requires a sharp focus and disciplined execution, but it is not about looking for rockets under rocks. It is about finding quality businesses that fit the fund’s criteria and sticking to the process.

Andrew McKie, co-founder of Elston Asset Management

I recently sat down with Andrew McKie, co-founder of Elston Asset Management, to discuss how the team at Elston think about markets, the key elements of the Elston investment process, and some of the opportunities they are pursuing right now.

McKie also challenges the idea that you can know up to 200 and 300 companies well, and that you can’t outperform by focusing just on the top 100 – and on that front, Elston’s record speaks volumes.

Topics discussed

0:30 – The Elston team and how they think about markets
2:30 – The Elston investment process and performance
5:45 – Managing risk, portfolio balance and stock selection
7:10 – Growth versus value and where the portfolio currently sits
9:30 – Current stock holding and thesis
10:50 – New opportunities
13:00 – Execution of business strategy

Note: This interview took place on Wednesday, 1 March 2023. The transcript below has been edited for length and clarity.

Edited Transcript

Can you talk a little bit about the team at Elston, how you came together and how you collectively think about markets?

When we developed the strategy, we wanted a team-based approach and there are a few reasons for that.

Firstly, as investors, we all have biases – cognitive and emotional biases that can affect our decision-making when it comes to money – and we wanted to round that out with a team approach. Also, we think that it leads to a more objective assessment of ideas. You get challenged in that team environment more than you would otherwise in maybe a more hierarchical structure.

We think having a broader collective decision-making process across sectors adds value to investors and advisers longer term.

And then lastly, we’ve recognised key person risk. We’ve seen a lot of that recently, whereby if there is that hierarchical structure, it can create significant risk for the underlying investors, the advisers, and the institutions using that particular product.

If you lose that individual, how does that affect the sustainability of the strategy? And the sustainability of the actual product for the investors as well? So a key consideration when we first developed the business and the strategy was to have a team-based approach for those reasons.

What are two or three key elements, Andrew, of the Elston investment process, and how do they contribute to your performance?

We wanted to specialise in large cap, so I think a key component of our competitive advantage is that specialisation in ASX 100.

For us, a lot of our competitors in large cap drift into the 200 and sometimes even into the 300, and our view is that it’s very difficult to understand those businesses well.

We find it hard enough to know the 100 well. And why we do that is that there is a bias we all tend to have; we focus on the businesses we own already, and we know them intimately, but your next best idea comes from the business that you don’t own. So you have to be across those in order to generate good idea development.

We would challenge those other managers who are drifting into that 200 to 300 businesses to be able to know them well.

So that’s our view and I think that’s been a key part of our competitive advantage and will be going forward.

I think definitely the concentration in the index, as well, actually plays to our advantage. There are a lot of views out there that with large-cap companies, you can’t outperform the index. A lot of institutions, advisers, and investors use passive for that large-cap exposure and then maybe add a little bit for opportunities and midcaps and things around that.

Our view is that the concentration in our market provides opportunity, a significant risk for investors, but also provides opportunity for us.

48% of the index is in the top 10 companies, and 52% of the index is just in materials and financials. So outside of that, there’s a big opportunity set for us to outperform over a five-year plus period.

Ironically, the risk in the index, which is the lack of diversity in the index, creates significant opportunity for us to outperform over the long term, although you need to manage that risk.

The third element was definitely in terms of developing a value proposition for investors and advisers to use us. Because we are large cap, we have our high capacity strategy and our view is that we could grow into that capacity over time, so we priced accordingly for that. And as I mentioned earlier, a lot of people selecting passive, which is low cost, and that’s what we think is valid for some markets, but it’s not valid for the Australian market given those concentration risks. It’s not a diversified index. And so we would challenge that idea as well.

You also limit your opportunity to generate alpha over the long term and there’s an opportunity cost for that. So we have generated 1.5% after fees over 10 years compounding in alpha in that strategy, just investing in large caps. And if you like, that’s a 1.5% MER when you’re just going passive because you give up that opportunity for outperformance.

Having said that, I think active managers are potentially too expensive and we do have a competitive advantage.

If we’re say 0.5 basis points cheaper than the average active manager because of our scale, it’s easier for us to generate 0.5% alpha against our competitors every year, just by being low cost.

So that’s our value equation: managing the risk in the index, giving the opportunity for outperformance of alpha through time, and being low cost. In combination, that’s a very powerful value proposition for investors and advisers.

The maximum position size in the portfolio is 6.5% and the minimum is 2.5%. Can you explain the justification for that and how that helps with portfolio balance and stock selection?

We have a fixed-weighted methodology, so we don’t use tracking error regarding portfolio construction.

Our view on why have fixed-weighted methodology is that if you’re following a tracking error approach, it does lead to some “buy high, sell low” activity in the portfolio where you are a relative performance of BHP; i.e. you’re forced to buy it when it’s doing well, you’re forced to sell it when it’s not doing so well. And we think that that’s counterintuitive to investing. That’s why we use a fixed-weighted methodology, but we’re worried about being wrong. So we limit the amount that we can invest in one business at 6.5%.

Equally, we want to outperform over the longer term and a 2.5% minimum weighting is actually bigger than the top 10. Once you get into the 11th company in Australia, that’s actually quite an active bet against the index.

It gives us the longer-term opportunity to outperform, generate alpha for our investors, but make sure that we’re managing risk, not concentrating the portfolio too much, adding sufficient diversity within the portfolio.

The fund is style agnostic and in the past, you’ve shown a willingness to focus on both growth and value. Where on that spectrum does the portfolio currently sit?

Before I get to the second part, I’ll just answer the first part, which is why we’re style neutral in the first place.

Our view is that those styles go through periods of relative outperformance and we wanted to give investors a smoother ride over time, not having a particular bias in the portfolio construction, and having the flexibility to be able to select securities and businesses based on their merits rather than a particular style.

So if we wanted a growth business, we’re happy to buy those growth-type names. We just don’t want to overpay for those businesses. We don’t want to buy a value business because you’re a value-biased manager and end up in a value trap where there’s no pathway to sustainable shareholder value creation.

Those biases also affect your stock selection and we think that businesses should be treated on their own merits and selected on that basis.

Having said that, that means you do get relative opportunities and you will see some skew in the portfolio through time, some drift where it may look more “valuey”, it may look more “growthy” depending on the relative valuations of those businesses. And what I would’ve said the last 12 to 18 months is that drift has occurred and we are gradually building up our more typical growth-type names. And we think that’s a thematic that’s still to play out over the next 12 months to two years.

Let’s talk a little bit more about quality businesses. I know that the Lottery Corporation is a stock that you have held and are still holding. It had quite a good reporting season. Can you take us through the thesis there?

Lottery Corporation (ASX: TLC) ticks a number of boxes for us in terms of portfolio construction that we wanted coming out of COVID.

We wanted pricing power. We want a dominant market position, which really goes to sustainability and margins in a rising cost environment as well as a potentially slowing GDP environment.

We wanted companies to transition their business over time if you like; use digital to become more efficient and grow shareholder wealth through time. And if we do go into a more challenged GDP environment, we’d like more defensive earnings coming into that.

And so Lottery Corporation really ticked most of those boxes. They have very defensive earnings, they’re monopolistic, they have pricing power, they have the digital transition to improve margins over time, and so that was one of the reasons we selected it in the context of broader portfolio construction, and they had a good result that demonstrated a number of those factors.

What are some of the opportunities that you’re looking at over the next 12 to 24 months?

We have been moving the portfolio slightly towards earnings momentum-based businesses. So we’ve spoken previously about pricing power and market share, but earnings momentum follows the trajectory of earnings over the next three to five years.

We think if we are going into a tougher economic environment, we want businesses that can sustain reasonably strong earnings growth and we think that will be a driver for our performance.

It has been in the past and we think that will be the case in the future. It’s coming into a more challenging environment for businesses to be able to navigate that. So earnings momentum, we think, will be highly valued and prized in the market.

An example of a business we’ve only recently added is Carsales (ASX: CAR). So Carsales obviously has a dominant market position here in Australia, pricing power, all those things we’ve spoken about earlier, but have made a significant acquisition in Trader Interactive in the US and they have also further international divisions as well. We think that they can take the learnings from Australia and apply them to those businesses to improve the operational performance of those businesses. And they’ve looked for businesses that are dominant in their market as well, but maybe not as well developed.

So on the back of that acquisition, on the back of potentially some thematic benefits from a slowing new car, used car environment, actually benefits Carsales. So you’ve got a top-down benefit; you’ve got the acquisition. We look at that three to five-year earnings trajectory and it’s very strong for that business.

So although you are paying up for something like Carsales, it is a more traditional growth business, we think that’s justified in terms of the return on capital and the earnings outlook for that business.

That takeover was in two tranches – they bought half the business initially and then ran the ruler over it to understand how it operated and then they’ve since purchased the other half. Is that a strategy that you like and were happy to see employed?

I think it’s a great question, Chris. I think it goes to management execution – and execution of strategy specifically.

What is the strategy? What’s the track record of management’s ability to execute as well? The strategy is one thing, but if you can’t execute on that, it’s nothing.

And so they have done that in the past and they’ve had a similar approach to doing that. And it’s a good way in terms of hedging out your risk of an acquisition, getting to know that business, getting to know the management in that business, and then deciding to use shareholders’ capital wisely at the time to take 100% ownership when you understand it.

Because they’ve done it in the past, it gives us confidence they’re going to execute in the future.

I think part of the work that we do is very much from a business owner’s perspective, understanding management, understanding their ability to formulate strategy and effectively execute. And I think that’s a really good example of that.

If you would like more information, please call 1300 ELSTON or contact us.