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In Search Of ‘Value’, Avoiding ‘Cheap Junk’

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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 | Jul 18 2019

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

-In Search Of 'Value', Avoiding 'Cheap Junk'
-All-Weather Portfolio Update
-Unveiling The US Corporate 'Secret' – Three Charts
-Conviction Calls
Rudi Talks
-Rudi On Tour
-Rudi Talks

In Search Of 'Value', Avoiding 'Cheap Junk'

By Rudi Filapek-Vandyck, Editor FNArena

The sharp division between investors in "Growth" and in "Value" has added yet another chapter over the past six months, despite a notable resurgence for banking stocks and iron ore miners throughout the half.

But, as highlighted in the graphic below from a recent market analysis released by Morgan Stanley, there is more to the persistent market division between "winners" and "losers" than simply the concept of investors continuing to buy Growth Stocks because, well, they are growing strongly, while largely ignoring the companies that are struggling.

Morgan Stanley correctly points out today's popular Go-To Stocks do not simply comprise of "Growth" stocks like a2 Milk ((A2M)), Altium ((ALU)) or Nearmap ((NEA)), they equally include "High Quality" names such as CSL ((CSL)), REA Group ((REA)) and TechnologyOne ((TNE)).

And on the losing side, among the laggards while share market indices have done nothing but surge higher, the story is not just about "Value" having fallen out of fashion against "Growth"; this is equally about the division between "Low Quality" and "High Quality" companies.

For most investors, professional or otherwise, the concept of using a "Quality" mark for listed equities is a rather uncomfortable one. No stockbroking analyst will ever put on paper that the company under scrutiny is of Low Quality because management at the helm will take offence, leading to negative consequences for the analysts or their employer.

Similarly, there's no value investing funds manager in the country, or elsewhere, who runs the marketing slogan: we buy the lowest quality of listed businesses, but only when their stock looks really cheap. While, in reality, that is exactly what buying "deep value" translates to in the share market.

High Quality names such as CSL, REA Group and TechnologyOne might be just as susceptible to market sentiment and equally be impacted by market volatility, their equities are never as "cheap" as, for example, AMP ((AMP)), Retail Food Group ((RFG)), EclipX Group ((ECX)), Speedcast International ((SDA)), iSentia ((ISD)), Freedom Insurance ((FIG)), The Reject Shop ((TRS)), and many, many others.


While cheap, beaten down share prices can potentially start a rally anytime, and at a moment's notice -just look at Retail Food Group recently, or Eclipx Group- the experience of the past years shows these rallies are rather unlikely to stick around for long.

Witness how shares in Myer ((MYR)) more than doubled between February and April this year, but they've subsequently lost half of that rally. In the case of AMP, the end destination has continually remained a share price at a lower level. Now speculation is rife a dilutive equity raising might be unavoidable.

But the Morgan Stanley graphic makes a good point in highlighting today's share market laggards do not solely consist of Low Quality operations with a gigantic chip on the shoulder. There are plenty of listed companies out there that are regrettably operating inside the wrong sector at the wrong time, or battling temporary set-backs that won't hold them back forever and ever.

The steep come-back for Ramsay Health Care ((RHC)) shares over the past seven months would be one such fine example, as is the even steeper recovery enjoyed by InvoCare ((IVC)) shares. Let's not forget that prior to June last year, nobody seemed very much interested in owning shares in TechnologyOne. Or try Cochlear ((COH)) shares up until April.

The timing for such a share price recovery is never easy to predict. Most investors who own "value", deliberately or through misfortune, don't sell when the timing for recovery is delayed, unless the investment case changes. Part of the underperformance of large swathes of professional funds managers can thus be traced back to sectors and stocks that seem undervalued, but for whom the time to shine has not arrived just yet.

Another way of looking at this is through the concept of a rolling, evolving and shifting bear market in today's share market. When I published Who's Afraid Of The Big Bad Bear?" in December 2016, the final page of the book contained the following conclusion:

Whereas most market participants still carry lively memories (and possibly traumas) about what happened between late 2007 and early March 2009, and maybe about the period 2000-2002 as well, the Grizzly Bear nowadays travels through specific sectors and segments of the share market.

Hence, part of understanding the dynamics in today's share market is the realisation (acceptance?) that parts and sectors will alternate between falling out of favour and joining the raging bull market. Next comes trying to understand what is keeping sentiment low and investors not interested.

Let's first draw up a list of themes and sectors that mid-2019 remain out of favour (in no particular order):

Building materials; Boral ((BLD)), Reliance Worldwide ((RWC)), Adelaide Brighton ((ABC)), etc

Automobiles; Bapcor ((BAP)), GUD Holdings ((GUD)), Motorcycle Holdings ((MTO)), etc

Travel & Tourism: Sealink Travel Group ((SLK)), Event Hospitality and Entertainment ((EVT)), Flight Centre ((FLT)), etc

Value investors: Platinum Asset Management ((PTM)), Janus Henderson ((JHG)), Pendal Group ((PDL)), etc

Retail landlords: Vicinity Centres ((NVC)), Unibail-Rodamco-Westfield ((URW)), Scentre Group ((SCG)), etc

East Coast Infrastructure Boom: Lendlease Group ((LLC)), Wagners Holding ((WGN)), Fletcher Building ((FBU)), etc

Electric Vehicles and new batteries: Orocobre ((ORE)), Galaxy Resources ((GXY)), Syrah Resources ((GXY)), etc

Thermal coal: New Hope Coal ((NHC)), Whitehaven Coal ((WHC)), Metro Mining ((MMI)), etc

This list is by no means complete, but probably covers the most obvious parts of the share market that simply refuse to fully participate in the 2019 equities bull market, the occasional exception notwithstanding.

The main problem for investors looking for "value" in these segments is that timing the next recovery is exceptionally hard to do. And you'd want to own "Quality" when times are tough and uncertain. Moreover, while it is broadly accepted that building activity is highly cyclical, and the RBA lowering interest rates might accommodate a recovery in due course, the case for any of the other segments looks decisively less straightforward.

For example: on Monday, analysts at UBS argued the case that house prices for the main cities in Australia are probably close to bottoming, but their research into the historical correlation between house prices and Australian car sales suggests the latter might not see a noticeable recovery until the June quarter next year.

UBS also acknowledges investors are worried about the long term prospects for car sales as they anticipate ride-sharing and robotaxis ("autonomous vehicles") will be making steady inroads shortly, but the overriding view is that global new car sales are most likely to continue growing until at least 2030. Other forecasters have made similar projections when asked about the impact of Electric Vehicles (EVs).

This does not mean there is no sustainable recovery possible for individual companies inside these segments. Management teams can still pull levers such as new products, new markets, cost out, restructuring, spin-offs, and acquisitions (apart from companies becoming a corporate target themselves).

Woolworths ((WOW)) recently provided a possible blue print for others by preparing its ownership of pubs and clubs with its alcohol sales outlets for spin-off next year.

While most commentary has focused on the supermarket operator (finally) separating from its long contentious relationship with the gaming machines inside these pubs and clubs -potentially putting the stock back on the radar of ESG-filters and responsible investment strategies- I believe the board's decision was mostly led by the realisation that supermarkets are not the only part of the businesses that will be facing enormous challenges in the years ahead, including Kaufland/Lidl and online delivery orders.

The advent of online competitors for bricks and mortar bottle shops is today probably not well-understood by the broader investment community, but it won't be long before changing times/increased competition starts showing up in the sales numbers and other financial metrics of alcohol distribution channels BWS and Dan Murphy's.

Either way, it is but fair to conclude these businesses need all the support and management focus they can get to fend off the various challenges in the medium term, and stay viable and relevant further out.

Separation seems more like a necessity than a smart move by Woolworths in order to please ESG-concerned investors.

All of this sets the broader context as to why the upcoming August reporting season in Australia might prove quite the pivotal event, with investors looking for answers and for tangible evidence whether companies' resilience and earnings potential has been underestimated, or whether long loyal shareholders -frustrated as their patience continues to be tested- will have to wait (even) longer.

The one group missing on Morgan Stanley's graphic consists, of course, of REITs and other bond proxies. While most attention among investors and market commentators is usually reserved for banks, resources, IT and healthcare, or maybe large caps versus small caps, it is seldom highlighted that names like Transurban ((TCL)), Goodman Group ((GMG)) and Charter Hall ((CHC)) have become the new Superstar Stocks in an environment of mostly uninterrupted central banks support, and ever lower bond yields.

As with "Growth" and "Quality", too many value investors have been calling these "Yield plus Growth" stocks grossly overvalued, while share prices post 2013 have largely ignored these calls, and continued appreciating instead.

While everybody likes a bargain, all of the above suggests investors should be extra-careful when seeking value near the bottom of the share market. Making the accurate distinction between genuine "Value" and "Cheap Junk" might make a significant difference in August, and beyond.

In case anyone does reach the uncomfortable realisation that yesterday's promise has simply turned into today's Grave Disappointment, always remember: it is never too late to sell. One look at share price graphs for AMP, Retail Food Group, iSentia, Slater & Gordon ((SGH)) and the likes reveals just that.

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Who's Afraid Of The Big Bad Bear?" is included in the bonus items that are available to every paid subscriber (6 and 12 months). A copy can be downloaded via SPECIAL REPORTS on the website.

Rudi Talks

Audio interview on Wednesday (last week) about how much central bankers are invested in today's financial markets, and how far exactly is this going to take them:

https://www.youtube.com/watch?v=wFktIuKZji4

Rudi On Tour In 2019

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

(This story was written on Monday and Tuesday 15th & 16th July 2019. It 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 follows 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 $440 (incl GST) for twelve months or $245 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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