Protean Funds Scandinavia AB August 2024 Partner Letter

Dear Partners,

Five days into August most markets were -10%, in a violent and inexplicable sell-off. Yet markets closed the month flat. In this letter, we detail how we acted during the period, as an example of how we handle risk in the hedge fund. Our COO Daniel Mackey also debuts in this letter, contributing some thoughts on the importance of the thankless job of achieving operational excellence. We dismantle the dream of Permanent Capital and think out loud about sharing scale economies.

We are pleased both funds continue to do well.

Protean Small Cap outperformed its benchmark in August. The fund rose by 1.2%, which is 1.7% ahead of the CSXRN (SEK) benchmark index for the month. It is up 25.9% year to date. Performance since inception in June 2023 stands at +40.9%, outperforming the index by 19.2%.

Top contributors were Ambea (AMBEF), Raysearch (OTCPK:RSLBF) and MT Hoejgaard. Detractors include Fasadgruppen (FGSSF), Metsa Board (OTC:MTSAF) and OssDesign.

Protean Select posted a 1.4% return for the month. That is 11.1% YTD and 26.1% since inception. The volatility in the strategy remains below 7%, which can be interpreted as about a third of the risk of the overall market.

Top contributors were Ambea, Raysearch and Neste (OTCPK:NTOIF). Notable detractors were Carlsberg (OTCPK:CABGY), Nordea (OTCQX:NRDBY) and EQT (EQT).

Thank you for being an investor!

Team Protean

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Crash-and-snap-back

An intelligent friend of mine, when I asked him what he’d like to read about in this month’s letter, said “how did you handle the 10% correction in the beginning of the month?”. It’s a fair question, and a good example of how it works to run a hedge fund (at least I tell myself that, I have only ever run this one, and only for a little over two years).

Going into August we had a relatively high net exposure of 50% in Protean Select (a level we think will be average over the long term). Bad timing, given what was about to happen.

As markets started trending decidedly southwards on Thursday August 1, we added some short index futures and reduced net exposure to 38%. Given the size (small, by choice) of our fund, this takes a few minutes, with limited market impact. Why did we do it? Because our number one job is to protect capital – like the Oracle from Omaha says: “In order to win, you must first survive.” Why were markets down almost 3%? We had no real idea but noted elevated volumes and chatter about the USDJPY carry trade. In the background were US recession fears considering recent data. Several comments mentioned a “FED policy error” of not cutting rates earlier and more forcefully.

Friday August 2 was eerily similar: down 3% and a sharp smell of systemic unwind. The tape was nearly unanimously red, which means there’s an exogenic shock to the system, causing a risk-model induced de-leveraging. Real time data showed that the ratio of index future to cash volumes was near record levels. During the day we further added to our hedges, reducing net exposure to 25%. That’s two days in a row of near indiscriminate selling, and a weekend of geopolitical risks to look forward to, likely exacerbating the hedging needs of levered actors. We slightly reduced our position in our most business cycle sensitive names and added a short in an automotive sub-supplier.

Monday: headlines shouting, “Nasdaq futures down 6%” and various other doomsday-sounding quips. The opening prints turned out to be the bottom of this correction. But, sitting in the middle, it was far from obvious. With markets down around 9-10%, we were nursing a 3% drawdown. Better than the 5% we would have suffered had we not reduced risk. The sense now was a lot of wood had been chopped in a short period, and the mayhem appeared fairly isolated to the systematic pocket of the market. We added a position in Novo Nordisk back to the portfolio.

On Tuesday, as markets staged a tentative recovery, we did very little: added some Neste. Wednesday, we covered some index futures, added more Neste, added more Novo Nordisk (NVO). Covered a cyclical short. Net exposure back to 35%. Then markets went up 8 days in a row.

We continuously added more length, and replaced the futures shorts with an index put-spread (better dynamics: capped loss-level and a position that shrinks rather than grows if markets keep trending higher). We closed the month with exposure back where we started.

Thanks to the footwork, we outperformed markets while trying to minimize risk. This time, it worked as designed: reasonable return with reasonable risk.

Permanent Capital Arrogance

Many in the investing business dream of “permanent capital”. With an investor base that can withdraw their funds at a moment’s notice, it’s easy to imagine how all will rush for the exit following a period of poor performance.

I think that’s getting it wrong. Investors’ patience and trust is something that needs to be built and earned over time. If your fund is abandoned during a poor period, it is likely a consequence of mis-selling or overpromising, causing disappointment. Ultimately, you get the investors you deserve.

The risk with permanent capital is that poor periods are glossed over by a mantra of “patience” and “we’re in it for the long term”. But how do you steer clear of complacency? Of not challenging your holdings and convictions frequently enough? We have seen numerous examples of permanent capital arrogance in recent years, where big organizations play down terrible investment decisions with “it was a relatively small part of our portfolio” or “it is a long-term holding”. I think the beneficial owners of that permanent capital wished it wasn’t all that permanent.

With permanent capital institutions, there is always a clear risk of confusing the end goal with various proxies. The most common probably process as a proxy: when the organization stops looking at outcomes and instead focuses on the process. If the consequences of being wrong in the short or medium term are slim to none, and don’t have any bearing on your incentives, you might end up with a team fully focused on executing a process that leads to suboptimal outcomes.

Although it would be cushy with permanent capital, we would much rather die by the sword. Should our performance, short-, medium-, long- and all kinds of term, be below expectations, our investors are free to vote with their feet and pull their cash.

The long-term is nothing but a collection of many short terms. If we get those right, things will be ok.

Permanent schmermanent.

Scale Economies Shared

In the past year, a wave of consolidation has hit the Nordic fund industry. Articles and press releases about the phenomenon portray the process as something positive: the industry needs scale considering increasing regulation and costs. Consolidation does bring about that scale, but it also reduces diversity, and crucially, offers no benefit to investors. Some of the funds have been underperforming for years, likely only holding on to assets due to pension platform inertia and customer captivity in old savings schemes.

The scale benefits of raising assets under management (either by M&A or organically) are all too obvious. The cost base of managing a fund is 99% fixed, which means the fees from incremental assets when you are above break-even are pure profits.

Scale Economies Shared is a powerful concept coined by Nick Sleep and Qais Zakaria of Nomad Partners (great investor letters, they are available, but Nomad has closed down). Most businesses pursue these scale advantages, but very few think of sharing the windfall with their customers because it breaks with the axiom of Economy: “more is preferred to less.”

The capitalist view is that high profits attract competition, which lowers profits. But what if you share the scale benefits with your customers? As your business grows, and scale advantages start to accumulate, you re-invest by lowering prices, enabling a better product value, further growth, and even lower prices, enabling growth. Rinse and repeat into eternity.

This is the playbook of Costco (COST) and Amazon (AMZN). Grow by focusing on customer value. Share the scale instead of harvesting it. Using scale to create a moat, by lowering prices so much competition can’t find a way in. Imagine some of these recent fund mergers justified with “so we can lower fees to our investors and make a better product”? Sorry but: Hahaha!

What if we, in a few years, could steal the below from Jeff Bezos 1997 shareholder letter?

“We dramatically lowered prices, further increasing customer value. Word of mouth remains the most powerful customer acquisition tool we have, and we are grateful for the trust our customers have placed in us.”

Wouldn’t that be something?

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Operational Efficiency

– Daniel Mackey, Chief Operating Officer

You seldom get a thank you when things go right. This is especially true in asset management, where things simply must go right. As I learned early in my career, the foundational level of any fund is to ensure investors are not harmed. Portfolio management’s mission is to create alpha, but before we can even dream of outperforming, we need the basics done right. The stakes are high; mistakes, after all, usually cost money.

Early in my career I was exposed to some of these mistakes. Late-settled trades (Buy-ins in southeast Asia!)? Those cost money. A misstep in foreign exchange trades during market volatility? More costs. An incorrect NAV calculation? Recalculate, restate, and compensate. They’re the reality of our business and why robust operations are crucial. Luckily there has been a lot of development in improving low touch and creating high levels of straight-through processing in asset management. It makes it easier to focus on the issues. Back office, middle office, risk management, and compliance might not sound like the most thrilling part of asset management, but one could make the case that it’s more than just necessary; it can be interesting and create value.

Operations in asset management is an ever-evolving space. Whether it’s adapting to new regulations, accommodating investor preferences, or keeping up with technological advancements, the industry does not stand still. Sure, compliance might not generate returns, but failing to comply can certainly eliminate them. When I first started my career in fund administration, a disaster recovery plan was little more than a pencil, paper, and an adding machine for calculating a daily NAV. Now, the complexities have developed, and so has the need for a “belt and suspenders” approach across the board.

At Protean, we’ve built an infrastructure designed to withstand the test of time and scrutiny. Our operations are not a mere back-office necessity; they are a strategic asset that ensures we can execute our investment strategy effectively. From our combined experience from operations at larger asset managers, banks, and fund administrators, we understand the importance of building an institutional-quality framework even in a smaller, nimbler environment. It’s about identifying the right systems and processes to prevent errors, manage risks, and, ultimately, protect the fund’s investors’ capital.

What drew me to Protean was not just the opportunity to participate in building something from the ground up, but the “why” behind it. We’re not just in the business of asset gathering; we’re here to create an edge, to be versatile, and to stay small enough to remain agile. This is a firm where the founders understand the nuts and bolts of what we do. They know why we have policies, choose our service providers carefully, and take on certain costs to mitigate risks. In larger organisations, operations can often feel like a straitjacket, a cost center rather than a crucial part of the value chain. Here, it’s different. The approach is intentional.

Running funds isn’t just about chasing returns; it’s about ensuring the operational foundation is rock solid. We focus on things that can go wrong so that you can be confident in what goes right. It might not always be glamorous (oh, trust me, it’s not) but it’s essential.

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Protean Small Cap

– Carl’s update for August

Protean Small Cap gained 1.0% in August. That is 1.7% ahead of the CSXRN (SEK) benchmark index for the month. This puts the fund 19.2% ahead of our index (CSRXN SEK) since inception and 10.5% ahead so far this year. The fund now manages SEK425m. Thank you for your trust.

Our top contributors in August were Ambea, Raysearch, MT Højgaard, Pexip (OTCPK:PXPHF) and Netel.

Ambea has been a very, very strong contributor for us since inception and the Q2 earnings in August propelled it further. The share has gained 150% since entry to the portfolio, and given how low valuation was, as well as the positive estimate trend, it still trades at an unjust discount in our view.

There are similar traits to this in our other winners for the month. They have all suffered from market mistrust, rightly so, but we often find that the mistrust stays a little longer than what is justified. Low expectations can be a wonderful starting point for an investment. This point is very true for our position in MT Højgaard. This Danish construction company reported a continued improvement in profitability, which puts it firmly in reach of overachieving their full year guidance of 400-425m in EBIT. The 25% share price increase in August puts the enterprise value at ca. 1bn DKK, which means that the multiple creates a compelling set-up.

Detractors include Ossdsign, Metsä Board and Fasadgruppen. Ossdsign is a player in orthobiologics, and their Catalyst product makes your bones heal quicker (we’re simplifying things by making this statement, as you might understand) is showing strong growth. The share suffered in August as the Q2 report showed that third-party commission rates in the US are at a higher level than previously believed. Metsä Board is a relatively new entrant to the portfolio and was hit by lower pulp prices. Fasadgruppen is a tactical play on lower interest rates, but while rates are trending lower, so is the share price of this Nordic renovation services provider. An increase in gearing during the quarter spooked the market, which is forgetting that H2 cash flow is seasonally stronger.

Among new entrants we have MEKO and BTS. Meko is a the (by far) largest provider of independent auto parts in the Nordic. Following years of mishaps and own goals, the current CEO appears to be on top of things and has also become a very sizeable shareholder. We initiated the position post the Q2 report, as the set-up fits a profile we witnessed in Ambea a year ago: expectations are low and operations are trending in the right direction. In financial lingo this translates to low valuation and estimate upgrades, which more often than not leads to good share price development. BTS is a consultant company active in strategy execution which has a wonderful track-record. That has continued in North America and Asia, while Europe suffered so far this year. This appears to be due to cyclical more than structural factors. Paying 11x EBITA for a company with such a stellar track record is something we gladly do.

We’ve exited our positions in Camurus (OTCPK:CAMRF), TietoEvry (TCYBY), Kalmar, NNIT, Nibe (OTCPK:NDRBF) and Vimian (OTCPK:VIMGF). The portfolio remains diversified, with roughly 50 names.

The ten biggest positions in Protean Small Cap as we enter July are:

Acast	5.5%
Devyser	4.2%
Ambea	4.0%
Cargotec	3.7%
Lindex	3.3%
Valmet	3.3%
Rejlers	3.1%
Kemira	2.9%
Raysearch	2.8%
Tieto	2.9%

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Protean Select

– Pontus’ update for August

*We illustrate our performance by showing a comparison with the NHX Equities index. This is an index constructed from the performance of 54 Nordic hedge funds focusing on equity strategies. NHX is published after our Partner Letter, so updates with one-month lag in the chart above. We aim to have positive returns regardless of the market, but no return is created in a vacuum, and a net-long strategy will correlate. Our hurdle rate is 7.6% annualized (4% + 90-day Swedish T-bills). All figures are net of fees.

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Protean Select posted 1.4% return in August. That’s +11% YTD and +26.1% since inception. The volatility remains below 7%. We exit August with 48% beta-adjusted net long exposure and 125% gross exposure. The portfolio remains diversified and we are satisfied with the current composition.

Top contributors were longs in Ambea, Raysearch and Neste.

Notable detractors were longs in Carlsberg, Nordea and EQT.

As recession fears are turned on and off, it appears many are hiding in healthcare names. Some of which have reached eyewatering levels. During the month we have initiated short positions in two Nordic pharma companies, anticipating a pull-back.

The monthly reminder

We optimize for performance, not for convenience, size, or marketing.

You can withdraw money only quarterly (monthly in Small Cap).

We will tell you very little about our holdings.

Our strategy is tricky to describe as we aim to be versatile.

A hedge fund can lose money even if markets are up.

We charge a performance fee if we do well.

You do not get a discount if you have a larger sum to invest.

We do not have a long track record.

Thank you for being an investor.

Pontus Dackmo, CEO & Investment Manager, Protean Funds Scandinavia AB

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DISCLAIMER: Investments in a fund can both increase and decrease in value. You are not guaranteed preservation of invested capital.

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