Patience – The Final Frontier?

Sinclair Currie, Principal and Co-Portfolio Manager

Market Recap

The Small Ordinaries Accumulation Index declined 0.35% during the quarter. Stock specific factors were a dominant driver of performance however we did notice two themes during the quarter. The primary was negative sentiment towards retailers. This appears to have been partially driven by signs of weaker consumer spending but mainly due to growing fears about the impact Amazon will have when it establishes a physical presence in Australia. Consumer sentiment tends to wax and wane however the competitive squeeze Amazon will place on future earnings is impossible to reliably predict at this stage. We also observed generally strong performance of technology related companies during the quarter. In part this may have been driven by investors wishing to avoid exposure to companies exposed to the domestic economy. We suspect it also reflects global market sentiment and strong performance of international technology shares.

Being the final quarter of the financial year we entered the period braced for the risk of earnings downgrades however these featured less than in previous years. This is a relatively positive sign and while the potential for earnings surprises remains, at this stage it appears that management forecasts have been sufficiently conservative to meet market expectations (or vice versa!).

Debate about the future direction of central bank policy (globally) is relevant to investors and their positioning. We believe our best strategy to deal with these risks is to focus on the individual fundamentals of the companies in which we invest our clients’ money. To that end we continue to observe valuation dispersions in the small cap sector. Their presence supports our view that attractive stock selection opportunities remain.

Patience – The Final Frontier?

Almost a decade has passed since markets first acknowledged the credit problems which created the Global Financial Crises.  Markets have since recovered (some more than others) lead by easy money and gradual economic growth. Yield assets drove the initial recovery and growth assets have sustained it. As a result we now find quality yield and growth companies are highly valued. While equity markets have been willing to pay premiums for known yield and growth trends, they remain impatient and less willing to take a view where these trends are changing. As a result, we think patience continues to provide a rewarding frontier in the current environment. 

The Hunt for yield

The (enduring) easy monetary policy implemented by central banks in the last decade created a fantastic incentive for investors to seek carry trades.  Equities offering sustainable yields have been sought after and repriced.   Capitalisation rates for property investments have fallen, bonds of all description have enjoyed a bull market and infrastructure and utility stocks have also performed well. From current levels we believe further compression of yields would require even more central bank stimulus, which seems unlikely at this point. Simply put, we believe yield investors have already picked the low hanging fruit. 

Going for growth

Tepid economic growth within the world’s major economies has failed to provide companies with underlying earnings growth tailwinds and few sectors offer robust growth momentum. In the current environment companies have had to invest, innovate and execute well to drive profit growth. With fewer options to choose from, investors have converged around the same companies or taken elevated risks to gain exposure to growth. As a result we have seen increased valuation premiums for listed growth companies and massive valuations (unscrutinised by liquid markets) for some unlisted start-up businesses.

So, what’s next?

Where should investors turn when their favourite yield and growth stocks are already highly valued by the market? Continuing to buy momentum stocks in anticipation of growth exceeding already high expectations is one strategy, as well as buying yield on the assumption of further central bank stimulus. However we think that after nearly a decade of easy money, both of these strategies are getting mature and more risky.

Playing a longer game

Where we have seen less ‘investor crowding’ is in listed companies which require a more patient approach. At NovaPort we find that by broadening our focus to a three year timeframe we begin to uncover more attractively priced opportunities. Propositions where one can identify sustainable ‘franchise’ businesses with growth potential, albeit lacking a widely held narrative driving today’s share price.

We suspect the reason the market tends to be impatient with opportunities requiring a three year view is partly explained by a rational tendency for investors seek positions supported by a current trend (possibly reinforced by the frequently short term incentive structures of professional investors). Buying into momentum provides comfort in the form of immediate justification and reward. The theory is captured by the saying ‘the trend’s your friend’, risk mitigation by investing in business which are well known success stories rather than taking an independent view on which businesses will succeed. It is important to note that these strategies only mitigate a few of many possible risks. Trends are regularly over-extrapolated, thus disappointing investors. Downside risks to this strategy arise because

1. it is possible to pay too much, even for a good asset, and
2. trends can stall or reverse.

When forecasting over a three year time horizon the likelihood that trends or momentum shift is much higher and relying on the low risk of short term trend extrapolation is not a viable strategy. Instead to mitigate risk over a three year time frame we focus on quality. We try to assess whether the business’ product or service has a valuable and sustainable differentiation which assist in growth. We also need to ensure that the underlying arithmetic behind earnings stacks up for shareholders and that management are engaged and incentivised to deliver. Taking a longer time frame requires us to align our return target, thus we seek a meaningful (50%) upside over three years.  Finally, in the current environment we believe taking a patient perspective provides a valuable purpose in helping investors avoid the worst pitfalls of crowded trades.