It’s time to wake up and face the music
Author: Bella Kidman. This article featured on Livewire Markets, 31 March 2021
Low interest rates, excessive amounts of stimulus and multiple COVID-19 vaccines… is this what paradise looks like? It probably should be, but when you combine these dreamy market conditions with talk of bubbles, rising bond yields and market exuberance you’ll open your eyes and realise you’ve booked yourself a one-way ticket back to reality. The market is all over the shop. Every man and his dog has an opinion on the market, and they won’t hide it from you. But occasionally, it’s better to block out the noise and focus on the fundamentals says Alex Milton, Principal and Portfolio Manager at NovaPort Capital.
In this Fund Manager Q&A, Milton discusses why now is time for the COVID-19 winners to take a seat, how important the rotation to cyclical stocks is for your portfolio, the GameStop surge and what it means for the future of markets, and the importance of rising bond yields. Milton also discusses why NovaPort is overweight healthcare and shares one stock that the market has misunderstood.
There has been discussion about a rotation from high growth stocks to more cyclical names. How important is this rotation and how have you positioned your portfolio for it?
With the rollout of vaccines, massive fiscal stimulus and central bankers indicating that interest rates will stay low for an extended period of time, investors are revisiting economically sensitive companies and adjusting their portfolio settings accordingly. The drivers include better than expected outcomes on key economic indicators such as buoyant house prices, the decline in unemployment and much-improved business and consumer confidence levels. Higher savings rates over the past year has generated pent up capacity for discretionary items as lives get back to a semblance of normality.
The case for a rotation gets further support from a valuation perspective. Companies that weren’t beneficiaries of the stay at home trade underperformed and look relatively cheap compared to the “COVID winners” such as the online retailers e.g. Kogan.com and Temple and Webster and the buy now pay later sector.
Another key driver of the rotation has been the bottoming out and rebound in long term interest rates that occurred in late 2020. When equity markets were in free fall in March last year, central banks assured equity investors they wouldn’t hesitate to flick the switch to overdrive and use the tried and tested post GFC strategy of injecting ample liquidity and suppressing interest rates for as long as required.
Plentiful liquidity, compressed interest rates and enormous fiscal stimulus – perhaps even more than was needed – incentivised investors to buy the COVID winners. This was despite some of these stocks generating losses even with (or maybe because of) strong revenue growth. Analysing these stocks with a 10 year discounted cash flow model adds more weight to longer term earnings versus miniscule or even negative profits in the earlier years. If the expected growth in the outer years is bullish enough, it can justify the expansion in the price to earnings multiple which is in many cases priced in already. While the US Federal Reserve is no doubt focusing on supporting the economy, it is inadvertently giving a very good impression that they will continue to act on the unofficial post GFC mandate; bear markets don’t happen on their watch. This gives investors cover to focus almost exclusively on the upside risk with minimal consideration to the downside.
The unique outcome of the last year’s bear market was twofold: it lasted all of 20 trading days and, a company trading on a high P/E ratio going into COVID came out of it on an even higher multiple! Normally a bear market sees market darlings de-rated and companies ignored in the lead up to the peak of the market, stage a comeback.
Intensive monetary stimulus made highly priced stocks even more expensive over the course of 2020. However, with interest rates heading back up, due to the potentially inflationary consequences of the vaccine in combination with fiscal stimulus, that transition appears to be finally underway.
Our portfolio positioning hasn’t changed over recent months despite this rotation to cyclicals. We have always held growth names in the portfolio such as long-term investments in Technology One, Fisher & Paykel and Nanosonics but we have been conservative in managing the positions whenever valuations became overextended; too much upside priced in relative to the downside risk.
Mid-2020 presented lots of opportunities and we added the largest number of new companies to the fund within a short period of time since the GFC.; although not all inclusions were what you’d call the COVID winners. No doubt new inclusions like Baby Bunting and Data #3 benefitted from the tailwinds. However, we also increased our weighting in housing related exposures like CSR on price weakness. This weakness can be attributed to an expectation that a pickup in housing related activity would likely take time due to high unemployment levels and the long awaited correction in home prices.
Invocare was added on price weakness due to a lower overall number of total deaths (including COVID related) in Australia last year. Lockdowns, a big emphasis on handwashing hygiene and social distancing saw fewer road and non-COVID respiratory related fatalities. In addition, restrictions on service attendance numbers adversely impacted function related revenue.
In summary, even when the enticement to own long duration equities such as online business models, loss making software companies and strong top line growth stories was at its peak, we elected to hold a more diversified portfolio of both growth as well as economically sensitive companies that would benefit from an improving economic environment as countries eventually manage their way out of the health crisis. As would be expected, we have seen this part of the portfolio drive returns during the rotation while some of the growth names have taken more of a back seat.
Company fundamentals have seemingly been thrown out of the window with recent short squeezes and the GameStop surge. What are the most egregious examples of this that you’ve seen and did it present any useful lessons?
If there is a lesson to be learnt from wild market gyrations at an individual stock level, it’s that central banks are averse to share markets falling. This, combined with technology bringing trading capability to mobile devices at minimal cost has inadvertently freed animal spirits. Not only can you participate in opportunities such as GameStop a lot easier, if the social media impetus is strong enough, you can use the opportunity to thrash millionaire hedge fund managers at their own game while you’re at it. It’s a lot of fun, unless of course you were that marginal investor, the one that downloaded the Robinhood app so you could buy shares at $480 before the price collapsed a few days later.
The GameStop saga is not unique and history is rife with examples of dysfunctional share trading. It is a manifestation of what can happen when interest rates are at zero and markets are awash with liquidity.
Investors can safely operate on the assumption that central banks will act quickly when markets go down but stand aside when they go up. It is the culmination of years of central banks acquiescing to taper tantrums and market corrections. The mentality of traders has evolved from complacency to outright confidence that markets ratchet up over time because monetary authorities believe the systemic risks of the alternative are worse.
After all, it wasn’t that long ago that no less than the president of the United States was goading the US Federal Reserve to keep suppressing rates. This was partly due to the perception that stock prices breaking new records indicate an administration’s effectiveness and proof that America was in fact becoming Great Again. That degree of intervention by the executive branch of the US government was something we’ve never really seen before, but not surprising when jawboning can be done instantly in a tweet.
Are rising bond yields a concern for your portfolio? If so, why, and how are you consequentially positioning your portfolio?
Rising bond yields are generally good for our portfolio.
Delving into the long-term attribution of our funds shows our focus on capital preservation and sustainable earnings growth rather than attempting to outperform markets that are rallying hard on aggressive multiple expansion. High P/E stocks have a long way down if the news flow falls even just a little bit below optimistic expectations. To illustrate this, we compare how our Smaller Companies Fund has performed on days where the Small Ordinaries Index is down by more than 1%. Since late February last year when markets started pricing COVID as a global health crisis rather than something impacting supply chains out of China, there have been 52 days where small caps have been down by more than 1% on the day. The vast majority of these negative days have been a consequence of a poor lead from US markets usually driven by concerns that interest rates may be on the rise again, or that high technology stock valuations are under threat (i.e. the NASDAQ 100 falling more than the S&P 500). Our Smaller Companies Fund has outperformed on 42 of those 52 days. While we hold some technology companies and other higher priced growth stocks, we have been conservative in our weightings to these and took the opportunity last year when share prices were in free fall to increase our allocation to economically sensitive, cyclical companies.
From here, we are constructive on the broader economic outlook and can see why commentators are leaning towards the view that yields will continue to trend higher. With enormous fiscal stimulus landing just as vaccines have their intended effect, expectations of inflation and broader economic growth are being upgraded. As a result, investors are expanding their investment universe to include economically sensitive cyclicals which were ignored for most of last year but are set to benefit from the “re-opening trade.” This augurs well for us given our diversification. Likewise, should the rotation from growth to value accelerate as index funds swap horses, our underweight exposure to high P/E growth and technology should provide some downside protection.
Why is healthcare a preferred sector for NovaPort now?
Our overweight to the healthcare sector is the outcome of individual stock selection decisions over time rather than a concerted effort to add companies to reach a target portfolio weighting. It includes medical device companies with a global market opportunity such as Nanosonics and Fisher & Paykel as well as Integral Diagnostics, EBOS and aged care exposures.
Some of these companies have benefitted from COVID tailwinds, with Fisher & Paykel the standout as a supplier of respiratory devices to hospitals, while others like the aged care exposures were adversely impacted by the pandemic. Some are high growth companies which justifies their valuations in our view. We increased our weighting in others such as aged care operators during periods of share price weakness which was driven by factors unlikely to hold longer term. These include the impact of the virus on occupancy levels in aged care facilities (which are on the up again) and uncertainty in the lead up to the Royal Commission report (which didn’t lead to any significantly adverse outcomes).
Can you nominate one stock currently in the portfolio that you think the market has misunderstood? Why?
We added patent and trademark legal services group IPH to the fund last year on COVID related share price weakness. The company is very well managed with a strong balance sheet, high margins, good cashflow, and has a substantial market presence in Australia and New Zealand as well as growth options across Asia including China. History has shown their revenues to be relatively resilient in times of crises as noted during the GFC as well as COVID more recently. We were of the view the price weakness during the early months of the pandemic presented a longer-term opportunity.
It is one we believe the market understands but in our view has undervalued because of the adverse impact to earnings of a stronger Australian dollar as an exporter of legal services to offshore clients. While no doubt this will impede earnings growth year on year, over the longer term it is the positive company dynamics that will ultimately drive the share price.
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