Harry is a lousy investor!
We are approaching another “reconciliation point” for equities being the first half results for FY16. These have increasingly become more volatile periods as all the jockeying and positioning by investors is measured by the more fundamental yardsticks of earnings and cash flow. January has commenced in relatively poor fashion for most equity markets and we suspect we may be in for a relatively turbulent year ahead. Tomes have been written on the global macro-economic backdrop for equities and thankfully I won’t try to add to the paper mound! What the more sage voices out there are saying however is that it’s time to be cautious. We think doubly so as we are going into a challenging period with broadly full equity valuations. With that in mind what are we looking for and what are we looking to avoid - not merely over the reporting season, but for the remainder of this year? We start again with our bedrocks of good cash flow generation, sound balance sheets and attractive valuations. Good businesses are those where we believe returns on capital are broadly sustainable at better than market levels. Combine this trait with reasonable valuations and good cash flows and we think you are likely to be in good shape in 2016.
Over the past month we’ve witnessed a few stocks that don’t fulfil some of these criteria. Amongst the list we’d highlight Lovisa Holdings and Shine Corporate both of whom have issued significant profit warnings. Whilst Lovisa, at least, generated decent cash flows, the current margins and returns are unlikely to be sustainable into the medium term in our view. Lovisa Holdings is a relatively recent IPO; retailing affordable fast fashion jewellery and accessories. With a gross profit margin of 76% the cost of a $10 necklace is low at around $2.50. Consumers don’t have great price transparency on high turnover fashion items as it is unlikely they will be able to find two stores selling precisely the same product. This however belies the fact that with margins like these who wouldn’t want to be selling fashion jewellery? Fat margins and apparently high returns beget competition. Inevitably competitors steal some sales reducing turnover per store which sees returns and operating margins (that is margins after staff, rental and associated costs) decline markedly. January’s profit warning was largely around the group’s inability to pass on the impact of the decline in the AUD however reference is already being made to an increase in sale events and competitive activity.
Shine Corporate is a personal injury law firm based in Brisbane. In similar fashion to Slater & Gordon they have built their business around a ‘no win no fee’ proposal to attract clients. This type of business model is cash consumptive as they have to fund their client’s cases for up to 18 months before a case is resolved. The build-up in working capital is called WIP (work in progress). Shine recently reduced its earnings guidance based on increased competition and warned on cash flows. WIP conversion rates vary over time and are based on estimates at reporting dates. Unfortunately they are prone to revisions sometimes, as in this case, negative ones. The Schroder Australian Smaller Companies Fund and Schroder Microcap Fund had no exposure to either of these investments.
With the global rout in resource related industries we have been seeking to increase our exposure to opportunities in either mining or mining services industries. As appears to be the case with most forecasters, the market over-weights the near term experience with scant regard for possible events 12-18 months down the track. The only thing certain about the future is that it’s uncertain. With this in mind we note that the small resources component of the small ordinaries index at 12.4% is at its lowest relative weighting in 15 years. The absolute nadir of its relative weight was a low of 8.1% in September 2001 close to the peak of the dot com bubble. On some sector valuations the resource sector is trading at the lowest price/book in 15 years. Of course things could stay bad for a long time, but just as things turned around after the GFC, a little imagination at the bottom as to how things could be in several years back then could have made you a fortune, so too it is possible that at these levels things could get a lot better for resource related industries. In fact, given I suspect few investors own these sectors, a few even modestly positive improvements could see a lot of people rush back in to buy them. Mines are closing, capacity is coming off stream and capital investment is being cut in oil and gas and minerals across the globe. Exxon and Chevron both reported numbers this week and announced capex cuts of 25% and 22% respectively for calendar 2016. This is on the back of capital reductions of 18% and 16% in calendar 2015. Demand on the other side, admittedly is not super elastic given what the oil price has done, has increased with oil demand up somewhere in the order of 1.5-2% over calendar 2015. As with most cycles, the turning point will only be obvious in hindsight and good ‘ol Harry hasn’t proven to be that good of an investor!
With 2016 likely to be a year of ‘transition’ for the market – that’s the term fund managers use which means it could be rough out there – we think it’s going to pay more than ever to be conservative. Some small cap investors have continued to move away from the ‘painful’ sectors - the sectors that have seen earnings forecasts continually cut. At some stage this move away from earnings declines gets more than fully factored into share prices and the fear factor takes over and continues to depress the price. We suspect we are at that point with some stocks in the cyclical areas of the economy. We are certain that on the other side of the ledger some investors are paying a “high price for the cheery consensus” of owning earnings upgrade stories. That trade has been a successful one now for close to three years. Whilst we are never precisely sure of when these trends will end, we are confident that investing on fundamentals will yield better results for investors through cycles than merely pursuing stocks based on earnings momentum.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.