Category: Trading Diary

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.

Markets in Australia and around the world have begun to stabilise after an incredibly turbulent period beginning in late February. The VIX volatility index rose in March to levels not seen since March 2009 during the GFC. Over the last eight weeks, volatility has slowly declined and is now closer to more normal levels (although it remains elevated)

The Federal Reserve in the US acted with unprecedented size and speed to backstop the liquidity crisis created by the panic. The fed flows are unparalleled in both their sheer size and their ability to buy bonds and bond market ETFs at the lower end of the quality spectrum. 

This action caused a waterfall effect of liquidity that has ultimately found its way into the equity markets. The stock market appears to have bottomed in late March. The sudden bottom and subsequent rally resulted from both the fed action and the realisation that the public health crisis might begin to recede faster than initially thought. 

Low-interest rates that will stay low for longer have put a floor under valuation. Central bank funding has ensured that markets remain open and orderly. The market appears to be looking through the health crisis and acting to discount its effect over the next 12-24 months. The market should serve as a long-term discounting machine, so this is precisely rational. 

My initial expectation was that the Pandemic would result in better valuation opportunities than those that have occurred. The stock market remains elevated from a valuation perspective. However, it appears that the panic is now over, and we’ve returned to an environment where the best companies will be able to outperform over time. 

Energy, Financials and Industrials have been the sectors hardest hit year-to-date by the Pandemic. While Health Care, Technology and Staples have performed best. This dispersion of sector performance is very close to what we would expect during the onset of a weaker economic climate – defensive performing well relative to cyclical. It’s interesting how the market has recast the Technology sector as defensive during this cycle.

As a result, we are beginning to increase our exposure to equities again. We plan to do this at a slow and measured pace as opportunities present themselves. My investing mantra at this time is to proceed, but with caution. 

We won’t know the true extent of the damage done to the economy by the Pandemic for some time. Nor will we know how long it will take for a full recovery to take place. With that in mind, I intend to build the portfolio around structural growth opportunities, to begin with. I’ll add cyclical exposures only if opportunities present themselves opportunistically. 

Buys

1. Xero (XRO)
2. Appen (APX)
3. Domino’s Pizza (DMP)
4. Medical Developments (MVP)
5. Polynova (PNV)

We’ve further reduced our exposure to the stock market today with the sales of BWX (BWX) and Credit Corp (CCP). Our cash allocation has increased to 50% in the Model Portfolio, and we are now holding nine individual stock positions.  

Both stocks had been acting well until the beginning of this latest bout of volatility related to the CONVID-19 virus. However, both have now broken below stop-loss levels, and as a result, we have sold. 

The market is now in a downtrend; therefore, we will not reallocate the cash released from these transactions back into new companies. 

Our strategy is designed to participate in uptrends and avoid the worst downtrends by eliminating positions and staying in cash while a downtrend persists. It’s not perfect, but it allows us to keep a seat at the table and to keep investing over multiple market cycles.

Sells

Credit Corp (CCP)

Sold for a 6% profit.

The stock has broken below key moving averages, including the 50, 100 and 200-day moving averages. Also, the stock price has fallen below its most recent basing point. Trading volume increased significantly during the latest down move. 

The uptrend that began in April 2019 is now over. When this recent bout of selling concludes, we expect the stock to spend some time in consolidation. At this stage, it’s unclear whether this will turn out to be a reaccumulation range or a distribution range. How the economic impact of the virus affects the company’s earnings and profitability (if at all) will ultimately determine the stocks next move. 

BWX Limited (BWX)

Sold for a 10% loss.

BWX is a similar story to CCP above. The stock has been unable to stay above key moving averages (although it remains above the 200-day) and has now fallen below its most recent basing point. Volume was elevated over the last two weeks since the release of 1H20 results and remained so this week. 

While fundamentally, the stock was on track to deliver, with revenue growth and margin improvement providing a powerful combination. However, improving operating metrics has not been enough to counter negative newsflow relating to the CONVID-19 virus. 

Companies exposed to the global consumer will be under pressure while significant uncertainty relating to the virus persists. As a result, we have moved to the sidelines for the time being.

The fears related to the COVID-19 virus have continued unabated, and as a result, a further 4 of our stock positions have tripped sell rules. Following these transactions, we now hold 11 stocks in our Model Portfolio and have 39% allocation to cash. 

The trend of the overall market has now turned negative. Our cash allocation will not be reallocated into the market until the trend becomes positive again. 

Sells

Kathmandu (KMD)

Sold with a 2% loss. 

The company sells adventure travel clothing and equipment under the Kathmandu banner, as well as surfwear, under the newly acquired Rip Curl brand. Both businesses will be severely affected by any further escalation in the outbreak of the COVID-19 virus. Consumers will likely curb overseas travel, which will have a flow-on effect to the Kathmandu business. Foot traffic to stores and general consumer confidence will take a beating should the virus become widespread in Australia. 

The market in the stock is reflecting this change in sentiment. The stock has retraced back through the gap-up that occurred on the day the company released 1H20. The stock has also now fallen below crucial moving averages. As a result, we’ve exited our position for the time being.

EML Payments (EML)

Sold with a 30% loss. 

The stock has been in free-fall since releasing 1H20 results on the 19th of February and has now fallen 35% over the two weeks. Under more normal circumstances, the selling climax would subside more quickly.  However, with the current state of the overall market, support for the stock has not emerged. 

The stock has easily blown through crucial support levels and moving averages. Institutional support for the stock appears to have all but disappeared at this point. With the uptrend broken, we’ve exited our position in the company. 

Austal (ASB)

Sold with a 30% profit.

We bought ASB as it was breaking to new all-time highs in May 2019 after emerging from a 2-year trading range. The uptrend continued for four months before topping out in September and entering a new trading range. This range displayed numerous signs of being a reaccumulation range — the above-average volume on up weeks and more subdued volume during the down waves.  

However, the stock has now breached the lower limit of this trading range as well as crucial moving averages. Support has not re-emerged and therefore, we’ve sold and moved to the sidelines for the time being.  

Collins Foods (CKF)

Sold with a 3% profit.

CKF has fallen below key moving averages and broken below short term support levels. The company relies on foot traffic through its stores and positive overall consumer sentiment.  In the event of an outbreak of CONVID-19 in Australia, both will be negatively affected. 

Sentiment has changed for the stock, along with the rest of the market. Therefore we’ve taken the opportunity to exit the position until the potential risk of the viral pandemic has dissipated. 

We’ve sold two positions this week. Both stocks have exposure to the consumer sector. Increased fears relating to the spread of COVID-19 have caused a change of sentiment towards these companies.

Specialty retailers, in particular with suppliers predominantly based in China, are likely to face supply issues. Also, a subdued retail spending environment in the event of an outbreak of the virus in Australia could severely affect the operating environments for these companies.

In general, we prefer to give our holdings wide births for their ongoing uptrends to unfold. However, we also have strict protocols in place that dictate when we sell.

We now have a total of 15 stocks in the Model Portfolio and a 17% allocation to cash.

Sell

Flexigoup (FXL)

We’ve exited our position in FXL with a 13% loss.

We purchased the stock at what we thought was the beginning of a new uptrend. Management had articulated and began implementing a feasible pathway towards accelerated growth. Also, the stock had moved to the top of an 18-week trading range, having experienced multiple up weeks on above-average volume signalling accumulation.

Shortly after our purchase, the stock broke out above the range, on another high volume week. However, very soon after that, it ran into selling pressure and has been unable to maintain the upward momentum.

The new management team is one year into a 3-year transformation plan. While the strategy is gaining some traction, with 1H20 volume up 23% in the Buy Now Pay Later segment, profitability was stagnant for the period.

There appears to be substantial overhead supply still trapped in the stock. The fundamentals need to improve dramatically before these investors start believing again. However, with a weak retail environment and strong competitors operating in the space, this is becoming a steep mountain to climb. As a result, we’ve sold our position.

Baby Bunting (BBN)

We’ve exited our position in Baby Bunting with a 15% loss.

1H20 results released by the company showed positive same-store sales growth as well as improving gross and operating margins. The results were in line with our expectations of accelerating profitability and top-line sales growth. Despite this, the stock showed no signs of continuing its uptrend upon the release of the results.

The stock had been in a multi-month trading range since our purchase in late September 2019. This week it fell below the lower bounds of this trading range indicating a change of sentiment towards the stock. The fall has taken place on above-average volume. It is most likely related to the market’s expectation of supply disruptions and lower sales growth resulting from the spread of COVID-19.