Australian Equities

“I always dreamed we’d be back here”

05/11/2013

Australian Equities Team

After yet another strong month for markets in October you really have to sit back and marvel at the effects of money flowing down the global sluice gates.  Continued low yields and rising asset prices are starting to work their way through the nervous system of the hitherto frozen corpse of investor sentiment.  The patient is twitching and convulsing and there might be some signs of life in them yet.  When the patient’s cognitive function finally switches on though will it register with disdain or delight the investment landscape that confronts it.

October is AGM season and often called “confession” season for soon to be obvious reasons.  The ratio of upbeat assessments to downgrades is at a low ebb.  Unless you are making Pizzas (aka Domino’s which reported strong sales in Australia and Japan) or opening pizza stores (aka RFG – with their successful rollout of Pizza Capers and Crust) trading has been pretty much universally challenging.  Investors have flocked to the high growth, high ROE stocks in the small cap universe and pretty much eschewed anything with earnings risk.  At the smaller end of the market we are seeing some signs of speculative excess with a number of micro cap technology stocks doubling or tripling over the past two months.  This is not a tech boom per se but a mobile advertising mini boom - any technology stock that has something to do with mobile advertising has suddenly found favour.  Many of these businesses have interesting sounding business models but limited sales and often no earnings or cashflow to speak of.  Whilst the market seems keen to chase these investments our assessment on the duration risk is high – even if they do start to make money one day.  These types of phenomena make investing in the small cap arena challenging in the short run but should make our job easier in the long run.  This will remain true so long as we can identify excesses and bubbles and hold to our processes and principles.  Investors in our fund should be aware that we are trying to achieve sensible returns in the medium to longer term and team’s processes and valuation disciplines are designed to weed out largely unsubstantiated investor exuberance.

Over the past year our small cap fund has avoided the unwinding of the overvalued small resources sector – as did many others it would seem.  It wasn’t too hard to have bought into many of the more attractive small cap names which have now performed exceptionally well.  It is proving much more difficult however, to reinvest those proceeds into quality names at reasonable valuations.  Ironically this is happening just as investor enthusiasm appears to be returning.  Cue the return of the IPO market and presto the market offers an answer?  Or does it?  Generally IPO markets begin with a whimper and end with a bang.  The whimper comes in the form of a tentative voice from an ECM (Equity Capital Markets) desk suggesting you might like to take a look at a reasonable quality company coming at an attractive price.  It ends when businesses with no history are literally cobbled together to fill the clamouring demand from cynical investors blatantly playing the greater fool theory.  What is concerning about the current return of the IPO market is the ferocity, speed and potential recklessness we are now witnessing from the investment community.  In other words it feels like this cycle is being compressed – a cynic would suggest bankers are worried the Fed might turn off the printing presses early next year and ruin their short lived party – better hit the exits whilst you can!  All this makes us sound like Statler and Waldorf, the two grumpy old curmudgeons on the balcony box in the Muppet Theatre.

Statler “I always dreamed we’d be back here”

Waldorf “Dream? Those were nightmares!”

On the one hand IPOs are great because they bring to the market new businesses, usually with dynamic founders, which are often in growth segments.  Against this must be weighed the limited financial history and lack of listed market experience.  A former colleague of mine used to warn all management teams from soon to be listed companies anticipating three serious issues in their first full year of being listed.  This was part wisecrack and part truth.  When a company moves from the relative anonymity of the private markets to the full scrutiny and fickleness of the public markets there’s the risk of ‘taking your eye off the ball‘ and paying too much heed to the investing pundits.  Some, and I stress ‘some’ interaction with the public market mechanism can be good.  On the other hand, sometimes the investment horizon of an institutional investor doesn’t match the sensible investment horizon of a well run company and only capable management are really in the position to be able to weigh up the competing interests of all the company’s stakeholders (employees, customers, managers, the environment and shareholders to name a few).  As the IPO market heats up we would anticipate becoming even more selective and will remain focussed on those businesses that aren’t just trying to hit the exits whilst the going is good.

Outlook

Absent the global backdrop of excess liquidity there is little doubt in our minds that market valuations would probably be lower.  The recent AGM season only further highlights the broadly challenging economic backdrop of the Australian economy and the difficulty companies are having finding growth.  There are multiple signs things are getting a little stretched, valuations are very full in the attractive segments of the market, capital raisings have been aggressively bid and the IPO market has returned quickly.  The only factors really missing from this backdrop are strong retail investment inflows and much in the way of M&A kicked off by panicked Boards who don’t want to be left out of the party.  Perhaps the frenzied bidding around an asset as unglamorous as Warrnambool Cheese and Butter might be a sign that the latter is heating up as well.  We will continue to reinvest the returns we have seen in highly sought after stocks in the small cap market into less glamorous but nonetheless more attractively priced companies where we feel our investors are likely to prosper more in the medium term.

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