November 2018 | Market Commentary
After a poor showing in October, November is a reconciliation point (also called “confession season” by the cognoscenti) as many companies provide a trading update at their AGM’s. Overall it’s fair to say these were poor, with the general experience being one of softening business conditions across most industries.
The energy sector was particularly hard hit, falling 12% in sympathy with the declining oil price. Brent Crude fell a further 21% over November after already trading well off its highs in October, as the outlook weakened on both global growth concerns and supply related issues. Construction materials and housing related stocks also struggled with GWA Ltd (GWA) down 5%, Fletcher Building (FBU) off 20% on a weaker Australian housing outlook and Wagners (WGN) down 26%. The outlook for discretionary retailers also looks challenging with many reporting a softening in their Like for Like sales and an outlook which, somewhat optimistically in most cases, hopes for a recovery in second half trading.
The Value of Valuation
Why should valuation matter especially when so much of our market segment appears to be driven by quantitative and passive investors? And why should cash flow valuation techniques be the right way to value equities? The answer to both these questions is that at some point, people exchange cash for stocks and vice versa. Whether they be private equity investors who are seeking funding from banks, or retail investors, they will ultimately be exchanging cash for the scrip they wish to buy or sell. Most rational investors will ultimately compare the value of that marginal investment with either keeping cash in the bank or investing in another alternative asset class – in other words what cash returns can they reasonably expect to earn on that invested dollar across asset classes.
It is for this reason that we anchor our investment decisions to cash flow valuations and why we look for businesses whose values we can reasonably ascertain. If, as we suspect could be the case, liquidity in the system reduces then it will be the cash generating companies who can fund themselves through the business cycle who will trade out of it better than others.
There were good contributions from A2B Australia (formerly named Cabcharge; A2B.AX) which rose 7%, from Isentia (ISD.AX) up 35% on a re-affirmed earnings outlook and Vita Group (VTG.AX) which rose 6%. The Spheria Australian Microcap Fund and Spheria Australian Smaller Companies Fund also owned a position in Greencross Ltd (GXL.AX) which received a takeover via scheme of arrangement from TPG at $5.55 a share (20% premium to the prevailing share price). Meanwhile, the Spheria Opportunities Fund continues to maintain a decent position in both Navitas (NVT.AX) and Healthscope (HSO), both of which have received takeover approaches. NVT has received an indicative bid from a consortium involving the founder of NVT and Private Equity group BGH. We believe the bid price is materially under our assessment of fair value and is also insufficient in terms of the usual control premium paid by bidders.
Meanwhile, Trade Me (TME.NZ) received an indicative, non-binding offer from Apax Partners at NZ$6.40 a share – a 25% premium to the share price at the time. Whilst TME continues to trade at a discount to this indicative offer, the emergence of another suitor in the form of Hellman and Friedman (US based PE firm) should see tension emerge and we are reasonably confident of a final bid being lodged. TME is a great example of an incredibly strong cash generative business which had material upside in its online classifieds business (comprising 60% of its revenue).
Against this, we had a negative contribution from Donaco (DNA.AX) which was down 47% on a poor trading outlook at its Cambodian operations. Whilst the share price has been disappointing to date, we often find some of our best investment wins come from truly contrarian investments. Other negative contributors were Horizon Oil (HZN.AX) down 31% based on the earlier mentioned oil price retracement and Fletcher Building (FBU.NZ) down 20% on the back of a weaker trading update.
The market backdrop has become decidedly more challenging in view of the tightening credit conditions in Australia which are having a flow on effect on the broader economy. After almost 10 years of very easy liquidity and low interest rates, asset valuations are broadly not cheap in almost any asset class. We would anticipate market volatility to remain a feature of the markets for some time as markets adjust to higher global interest rates and lower economic growth. In light of this, our focus on valuations and cash flows should continue to see the portfolios perform relatively well and enable us to position for decent longer-term returns.