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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.

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Trading Diary

Trading Diary – 19 May 2020

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)
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ASX.Express Weekly Round Up

Retail leaders emerging from the Pandemic

Investors in the retail sector have been on quite a ride over the last few months. The uncertainty regarding how the industry will be affected by the Pandemic has driven wild gyrations in stock prices.

Stock prices are primarily about narrative and how this drives investors expectations. Below we’ve looked at some of the listed retail leaders. The table shows our estimates of market expectations for revenue growth and margins baked into current stock prices.    

Price Implied Expectations

* Assumes 5 years of growth and target margin achieved in 2024. Source S&P Capital IQ and SANEQ.

Premier Investments (PMV)

Price implied expectations are for revenue to decline by 12.5% during 2020 before returning to growth in 2021. The market expects margins to fall to under 11%. The company was able to achieve margins of more than 13% in the period before COVID. 

The market expects the company to achieve growth of ~8% p.a. and margins to grow to 14% from 2021 onwards. 

The primary growth driver in the PMV portfolio is Smiggle. The brand achieved record sales in FY19 of $306.5 million. PMV is targeting to deliver $450 million in annual global Smiggle retail sales in calendar 2021 or calendar 2022. This target might be delayed by the Pandemic. 

The Peter Alexander brand also has the potential to deliver significant growth going forward. The brand has the potential to open a further 20-30 stores over the next two years, adding to the already 137 stores in the portfolio. Peter Alexander is PMV’s second-largest brand with sales during FY19 of $248 million. 

Together these two brands account for 50% of PMV’s total retail sales revenue. The other brands are more mature and don’t have the global potential of Smiggle and Peter Alexander.  

The Pandemic has thrown a spanner in the works for PMV’s global growth ambitions. Currently, only around 16% of the company’s revenue is from overseas. Australian retail will likely recover faster than the rest of the world. However, the company is still exposed to a weaker local consumer, reduced sales in tourist locations and from international students. These, along with the slowed global rollout, makes the company vulnerable to downward expectation revisions in the short-medium term. 

The stock is now back into its long-term trading range, where it has traded sideways since March 2016. It’s unlikely that the stock will enter a new uptrend until the market can recalibrate earnings and growth expectations in a positive direction for the next few years with a higher level of certainty. 

Super Retail (SUL)

SUL is priced for slower growth than some of the others we are looking at here. SUL is a relatively mature business with stable margins and returns. The market is expecting sales to drop 2% in 2020 and then to grow 5% p.a. after that. 

Margins are expected to remain relatively stable, around 8% and then to expand slightly to 8.5% as sales recover. 

SUL suffered from the drought and fires during its peak sales periods in H1, with sales mostly flat and EBIT declining during the period. The company announced that sales during the Pandemic have held up well, especially in its two largest brands, Rebel and Supercheap Auto. However, the outlook for sales remains highly uncertain.

Unless SUL can fire up sales and profitability growth in its smaller BCF and Macpac brands, there is unlikely to be any scope for significant positive expectations revisions. The stock has been moving sideways in a trading range since 2015. It fell below long-term support during March 2020 but is now back up in the trading range. 

Lovisa (LOV)

The stock fell 84% from its high in October 2019 to the low in March. It’s now up more than 200% since March 24 – still more than 40% off its high. The stock has traded in an extensive range since June 2018. During this period, sales have continued to grow strongly, while profitability has flatlined due to margin compression. Margins fell as a result of increased costs associated with the global store rollout. 

Lovisa is interesting because they have almost no e-commerce capabilities and the majority of their growth is coming from international, mainly Europe and the USA. International revenue accounts for 45% of total sales. In FY19 the company opened 14 stores in the UK, six in France, four in Spain, and 18 in the USA. This global store rollout program accounts for a large portion of the company sales growth.

The current stock price implies that the market is expecting sales to fall 5% in 2020, with margins falling from 21% to ~14%. The market then expects growth to reaccelerate back to 18% p.a., with margins recovering back to 20% over the next few years. 

That is a lot of implied growth, especially coming from markets that are currently experiencing severe economic contractions. While these markets remain a significant long-term opportunity for the company, it’s hard not to see significant disruption to these plans as a result of the Pandemic.

The market will need to continue looking through the next year or two and maintain the faith in the long-term opportunity for growth for the stock to hold at these levels. There’s still a lot of growth priced.  And considering this growth is reliant on the health of the global consumer when the world emerges from the Pandemic, there’s still much uncertainty. 

Accent Group (AX1)

Accents stock price has also traded sideways in a range since early 2018. The March panic took the stock down through the support level that defined the trading range. However, since the March 24 low, it has fought its way back up into the bottom of the range.  

The implication from this is that the company’s long-term prospects have not changed as a result of the Pandemic. 

AX1 was threatening to enter a new uptrend, having jumped across the creek in late 2019. However the breakout did not hold as news of the spread of the virus came to light in late February, literally days after releasing a robust set of H1 results. The company outlined multiple avenues to growth, including new stores and digital as well as the rollout of new store concepts.

The current price implies 11% decline in sales during 2020 with operating margin declining to ~8.5% from 10% in FY19. The expectation is that growth will resume in 2021 at 12% p.a. and margins will improve to 10.5% over the next few years. 

A lot is riding on the health of the Australian consumer and their ability to continue buying shoes at the same rate as they did pre-pandemic. There is much uncertainty as to whether or not this will be the case. However, for the time being, the market seems to be looking through next year’s earnings and operating on the assumption that the long-term growth opportunity remains intact, albeit with much less certainty as in late February.   

Baby Bunting (BBN)

Baby Bunting is another Australia only retailer whose outlook is probably not as clouded as the international growers. The market is expecting sales growth to slow to 4% during 2020, with margins continuing to grow to 8% over time. The current share price implied expectation is that sales growth will recover quickly to 12% p.a. by 2021 as the store rollout continues and same-store sales growth resumes. 

The company has articulated its growth strategy, which includes increasing store numbers from 56 currently to 80 over time, digital growth and margin improvement. The current share price implies the achievement of these objectives over the next few years, albeit with a brief setback in 2020.  

The BBN stock price has traded sideways since listing in late 2015. The growth narrative has not changed over time, and therefore, for the most part, neither have expectations.   

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ASX.Express Weekly Round Up Inside the market

Banks, Consumer, Tech diverge

Banks, consumer discretionary and tech traded in tandem into the March 23 low. However, since that time, consumer and especially tech have bounced substantially, while banks have barely moved. I’m looking at these three sectors together because together they represent the more cyclical exposures in the market. These are the companies most exposed to the health of the underlying economy.  

So what’s happening under the hood and what is the reason for the divergence?

Banks

Looking at the banks, the big four, in particular, have suffered severe drawdowns during March and hardly recovered at all during April. NAB, WBC and ANZ are all languishing very close to their GFC lows, which is extraordinary. They’ve all essentially traded sideways for the last ten years. CBA, on the other hand, was able to put in a much more robust recovery out of the GFC but has also broken below a long term trading range and is currently sitting at levels last seen in 2010.

At the GFC low, the big four banks traded at around one times book value. This multiple was down from extravagant levels before the GFC of between 2.5 and 4 times book value. They then made their way back to the 2-3x level at their post-GFC highs in 2015. WBC, ANZ and NAB have now crashed to between 0.7-0.8 times book value. CBA has collapsed to a low of 1.24x.

From this, I can only surmise that the market is expecting significant damage to bank balance sheets and profitability in the coming months. 

Consumer Discretionary

Consumer discretionary stocks fell in tandem with the banking stocks at the onset of the current crisis, however, rebounded much more strongly in April. This action is in contrast to how they behaved during the GFC, where there was significant underperformance from the consumer sector. The banks also recovered faster coming out of the GFC.

Taking a look at some of the big caps in the sector:

And some of the smaller caps:

Both groups have shown strong bounces in April in contrast with the banking stocks. 

Information Technology

Technology stocks also fell in tandem with the banking and consumer discretionary sectors, however, recovered a large portion of the decline in April. By the end of April, the sector average was down only approximately 8%, after having been down 42% when it bottomed out on March 23. 

The strength of the bounce in technology stocks is not as surprising as the strength in the retailers. This behaviour is more in line with historical precedent. However, we are wary of discounting big techs exposure to the consumer, small business and the economy in general. These companies will struggle alongside everyone else in the event of a significant economic contraction. 

The top five largest technology stocks by market capitalisation, which account for more than half of the entire technology index include Xero, Afterpay, Computershare, Wisetech and Altium. Each has exposure to the underlying economy, and each will find growth harder to come by in the event of a system-wide contraction. 

Xero’s stock price has recovered to within 15% of 52-week highs. Afterpay is flirting with new highs today, following news of Tencent’s new 5% stake in the company. Neither of these companies will be immune in the event of a recession. 

Xero’s customers are the small businesses most exposed to this crisis. Volume growth in Afterpays consumer payments business is sure to slow in the event of a recession, not to mention the potential credit exposure from customers who’ve lost jobs and are unable to make repayments.

Summing up

This piece is not a prediction of the future. I’m merely pointing out the growing divergence between the banking stocks and some of the other cyclically exposed stocks. 

The banks are telling one story, while the consumer discretionary and technology stocks are saying something else entirely. Both have exposure to similar risks in varying degrees.

The banks have told us more. ANZ, NAB and WBC have each reported half-yearly results in the last week or two. Each set of results included hefty credit impairment charges and a deep sense of concern for what to expect in the months ahead. This concern is being reflected in their share prices, while other cyclically exposed stocks are currently reflecting hope.

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Trading Diary

Trading Diary – 4 March 2020

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.