It's Groundhog Day
The phase of mindless liquidity is upon us. Valuations have become secondary to momentum, particularly in the high quality spectrum of the market. Quality is the most abused term in funds management circles (every fund manager believes they have the best quality portfolio in the market!) with retrospective share price performance seemingly the key determinant of a good quality company. Anything generating high returns vis-à-vis an online site is bid up on the promise of unlimited growth potential regardless of duration and the low barriers to entry that are commonly associated with these business models. Concept stocks in the online space are all the rage and in some instances investors will be handsomely rewarded but the majority in the long term will be losing propositions. These are troubling times for value investors as valuations simply don’t matter. The flow of money is currently being directed to growth/momentum investment processes that have performed exceedingly well from the depths of the GFC, driving valuations in the online space to unfathomable levels. The thirst for trailing alpha is illogical. Corrections when they occur will be brutal when there is no valuation backstop. Minimising downside risk is paramount in this environment particularly in small cap space, as the upside generally takes care of itself in the long term.
We have a natural aversion to investing in resource companies given they are generally low returning/capital intensive businesses with replenishment of reserves absorbing cash flows. Our aversion was amplified by the speculative demand for commodities during the so-called super cycle of the last decade. With the sharp price deterioration in most of the commodity complexes last year, the small resources sector essentially evaporated. Our inclination was to increase our weighting towards miners that met our investment criteria (not many) and we probably went too early, which degraded performance in the latter half of the year. Interestingly, despite Chinese economic concerns, a nascent recovery in small resource sector has occurred by stealth in the last three months with small ordinaries index climbing 8% versus only 4% for the small industrials. Backing out the high PE stock outperformance during that period (discussed above) from the small industrial index would have increased the divergence. Whilst we cannot reliably predict short term commodity price movements, in some cases the demand and supply equation appears favourable. Operating conditions are improving with costs falling as labour supply has increased and the $A has receded. Management teams are espousing rational policies with exploration cutbacks and non-essential spending reduced that ultimately will result in better returns for shareholders – all other things being equal. The difficulty is finding small cap miners with long life reserves (or ability to extend reserve life) and low all in cost structures. In many cases cash costs do not include sustenance capex or are calculated off retrospective high grades that are no longer available. In particular, most of the gold companies we cover have all in costs well above cash costs meaning even after the recent uptick in the gold price, some of the mines are simply unviable. In one particular case, one mining company had to raise money recently to pay redundancies. That seems a fine use of shareholder capital.
In ‘Go-Go’ markets there is an elevated risk of corporate malfeasance as management teams’ fear being left behind. During reporting season there were a slew of companies that seemed to manufacture outcomes to meet market expectations whether it be cash flow, earnings or balance sheet measures. The most obvious cash flow engineering strategy was deferring large creditor payments to post balance date to create an artificial cash flow outcome and lower net debt at a finite point in time. Whilst satiating the market it’s hardly sustainable in the long term and the day of reckoning for these companies is probably nigh. Another notable accounting trick employed by one company to lift its earnings was extending the useful life of its depreciable assets, given it is a rental business its asset base is large hence the impact on earnings was relatively material. Despite accounting manipulation that was apparent during the reporting season and a lack of top line growth it seems the consensus view is that earnings as a whole are rebounding as is the economy. Whilst there might be patches of strength as discussed in previous commentaries there are a number of strong headwinds that are likely to cap bullish expectations. We continue to expect the labour market to suffer from technological innovation, offshoring, overcapacity and a sharp slowdown in mining investment. Unfortunately, the band-aid solution to these issues engaged by the central banks is loose monetary policy which like accounting trickery just delays the day of reckoning.
It’s ground-hog day. Whilst the majority are bullish, we feel there is significant downside risk in the share market that is not being appropriately priced. Our philosophy remains minimising downside risk by investing in companies that generate strong free cash flow with manageable debt levels and are not overhyped and therefore overpriced. Mindless liquidity is creating an asset bubble that could easily be pricked by unforeseen circumstances. It’s not the time to be daring.
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