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Market Rotations Are Not The Key Message

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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 | Sep 26 2019

Dear time-poor reader: global strategists at Citi suggest rotations between "Value" and "Growth" stocks will not last long, and I agree.

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

-Market Rotations Are Not The Key Message
-No Weekly Insights For Next Two Weeks

-Conviction Calls
-Is Everybody Into iSignthis?
-Rudi On Tour

Market Rotations Are Not The Key Message

By Rudi Filapek-Vandyck, Editor FNArena

"Growth/Value rotation may continue, especially if bond yields rise further. But history suggests the long-term outperformance of Growth will continue until the end of this bull market, which we don’t believe is imminent."
[Global strategists at Citi in their most recent update on markets]

Unless you only joined recently as a reader of my Weekly Insights, you'd be well aware that I remain firmly on the side of the "Growth" investors when it comes to assessing outlook and best investment opportunities in today's share market.

As you may have deduced from the above opening quote, the global strategy team at Citi remains fully sympathetic to my view, which is quite handy as this allows me to update on the sharp division that continues to characterise momentum and performances inside equity markets worldwide, not just in Australia.

"Growth" and "Value" are typical terms used by professional wealth managers, and they can be confusing as they do not always cover what we might think they do. To confuse matters a little more, there are idiosyncratic differences behind both terms in between geographic markets, and these differences can evolve over time.

But let's keep this simple for the purpose of cohesion and a basic understanding of what rules in today's equity markets. With "Growth" investors usually refer to technology stocks, healthcare and emerging new business models that can grow independently of GDP or the economic cycle. In most instances, these companies are enjoying earnings growth well in excess of the market average.

In Australia, think CSL, Carsales, Goodman Group, Afterpay Touch and WiseTech Global, among many others.

"Value", in this particular interpretation, does not necessarily refer to stocks that have not fully participated in this bull market. In this context, "Value" refers to cyclical industrials, such as discretionary retailers, and to miners and energy producers, as well as the banks. Prior to 2007, "Value" was killing it in the share market, but those days have long gone.

"Value" in the US is now underperforming for the twelfth year in succession. In Australia, it was pretty much the end of the European credit crisis of 2011-2012 that marked the start of noticeable outperformance by "Growth". That was 8.5 years ago. If, however, we start counting after Australian banks peaked in May 2015, then we are now in the fifth year of significant outperformance of "Growth" over "Value" as an investment style in the local share market.

Most investors globally, but in particular in Australia, are "Value" investors. Strictly taken, "Value" used in this sense does not mean they only buy discretionary retailers, commodity producers and banks. It means they have a never-wavering belief that optimal investment returns are achieved from buying cheaply priced shares.

Thus, while in theory there is a difference between "Value" as determined in usage number one and "Value" in the second scenario, in practice there usually isn't. This is also because your typical "Value" investor does not understand "Growth". It's like both groups of investors communicate through incompatible languages.

The latter is important. Because once we get this far through a share market bull phase, the first group tends to be quick, and persistent, in calling the share market "a bubble", "grossly overvalued", "full of complacency" and more similar cautionary warnings. In 2019, for instance, these are the expert voices that are most likely warning about the next spike higher in global bond yields, and what this might do to your average "Growth" stock.

Alternatively, they can also be part of that group of experts that continue to warn about the next recession coming, which surely will end the share market madness in "Growth" stocks.

The team at Citi does not think this bull market is nearing its end. There are rotations along the way, this time around typically triggered by long term bond movements, but outside of these rotations, which only last so long, as long as this bull market continues, the team believes "Growth" stocks are the ones most likely to outperform.

There are a number of factors underpinning this view.

Observation number one. When looked at the current share market valuations within a historical framework, it seems "Growth" stocks as a group are not that expensive. Low inflation and low bond yields support higher valuations for assets in general. What is the case is that the gap between "Growth" and "Value" is excessively wide, only superseded by the TMT rally up until the March 2000 Nasdaq crash.

In simple terms: "Growth" stocks are not cheap, but equally not excessively expensive. "Value" stocks, on the other hand, seem extremely cheap.

On Citi's calculations, the gap between both groups of stocks has risen to a relative premium/discount of 80%. The highest this relative difference has ever been measured was in 2000; back then the corresponding valuation gap was 92%.

This is not simply a result of falling bond yields. On current global analysts forecasts, "Growth" companies are expected to lift their profits for shareholders by an average of 12%. For "Value" companies projected growth is no more than 5%. Again, there are regional differences, but as a general discrepancy these numbers illustrate the point.

In Australia, the same differences revealed themselves (once again) during the August reporting season. We can all criticise investors who continue to chase the likes of Jumbo Interactive, Xero and Nanosonics, to name but three examples, but it remains the simple fact that profit warnings and dividend cuts and other kinds of negative announcements are predominantly coming from the cheap end of the market, otherwise known as "Value".

In Australia, the difference between "Growth" and "Value" is not determined by twice as much growth; over here the contrast is between high growth and no growth.

How much does one pay for a struggling business model that is going backwards? Most investors simply do not wait around wondering, leaving professional wealth managers such as Perpetual, Pendal, etc behind in sheer frustration.

For this one-sided momentum trend to end, something needs to happen that either disrupts the growth momentum among "Growth" companies or that significantly benefits the "Value" sections. A sharply higher oil price driven by increased demand could be such a catalyst (note the demand side of that statement). A sizeable and sustainable upswing in global PMIs could also turn into a positive catalyst for "Value". But probably the most likely swing factor at this point in the markets are government bond yields.

Whenever bond yields correct sharply higher (meaning: bonds are selling off), market rotation kicks in, favouring beaten down "Value" stocks while punishing popular "Growth" stocks. 

Thus far, these rotations have been nothing but temporary interruptions for a bull market in equities that very much favours "Growth" over "Value". In line with Citi's thoughts, I agree investors will have to get used to the ever-present prospect of such rotations happening, but they should not get carried away by them.

"Growth" still very much rules in this bull market. It is likely to continue doing exactly that, until this bull market ends, which would probably happen on the back of an outbreak in inflation a la 1970s or the plain old economic recession.

When it comes to the latter option, "Value" investors should be extremely careful in what they wish for. As also emphasised by the August reporting season, while "Growth" companies might prove too expensively priced in a recession, the real operational vulnerabilities would most likely open up on the "Value" side where companies such as Sims Metal Management, Incitec Pivot, CYBG and Boral would simply issue yet another profit warning – and cut or scrap their dividend.

To put this in the words of Citi strategists: "Maybe value investors will have to wait until the next meaningful early-cycle economic recovery before they see sustained outperformance. The problem is their portfolios would be too cyclical in the recession beforehand."

Note that last week UBS strategists in Australia predicted US bond yields will resume their downtrend towards the low point seen in August. In terms of momentum differences between "Growth" and "Value", this implies the same view as Citi's.

Back "Growth". You can do a lot worse in this market.

No Weekly Insights For Next Two Weeks

Next week I'll be presenting to investors and local members of the Australian Investors Association (AIA) and the Australian Shareholders Association (ASA) in Perth, hence I won't be writing my regular Weekly Insights update that week.

The following week New South Wales celebrates a long holiday weekend, which explains why Weekly Insights will have a two-week break and returns in the week commencing on Monday, 14th October.

This schedule will grant me the opportunity to close off my observations from the August reporting season and -finally- put together the next update on the CSL Challenge. Stay tuned. Don't get desperate in the meantime.

If anyone happens to be in the neighbourhood, both events in Perth are open to the general public. Come over and say 'Hi' afterwards.

Is Everybody Into iSignthis?

For the duration of a few weeks, it appears I was unable to be dragged into a conversation about the share market without one of the bystanders exclaiming "I have shares in iSignthis" ((ISX)).

For those who are as yet not familiar with this technology midget listed on the local bourse: iSignthis helps clients with online transactions including the necessary identity processing, required to comply with anti-money laundering regulations. A recent story on the company by the Australian Financial Review likened iSignthis to an alternative to PayPal.

As the share price has exploded from below 15c in January to a peak so far of $1.76, clearly there have been a large number of fresh supporters who have been making some extra dough along the way.

I also note three of the top eight contestants in the Sun-Herald's Shares Race hold iSignthis in their (imaginary) portfolio.

Next thing I know a research report pops into my inbox, with analyst Martyn Jacobs from Patersons reiterating his High Conviction Buy on the stock. According to the report, Jacobs also owns shares in the company.

I am yet to be mansplained by the next cab driver, or Uber driver, what a great investment opportunity this emerging fintech company is. In the meantime, let's find out why Patersons rates this stock a High Conviction Buy.

Reading through the report, issued after the company released interim results in late August, analyst Jacobs spotted sufficient progress and achievements to retain strong growth forecasts for the years ahead. As is standard in these emerging new business models, the inherent leverage is enormous, which implies that series of good news can quickly morph into a fantastic outcome for risk-carrying shareholders.

For good measure, Patersons did not increase its valuation for the stock post the result, but the analyst is flagging the potential payout of a maiden dividend in FY20 of 1.4 cent per share, while, in the meantime, "content to let the share price run ahead of our valuation". That valuation sits at $1.16.

iSignthis reported a breakeven result at the "underlying EBITDA" level which is seen as a significant improvement from the heavy losses of only a year earlier, which occurred during a time of supply disruption to the company's intermediary network. Investors should note this "disruption" occurred because one of the customers, KAB or Kobenhavns Andelskasse in Denmark, had collapsed under the weight of too many suspicious transactions without proper action taken being investigated by Danish regulators.

Since then, reports Patersons, iSignthis has accelerated the build of its own Tier 1 banking network in Europe with merchant clients coming on board over the past four months. According to media reports, customers for the new network include online trading platforms and gambling operators.

The interim report revealed the European business is already profitable at the pre-tax level, with merchant and deposit account approvals accelerating in July. Next thing that needs to happen is the leverage kicking in and all of a sudden the financial metrics of this company do not look overly demanding – all else remaining the same.

Patersons' Jacobs suggests there is upside risk to his forecasts which already, on a relative comparison with selected "peers" including Afterpay Touch, Zip Co and Xero, suggests iSignthis shares might not appear as expensive tomorrow as they look at face value today.

Though it has to be noted, most of the international peers cited in the research report are trading on much lower multiples, probably also because they might be a little more mature in their corporate development. On cited forecasts, most financial metrics are expected to grow parabolically, with Patersons estimating earnings per share (EPS) wil grow from 1.1c this year (Jan-Dec) to 2.7c next year, then 3.1c in 2021.

iSignthis originally started public life as Otis Energy (backdoor listing in 2014) in one of regular corporate transformations that characterise the smaller end of the ASX. Since the interim results release less than one month ago, some upheaval has been triggered by the awarding of performance milestone rewards to company executives, which subsequently led to a report by Ownership Matters criticising governance at the company, including calling the company's ownership structure opaque. The company has rejected the criticism.

Long story short: the share price went from $1.76 to below $1 in a flash. It has now recovered back to $1. The stock is now included in the ASX300.

Maybe this is as opportune as any other time to highlight the two highest quality technology companies in Australia are Altium ((ALU)) and WiseTech Global ((WTC)), while TechnologyOne ((TNE)) is at arm's length the superior software services provider on the ASX. Out of the three, TechnologyOne has the superior track record in Australia (it stretches out over a much longer time) with no sign on the horizon its habit of achieving double-digit growth per annum is about to end anytime soon.

All three highest quality tech stocks are part of the FNArena/Vested All-Weather Model Portfolio, in quantities that won't allow any unforeseen disaster to potentially destroy the portfolio's performance.

Investors should always attempt to understand the risks involved with (potential) opportunities on the stock exchange. A cautious Macquarie currently has no exposure to the local IT sector in its Model Portfolio. The above mentioned All-Weather Portfolio has exposure in moderate holdings, and only to high quality names. Small cap high flyers such as iSignthis, even though its market cap has now quickly risen above $1bn, are well up on the risk ladder.

Treat accordingly.

Conviction Calls will be published as Part Two on Friday morning on the FNArena website.

Rudi On Tour In 2019

-AIA and ASA, Perth, WA, October 1

In 2020:

-ASA Hunter Region, near Newcastle, May 25

(This story was written on Monday and Tuesday, 23 & 24 September 2019. Part One was published on the Tuesday in the form of an email to paying subscribers, and again on Thursday as a story on the website. Part Two will be published 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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(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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