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Rudi’s View: ‘Be Respectful Of The Past’

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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 | Dec 03 2020

This story features TECHNOLOGY ONE LIMITED, and other companies. For more info SHARE ANALYSIS: TNE

Dear time-conscious investor: Share price volatility does not equal risk, and this week's All-Weather Stock proves exactly that

In this week's Weekly Insights:

-"Be Respectful Of The Past"
-Question Of The Week
-Mayday. Mayday. Website Down

By Rudi Filapek-Vandyck, Editor FNArena

"Be Respectful Of The Past"

As every battle-hardened investor knows: achieving investment return comes with acceptance of risk. In the short term, taking on a lot of risk can be extremely rewarding, but in the long run reducing risk is key for survival.

Too many investors confuse "risk" with "share price volatility". There is almost always a fundamental difference, even though the result might look similar in the short term. Admittedly, we all feel bad when our asset or portfolio takes a deep dive, but that's only a bad event when that deep dive turns into a permanent new development, which it seldom is assuming there was more than just a temporary fad behind the share price rise in the first place.

One way to reduce risk is to stay alert for potential trend reversal cum share price weakness, but investors with a longer term horizon will inevitably discover jumping on and off stocks that display share price strength, then weakness, is sub-optimal and energy-consuming under the best of circumstances, not to mention the accumulation of costs and the loss of opportunity that both eat into the total return.

Option number two is to minimise risk through one's knowledge of the company and why it is in the portfolio. The deeper the knowledge, the greater the conviction and the comfort of holding on even when the share price is temporarily no longer strongly trending  upwards. If we are really comfortable, we might even add more money in order to boost future return.

But how does one know, really? We can all make forecasts and predictions, but that's all they are: an educated stab in the dark, at best. Forecasts do not always resemble actual outcomes, and that's probably putting it mildly.

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Last week, I came across the following statement on Twitter (thanks Motley Fool):

"Successful investing requires being respectful of the past, indifferent to the present, optimistic about the future, and skeptical of salespeople."

To minimise risk, I believe sound company analysis starts with paying respect to the past. Too many investors ignore the past and simply stick with "being optimistic about the future". Works sometimes, and often for a brief moment in time only.

The past does not provide all answers, for obvious reasons: economies change, circumstances change, cycles strengthen and deflate, but there are many valid clues and indications to be had from a company's past, including whether a business can withstand tougher times, pick itself up after unforeseen misfortune, and how successful it can defend its home turf.

As a long-term investor who has the intention to stay on board for a long while, it is almost of paramount importance we suss out the solidity and the sustainability of the business, for on what else are we basing our conviction and comfort to hold on when the share price moves in the wrong direction?


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Let's start with the basic premise, derived from many years of market observations and company research: unless a company or the sector in which it operates is severely disrupted, a business that has successfully navigated through the major challenges of the past is most likely to continue doing exactly that in the future.

This is how a company's past track record can provide a whole lot of confidence about its future.

It is on this basis that I often refer to TechnologyOne ((TNE)) as "by far the highest quality software services provider listed on the ASX", or when put in a less sector-specific context, "one of the highest quality, most reliable performers in the Australian share market".

To back up those statements, let's highlight some of the key achievements and characteristics that elevate this company above the masses listed on the ASX:

-Compound annual growth in earnings per share over the past decade is 14%
-Shareholders have always received a dividend, even during the GFC and the post-2000 tech bubble burst
-Average growth in dividends is 8% per annum, including the occasional special dividend
-Company spends circa 20% of annual revenues on Research & Development
-Is currently debt-free (never had much in the first place)
-Provides mission-critical products to extremely loyal and sticky customers, including universities, local councils, hospitals, governmental departments and financial institutions
-To back up that previous statement: customer churn is less than 1% (meaning 99%-plus of more than 1200 customers remains loyal to the company)

Most importantly, company management continues to guide investors towards annual growth in the mid-teens -say a little below or above that long-term trending 14%- and it keeps delivering on that promise. As has just happened when the company released its FY20 financial performance last week.

Those numbers were marked down due to management taking additional provision for a court case that unexpectedly did not end in the company's favour (an appeal will follow). Underneath this set-back, however, a familiar picture emerges once again:

-Growth in earnings per share ex-provisioning: up 13%
-Growth in cash dividends: up 8%
-Dividend payout ratio is 65%
-Of total annual revenues, 86% is now deemed "recurring"
-Customer churn in FY20 was a measly 0.57%, having peaked for the decade at 1.31% in 2011
-The loss-making entrance into the UK market is now breaking even, with management flagging a strong pipeline ahead
-Return on Equity (RoE) is 44%
-Cash flow came out above reported profit for the year

The company is transforming from a traditional seller of on-premise software licenses to the much more flexible and advantageous Software-as-a-Service (SaaS) model through the cloud. SaaS has turned out a win-win for all parties with customers paying on average -30% less while TechnologyOne can run its business on much lower cost. Management forecasts current operational margin of circa 29% will rise to 35% in the years ahead. Only a few years ago, that margin was 21%.

Part of management's ongoing confidence is those loyal customers are now increasingly taking on board additional products and services from the company.

(Earlier this year, the company found itself under attack from a foreign short-seller whose claims have been proved misguided by last week's results. Investors who panicked and sold should not expect an apology).

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One crucial element that needs to be put in proper context is the average growth of 14% per annum.

Apart from the cold hard fact such a steady pace of growth is extremely hard to replicate and maintain, just ask management at, say, CommBank, BHP Group, Incitec Pivot, Graincorp, Hansen Technologies and the many hundreds of more ASX-listed entities, what many an investor might not realise is that, at 14% growth, this company is doubling its size every five years.

Yes, that's correct. In five years time, this company will double its annual profits for shareholders, just like it has done over the five years past, and the five years prior to that.

Question: when a company doubles in size without compromising on its profitability, what do you think will happen to its share price?

If we look back in history, we find the share price performance has strongly outperformed the growth achieved by the company. No doubt, this is partially because investors have gradually warmed towards the steady-hand performances and rewarded management for its reliability and its commendable track record.

Lower bond yields and a shift towards more technology-driven market momentum would equally have assisted, though TechnologyOne has never enjoyed a strong re-rating similar to the likes of Altium ((ALU)) or Afterpay ((APT)); its growth has been rather steady, not spectacular.

Consider the following: today the share price is trading above $9 having temporary rallied as high as $10 a few months back. Five years ago, it moved from $3 to $4.84. Five years before that the share price was yet to cross the $1 mark. Five years before that, in 2005, the share price was about -50c lower.

While those numbers look mightily impressive, and they should as they are essentially but a reflection of what this company is consistently delivering for shareholders, it is far from the total picture. What is not included in those five year share price intervals is that at times the share market did not want to know about this company. It was either too small, not sexy enough, victim of portfolio rotation, or of rising bond yields, of markets selling off, investors worrying about the future, not relying on the past, or getting freaked out in the present.

At times, and I have seen it so often I lost count, the share price lands on the radar of traders watching charts, and it gets swept up in a blaze of irrational exuberance. Other times, it got spat out and ignored because of one noisy, public conflict with the Brisbane council that ultimately was settled outside court.

Emotions here, money flows over there, with general market sentiment in the middle. It has all impacted on the share price; pushing it up, tearing it down, pushing it back up again. If anything, TechnologyOne is one prime example of why investors make a big mistake when they think all the info they need to know is in the share price, and how it moves.

Instead, they should absorb all of the above, plus some, and consider whether this is the type of All-Weather, steady performer, that would suit their portfolio, and fit in with their investment philosophy and strategy. Because one thing remains certain: that share price might not necessarily move higher tomorrow, or even next week or next month, but if earnings-per-share continue growing by 14% per annum, on average, as is the current underlying trend according to company management, then that share price of today will be a lot higher when the calendar closes on 2025.

I can think of a few scenarios that might lead to a different outcome, but management's confidence and track record certainly suggest the odds remain very much stacked in favour of TechnologyOne doubling in size again over the next five years. Which is why this company remains part of my selection of All-Weather Performers on the Australian share market, alongside other prominent members such as CSL ((CSL)), REA Group ((REA)), Woolworths ((WOW)), et cetera.

One can never be too confident what will happen to the share price at any given time, but each of these High Quality businesses has that one factor in common: over a longer period of time, the risk is very much skewed in favour of the sitting shareholder – crucial for those investors seeking long term return, and survival.

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Paying subscribers (6 and 12 months) have 24/7 access to my research and selection of All-Weather Stocks and sub-sections. For more info about the FNArena/Vested Equities All-Weather Model Portfolio, see further below or send an email to info@fnarena.com

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This is my final Weekly Insights for 2020. I expect it to resume in early February next year. On Friday, Part II will be published as Rudi's View, including one more update on Conviction Calls made by strategists and stockbrokers in Australia. I hope you all enjoyed my writings this year as much as I enjoyed researching and writing them. Best wishes and the kindest regards to you all. No doubt, 2021 will not be as straightforward as it seems today, because it seldom is. But that'll be something to tackle in the new year.

Question Of The Week

I am an old widower with some cash sitting in a bank drawing a miserly interest. I have finally been convinced that I should do something with that money that could potentially get me 5-6%. Is this possible? What does your All-Weather Portfolio return?

Response:

To obtain 5-6% on average from your cash means you must move up (a lot) higher on the risk ladder.

When 10-year government bonds offer you less than below-average inflation, and the RBA cash rate is near zero, a yield/return that is 400 or 500 basis points above these levels almost by definition implies you are taking on a lot more risk. This is definitely something you need to get straight in your perception and intentions.

Things that come to mind are government bonds from Emerging Markets and high yielding corporate bonds (credit). Before you are ready to move into those spaces, I suggest you speak to a few people with knowledge, like maybe your current financial planner, and make sure they give you an accurate picture of the risks involved.

For example, I know from a number of local investors who have ventured into corporate bonds in Australia (there are few specialised firms around) that it can be extremely hard to on-sell your bonds if, at some stage, you no longer want to own them. Most likely, you will take a haircut during the process, and only if there is a buyer out there, which is not guaranteed.

Those specialised firms will not buy these bonds off you. This is something you need to keep in mind.

A more familiar place to get return from is probably the share market. I assume you know the risks. Equities have rallied pretty hard, and overall sentiment is extremely bullish; history suggests the big corrections, or worse, nearly always happen when nobody is expecting it.

But the share market does offer you a range of options. The least risky option, I think, is through combining growth with dividends. If you get it right, you should be able to achieve the 5-6% targeted, and potentially a lot more. FNArena just published a Special Report on Smart Dividend Investing.

Another option is to buy extremely reliable, dependable and sustainable dividend payers. Irrespective of the volatility in share price, this option would provide you with 4-6% yield income per annum. As part of my research into All-Weather Stocks, I have included a small number of such options available on the ASX.

The more adventurous approach is to pick some companies that used to be reliable dividend payers, and that will recover post-2020.

You could potentially reduce your risk through broad-based ETFs, but you can never really remove the risk that comes with investing in equities.

As far as the FNArena/Vested Equities All-Weather Model Portfolio is concerned, the aim is to generate an average annual return of 7-8% after fees and the experience of the past six years has shown this is possible (it has been achieved). Around 3%-3.5% of the return stems from dividends.

I hope the above helps you in making your decision.

As per always, I am simply sharing my observations, experience and insights. Nothing in my response should be seen as financial advice.

Mayday. Mayday. Website Down

It's that dreaded feeling we are all confronted with, at some point. The electronic device is conducting a necessary software update, and then something goes wrong. Why or where exactly, nobody really knows, but we can all see it is no longer working.

FNArena was hit by a Microsoft software update gone wrong last week and the result was a website that remained non-active for much longer than we thought it would, but it did.

While we can never fully protect our service from something similar happening in the future, we are looking into ways we might be able to reduce the time it took to get the website back fully functioning and up and running again.

Meanwhile, we have added five days to all subscriptions and trials to the service. That'll hopefully compensate for the temporary inconvenience of not being able to access our wonderful website. 2020 has been an extremely eventful year, indeed.

(This story was written on Monday 23rd November, 2020. 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).

(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/index.php/sign-up/

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CHARTS

ALU APT CSL REA TNE WOW

For more info SHARE ANALYSIS: ALU - ALTIUM

For more info SHARE ANALYSIS: APT - AFTERPAY LIMITED

For more info SHARE ANALYSIS: CSL - CSL LIMITED

For more info SHARE ANALYSIS: REA - REA GROUP LIMITED

For more info SHARE ANALYSIS: TNE - TECHNOLOGY ONE LIMITED

For more info SHARE ANALYSIS: WOW - WOOLWORTHS GROUP LIMITED