The little-known strategy delivering consistent, uncorrelated returns

Full disclosure, I had the distinct pleasure of working with Luke Cummings, chief investment officer of Harvest Lane Asset Management, many, many moons ago.

Cummings had started a broking business and the company that I worked for acquired his business. I was immediately impressed with his business knowledge but, more than that, his curiosity for markets.

He was always looking for an edge, an angle, a different way of doing things. So, I'm unsurprised that he has built Harvest Lane into a successful funds management business focusing on takeover arbitrage, with around $150 million under management and an enviable track record.

It’s not a typical strategy, as Cummings would readily admit, and it’s not something that retail investors can easily get their heads around. But the opportunity set and the ability to extract profits from it is robust, as he and his team have proven over the past decade.

After bumping into him recently, I took the opportunity to have a conversation, the highlights of which are shared below, where we shine a light on his strategy and how he assesses opportunities.

Out of necessity, a strategy is born

Cummings’ curiosity was perhaps born out of necessity. He makes no secret of the fact that in the early days of his business, some of his market positions were funded by credit cards.

“We started doing a lot of stock market stuff on credit cards, which is just absolutely crazy. But that's the reality of how we started. You obviously don't want to lose money when you're borrowing money, short-term off credit cards to fund your trading positions… you need to find ways to do something else”.

But there is also a more noble reason for his pursuits, and that came from observing his auntie and uncle’s experience post the 2000 tech crash.

As Cummings tells it, his uncle had just retired and had money invested in a series of funds via superannuation. The market took a big hit – and his uncle saw his super balance diminish significantly. Cummings remembers his auntie and uncle having a conversation about going to all cash at that stage, saying that they just didn’t want the stress of being invested in the stock market – they didn’t care for the variability or the volatility.

Of course, the next 20 years would have proven lucrative had they stayed invested.

“I think sequencing risk for a lot of people, especially older people who don't have the benefit of regular income, means you need equity market returns or something that looks like equity market returns. But you can't really do it in such a way where you're taking the full extended drawdowns and volatility that the market offers from time to time.

I think our mindset always was "There must be a way to capture returns in the market without having to be so beholden to markets more broadly”

The first trade

Cummings vividly remembers his first takeover arbitrage trade.

He credits a mate who brought the opportunity to his attention. As the story goes, this friend was working at Macquarie and called him to talk to him about a stock that had a “weird clause in the company constitution that dictated how payment would be distributed to shareholders in the event of a takeover”.

Although not that long ago, to access the company constitution in those days, Cummings had to traipse down to the registry to get a hard copy. It wasn’t online.

Upon reading the “weird clause” he wasn’t convinced at all. His thought process was “That sounds interesting, but I've been to university, and I believe in efficient market hypothesis. It's not meant to work like that”.

In any event, he and his mate took a little nibble and sat tight. The day of the announcement he remembers clearly. The state his office was in at the time had a public holiday but the market was open. It was a stinking hot day and the building had the aircon deactivated for the public holiday.

As Cummings tells it, “I was sitting there, dripping sweat, and the announcement happens. The company goes into a trading halt and announces exactly what we thought would be the case via this clause, and the stock goes up 35-40% instantly.

"I just thought it was the most amazing, incredible thing that I'd ever seen. And this was just sitting in plain sight", says Cummings. 

He was hooked.

The juiciest trades

Cummings readily admits that much of the time, a company will have a takeover offer in play at $1 and he is buying the stock at 97, 98, or 99c. Picking up pennies in front of a steamroller.

And, very occasionally, the bid will fall over and (using the example above) all of the takeover premium will disappear from $1 and he will cop 60c as the sale price.

There are, of course, trades that go the other way.

In Cummings’ time running his strategy, he has seen “takeovers where the first bid started at $1 and ended at $8.25.

We saw one where the first bid was at $3.50 for a stock that was trading a $1.75 price, i.e. a 100% premium. General consensus would be, "Well there's not going to be any improvements over and above that. It's 100% premium." That one finished north of $11”.

While these trades are almost as rare as the trades that slip back from $1 to 60c, they are the cherry on the cake and not the way that the fund makes most of its returns.

Rather, most of the returns – which have averaged 18.52% over the past three years, 8.07% over the past five years, and 8.36% since inception – are generated by picking the solid opportunities and avoiding the duds.

All about the checklist

To find only the best opportunities, Cummings employs a checklist of factors that he looks for “that effectively de-risk the transaction and all you have to do is build a portfolio of opportunities that meet your criteria”.

“The upside takes care of itself. I don't know in advance which ones are going to be the best performers. All I know is that if it got a spot in a portfolio on a risk/reward basis, it's earnt its right to be there”.

More specifically, Cummings is focused on “conditionality” and “downside” and says that the holy grail of any of these trades is a completely unconditional bid. And, in its purest form, an on-market unconditional bid.

For example, Cummings points to intelliHR (ASX: IHR).

“I think the first unconditional bid was 16 cents. So the beauty of having an unconditional bid at 16 is I know that no matter what happens, I can sell that stock for 16 cents to the bidder anytime between now and the offer close date”, says Cummings.

“And as it currently stands, it's at a 24-cent unconditional bid and they're standing in the market. So anytime between now and when the offer closes, I can hit the bid and I'm out.

Now, let's go back to when it was at 16 cents. If I can buy the stock at 16c, I'm risking nothing. If I buy it at 16.25c, I'm risking a quarter of a cent.

But my upside is unquantifiable at that point. So you literally could have bought a bunch of stock at 16.5c in IHR knowing that you were going to get no worse than 16c and now the stock's finished at 24c.

Cummings adds that he and his team think more than anything about risk and position sizing and go into every transaction using their checklist trying to figure out what the likelihood is the deal could fall over.

“We only want to invest in things that we have high conviction in. However, we have to assume that every single transaction, no matter how confident we are, could break”.

The checklist helps Cummings determine how many “outs” the bidder has. The fewer the number of outs, the better the opportunity is for Harvest Lane.

As for the outs, non-binding deals, deals subject to due diligence, deals subject to finance, or deals requiring ACCC or FIRB approval, are all red flags and reduce the probability of the deal being consummated.

“The critical part of our process is clearly this checklist, but the checklist is built to answer the question ‘if this buyer decides to walk away, how easy is it for them to do that?”

A recent trade

In terms of recent successful trades, Cummings mentions Warrego Energy, which was caught in a bidding war between Gina Rinehart’s Hancock, Strike Energy, and Beach Energy.

Strike Energy was increasing its offers in competition with Hancock in December last year, but Hancock kept coming back with better offers.

“So you had this bidding war at one stage. The first bid was worth roughly 20 cents and finished at 36c effectively”.

Is there enough to go around?

Since launching the fund, one of the questions Cummings has regularly been asked is whether there are enough takeover opportunities to pursue at any given time.

While just about everyone in the market knows when BHP is taking over OZ Minerals, or when Ramsay Healthcare is bid for, there are plenty of deals that fly well under the radar and aren’t picked up by the press.

“We'll typically find between eight and 20 positions at any given point in time. So yes [the opportunity set] is big enough", says Cummings.

“For the last three years at least, we haven't been anywhere near 20. It has been more like 30, 40, 50 positions at any given point in time”.

Cummings estimates that for 95% of the things that he has invested in over the last two years, there'd be a very small subset of people who would be aware of those particular stocks, “And that's probably part of the edge…they’re not on everyone’s radar”.

Necessity is the mother of market returns

Cumming’s view about the opportunities that he pursues and how he pursues them was born out of his experience and is very clear:

“There's a subset of people out there that, for various reasons, can't handle the inherent up and down volatility of markets. We're just trying to smooth that out somewhat and making returns be driven more by the individual stocks that we choose and the circumstances specific to those as opposed to market more broadly”.

He adds that a lack of correlation (with traditional strategies) and downside protection are the two objectives and two of the main benefits of the strategy for investors.

While the fund currently manages approximately $150 million, Cummings is open about its likely upper limit. In order to execute the strategy effectively via the opportunities he identifies, Cummings believes the fund will top out at around $300-400 million.