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In Quality We Trust

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | May 30 2019

In this week's Weekly Insights (published in two parts):

-Conviction Calls, Part I
In Quality We Trust
-Conviction Calls, Part II
Rudi On Tour

[Non-highlighted parts will appear in Part Two on Friday]

By Rudi Filapek-Vandyck, Editor FNArena

In Quality We Trust

About one year ago today there was virtually no one in the Australian share market who was interested in buying shares in TechnologyOne ((TNE)).

There was the occasional analyst who dared to point out the shares looked too cheap in light of the company's admirable track record, and ongoing buoyant growth prospects, but few only were paying attention.

One of the few was I because the FNArena/Vested Equities All-Weather Model Portfolio (see further below) owns shares in the company and I personally regard TechnologyOne the highest quality software company listed on the ASX, and one of the true all-weather performers locally.

But, as said, nobody wanted a bar of it. Upon persistent failure to move away from the $5 mark, the share price spent some time near $4.50 before turning back to around $5, where it still resided when I presented at the national conference of the Australian Investors Association (AIA) in early August.

There I was asked about my stock tip for the year ahead and I nominated TechnologyOne. More than ten years of growth in earnings per share averaging circa 15% per annum, and the decade ahead will most likely see more of the same, I explained at the conference. What exactly is there not to like?
It's not a question many are asking about this same stock today. In between last year's AIA conference and the company's interim earnings report earlier this month the share price had rallied to near $9.50, or more than double the $4.50 it was languishing at a little over a year ago.

Yes, I am hopeful this stock might catapult me to last year's best stock picker at the upcoming AIA conference in late July, even though the share price has rapidly given back a chunk of that massive rally since the interim report was released. Truth is I never thought TechnologyOne shares would double from last year's too cheap sub-$5 price level, but I knew it would only be a matter of time before momentum would revisit this champion software company.

This is what I have learned from observing the Australian share market over nearly two decades: a great and high quality, reliable performer such as is TechnologyOne can fall temporarily out of favour, for all kinds of reasons, but it never lasts long. This is one key difference with shares in companies of a lesser quality and with a far less admirable track record; they can remain out of favour for far longer than you and I can keep our faith in a favourable ending.

Most investors get interested in a stock after it has fallen by what appears a ridiculous percentage, and then risk getting caught into temporary rallies, followed up by ongoing bad news and further share price weakness. EclipX Group ((ECX)) is one such fine example. iSentia ((ISD)) is another one.

Sure, Myer ((MYR)) shares doubled between early March and mid-April, so congratulations to everybody who was on board (conveniently forgetting all the money that was lost trying to pick the bottom in the Myer share price during the eight years prior).

As I have been highlighting over the years past, there is a viable, far less riskier strategy for long-term oriented investors and that is through buying high quality when the share market temporarily doesn't feel like it, rather than through scavenging through the rubble at the bottom of the beaten down dogs basket of the ASX.

One of the key factors as to why too many professional funds managers have found beating the market too difficult over the past five years is because most cheaply priced stocks revealed themselves as being traps for "value" seeking investors.

On the other hand, quality stocks including CSL ((CSL)), ResMed ((RMD)), REA Group ((REA)), Altium ((ALU)), Carsales ((CAR)), and TechnologyOne equally experience rallies and dips, but the dips are always an opportunity. Everyone can see this from opening up a price chart from the past ten years or so.

Admittedly, not every stock on my list of All-Weather Performers has this year managed to rise above peak share price levels recorded last year, but many have, and history suggests for the others it'll be simply a matter of time.

Unless, of course, something fundamentally changes the outlook for the company involved.

It happened to Ramsay Health Care ((RHC)) which saw its shares peak below $80 in 2016, then fall to mid-$50s last year. The shares are back near $70 this month as investors are starting to consider the potential implications of a turnaround in operational dynamics.

The story for InvoCare ((IVC)) looks pretty similar. InvoCare shares peaked in late 2017 around $17.40, then tumbled to near $11. They have rallied back to above $16 this month.

Both examples show us a lot of pain is inflicted on popular quality growth stocks when the future outlook becomes uncertain and investors start doubting which will be the way forward. But investors should keep in mind the punishment is not necessarily less for cheaper priced stocks. Of that an example such as EclipX Group can serve as a fresh reminder.

Most importantly, and this statement is backed up by historical evidence, high quality companies such as CSL, Altium, et al are far less likely to issue a profit warning, let alone one as severe a la EclipX Group and iSentia. And share prices tend to recover much quicker from a temporary draw down. Just look at what has happened to ResMed, REA Group, and the other stocks I just mentioned over the past year or so.

On my analysis, the biggest mistake made by investors is by treating every listed stock in the same manner, as if they are all the same, with relative value the only point of difference. In practice, however, stocks are not all similar. Quality commands, deserves and receives a premium. In particular when most sectors and listed companies are challenged and unable to deliver sustainable, uninterrupted growth.

This is one of such periods.

One of the stocks on my personal share market radar, Treasury Wine Estates ((TWE)), included in my domestic Prime Growth Stories selection, has this year somewhat fallen from grace as can be seen from the share price languishing around $15 when $18-$19 was not out of the question not that long ago.

Given the share price's track record since 2015, it is easy to suspect that investors might want to put this stock in the same basket with CSL, InvoCare, REA Group, and so forth but I have become a lot more circumspect about what goes on inside the global operations of this former market darling.

The reason is because market chatter about bloated distributor inventories in China for second tier wine from the producer of some of Australia's finest continues to resurface. This makes me anxious there possibly is some truth to it, regardless of company management's continued denials.

As the story goes, every distributor in China keen to stock up on Treasury Wine's high quality, prime wine products (such as Penfold's Grange) is forced by the company to also purchase volumes of lesser quality, cheaper wine. It is these second tier inventories that are reportedly hard to sell.

If the speculation is correct, none of this shows up in Treasury Wine's financial reporting, but common logic tells us this will become a serious problem at some point. Hence my reluctance.

Investors should be aware Treasure Wine Estates is essentially an 80/20 proposition whereby 80% of the profits stems from 20% of all wines sold (the prime priced quality section) but problems in the 80% of cheaper volumes can still cause havoc with the share price and its valuation.

A more attractive proposition, perhaps, was recently put forward by tech analysts at Bell Potter. Local technology company Integrated Research ((IRI)) has been on my personal radar for quite a while, but the company issued a sudden profit warning last year which explains the big tumble on the price chart from a peak in the share price as high as $4.

I don't like companies issuing profit warnings, for obvious reasons. I consider it a lack of management control and it certainly removes whatever was there beforehand in terms of "quality" label attached to the company.

Integrated Research's profit warning also reminded investors about how quickly fortunes can turn for smaller cap software and technology companies. A large number of peers have equally issued profit warnings, if not more recently then certainly over the years past.

Once again, this observation emphasises the true quality that resides with TechnologyOne; a fact I simply cannot repeat often enough. Consider this statistic for a moment: 99% retention of customers.

Back to Integrated Research. Bell Potter observes the company has experienced a good year post last year's debacle. The share price is back near $3, still nowhere near $4 but also a long way off from the bottom below $1.70. Bell Potter thinks the upcoming full year result should be strong, showcasing double digit percentage growth in both revenues and profits.

Of more importance, I would argue, is the fact that if Integrated Research is indeed back on track to continue the company's track record prior to last year, then the years forthcoming should see a resumption, and continuation, of double digit growth in earnings per share per annum. This is indeed the forecast put forward by Bell Potter.

Somewhat irresponsibly almost, Bell Potter argues both Integrated Research and TechnologyOne should grow at 15% on average per annum over the next three years. Of course, the two are not comparable just because both are wearing the label of "technology", and that's why the latter shares should trade at a hefty premium to the former.

Anyway, none of this means Integrated Research shares cannot be re-rated again on vast improvement of management's execution of the company's growth path. Investors who are prepared to give the company a second chance might want to have a closer look. Bell Potter thinks Integrated Research should provide positive guidance for the current fiscal year at some point in July and that this will act as a catalyst for the share price (all else remaining equal).

On Tuesday, as I am writing this story, I notice shares in TechnologyOne have stopped falling post interim report (whatever the exact disappointment was). After an initially timid move higher, they ultimately rallied in excess of 4% on the day.

It again reconfirms the observations I mentioned above. It also feeds my confidence that some of the resilient smaller cap quality stocks owned by the All-Weather Model Portfolio that have not been able to attract positive investor sentiment thus far in 2019 will eventually regain their prior mojo a la TechnologyOne and Aristocrat Leisure ((ALL)) post interim profit result last week.

I am specifically thinking about Orora ((ORA)), Bapcor ((BAP)) and GUD Holdings ((GUD)).

At a time when many an investor has fallen for the lure of jumping on, and staying on board, positive momentum stocks, it's great to be reminded that positive investment returns can still come from quality stocks, even when they are temporarily out of fashion.

As explained so often in "Reminiscences of a Stock Operator", it's the sitting and waiting that reaps the biggest rewards, at least for those that can withstand the mind's impatience when a share price is not moving, and all others, so it seems, are.

As long as investors don't confuse CSL with EclipX Group, or TechnologyOne with iSentia, of course.

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Note: paying subscribers at FNArena have access to a dedicated section on All-Weather Performers on the website.

Note II: investors interested in attending this year's national AIA conference on Queensland's Gold Coast can still enjoy discount prices until May 31st.

https://administration.investors.asn.au/civicrm/?page=CiviCRM&q=civicrm%2Fcontribute%2Ftransact&reset=1&id=3

Note III: Reminiscences of a Stock Operator by Edwin Lefevre is one of the all-time classics about trading and speculating in US shares. I highly recommend reading it for those who haven't as yet

Also, for more information about the FNArena/Vested Equities All-Weather Model Portfolio send an email to info@fnarena.com, plus see further below.

Rudi On Tour In 2019

-AIA Adelaide, SA, June 11
-AIA National Conference, Gold Coast, Qld, 28-31 July
-AIA and ASA, Perth, WA, October 1

(This story was written on Tuesday and Wednesday 28th & 29th May 2019. Part One was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website. Part Two appears on the website on Friday).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

Subscriptions cost $420 (incl GST) for twelve months or $235 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): https://www.fnarena.com/index2.cfm?type=dsp_signup

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.) 

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