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Trading Diary

Trading Diary – 3 June 2020

The rally in stocks from the March low has continued, and while it feels disconnected from the economic reality, it is becoming increasingly difficult to deny its persistence. As a result, we’ve added to our exposure with three new stock purchases. Following these additions to the portfolio, we are roughly 50% invested. 

My position, as I’ve said before, is that the market is generally right. By that, I mean that the market is usually quite good at discounting long term corporate cash-flows and reflecting them in stock prices. Stock prices are the most reliable signal of the market’s expectations about a company’s future performance. 

Prices move (up or down) when expectation revisions take place. Expectation revisions don’t usually take place in one go (although they can). They typically take place over time as the market slowly comes to terms with a new reality. This slow revision in expectations is what causes prices to trend over time.

My job is to look for situations where there is potential for these types of expectation revisions to occur. 

Situations, where there is high uncertainty, are usually an excellent place to start when looking for expectation revision opportunities. Uncertainty creates conditions where the level of consensus about the future is low, and the range of potential outcomes is high. Growth stocks are attractive for this reason. 

Another reason why growth stocks are attractive is that they often come embedded with free options. They’re not always free, but frequently they are. Growing companies in new or high volatility industries tend to create opportunities in new products or markets that the share price doesn’t adequately reflect. This phenomenon is especially true in companies that are leading a new industry and have management teams that have a strong strategic vision. 

Each of the companies we’ve added to the Model Portfolio falls into this category to a varying degree. 

Buys

  1. Nearmap (NEA)
  2. Integrated Research (IRI)
  3. Electro Optic Systems (EOS)

Nearmap (NEA)

Nearmap captures high-resolution aerial images of cities from light aircraft and renders them seamlessly on a subscription-based browser for use in the construction, roofing, solar and transportation industries (among others).

The company operates primarily in Australia and New Zealand and the United States. The company is profitable and growing in the ANZ region. The ANZ segment reported an annualised contract value of $61m on 31 December 2019, up from $53m at 31 December 2018. The company earns an operating profit margin of 53% in the ANZ business. 

On the other hand, while the US business is fast-growing, it is currently operating at a loss. This situation is a result of the substantial investment in sales and marketing as well as aerial capture and technology. Revenue has grown in the US from a standing start in 2016 to ACV of more than $35m on 31 December 2019. 

It’s unclear whether NEA will achieve a margin in the US as high as they do in ANZ. However, it is clear that with scale, the US will be a very profitable business for NEA. Also, the opportunity in the US market is multiple times the size of the ANZ opportunity. 

The stock price currently reflects growth expectations of 20% p.a. for the next five years, with operating margins growing incrementally to 35%. There is an opportunity for expectation revisions on multiple fronts. Revenue has the potential to grow at a higher rate for longer than five years as the company fully exploits the US opportunity. Further, the company is investing heavily to enhance its market-leading position, which has the potential to open new avenues for growth. 

Integrated Research (IRI)

Integrated research is a global leader in performance monitoring and diagnostics software for business-critical IT infrastructure, unified communications and payments. 

The company has grown steadily over the years with stable (and high) margins and returns on capital. What’s interesting to me about IRI is the low expectations for future growth implied by the current share price. 

While revenue growth has slowed over the last three years, there is an opportunity for it to ramp up again with the introduction of new products. However, with the market not expecting much in the way of growth, the downside case is somewhat limited.

IRI is a market leader, with >25% of Fortune 500 companies as customers. They are the dominant vendor for on-premise UC, payments, and infrastructure management, with a high degree of revenue recurring.

The company’s payments revenue is growing at a faster rate than UC. However, UC accounts for a more substantial portion of the overall revenue base, which has hidden the strong growth in payments. As the payments product continues to grow, it will begin to have more of an impact on overall growth. The same is true for APAC and European regional revenues when compared to the Americas.      

As well as the above dynamic, the company has traditionally sold on-premises solutions. In 2020 IRI launched it’s new SaaS platform, featuring solutions for payments & UC. The plan is for the company to grow revenue with new value-added offerings on the new SaaS platform.

The stock has been in a trading range for a year. It’s followed a traditional Wyckoffian accumulation pattern with multiple tests of support and resistance. There’s been steady buying in the base with several high volume positive days, especially since the 23 March low. The stock now appears to be breaking out above resistance.

Electro Optic Systems (EOS)

EOS primary business is the sale of defence systems, including vehicle turrets and remote weapons systems. EOS is also in the early stages of commercialising owned technology in the space systems and communications sectors. This technology includes EOS-developed optical sensors to detect, track, classify and characterise objects in space.

Over the period 2010‑2016 EOS defence invested significantly in the development of next‑generation remote weapons systems (RMS) which offered significant improvements in size, weight, combat effectiveness, firepower, accuracy and cost overall existing RWS. This investment culminated in substantial bidding activity and contract wins relating to the R‑400S weapon system beginning in 2017.

Since 2017 sales have grown 167% p.a. to $166m in 2019 and will increase by 40% to $230m in 2020. 2020 guidance was revised down by $70m due to disruptions to delivery and payment resulting from COVID-19. However, the company expects growth to strengthen in 2021 as activity deferred from 2020 catches up, and they convert new contracts from the pipeline.

EOS estimates the global RWS market for its current product mix to exceed $12b over the period 2021‑2030. Also, the company expects that the demand for its counter unmanned aerial system products will grow to $12b over the same period. The current annual market for EOS defence products is expected to grow from $1.2bn p.a. in 2021 at a compound rate of 15% to more than $5bn in 2029.

EOS has $600m+ undelivered contracts in the backlog and $3b+ in the tendering pipeline. EOS expects to convert 20-40% of it’s tendering pipeline into contracts over the next 36 months.

The current EOS share price implies that revenue will grow at 22% p.a. over the next four years to 2024, and margins will increase to 16%. Given the above expectations for growth in the company’s addressable market, it is conceivable that EOS will grow revenue at a higher rate and for a longer duration than the market currently expects.

The company also has big plans in the space and communications sectors. The opportunity in these sectors is challenging to quantify at this time. However, with substantial growth expected from the defence sector, the optionality associated with space and communications is essentially being thrown in for free.

By Danny Sandler

Founder of Ocean Asset Management.