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October 2018 | Market Commentary

october-2018

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Overview

The Australian share market fell considerably in October, falling in sympathy with a US market that is finally showing signs of cracking under the pressure that has afflicted emerging markets since the beginning of the year. The Australian small to mid-sized companies space had seemingly been immune to the volatility until October, with a select cohort of market darling stocks driving the index higher, effectively camouflaging broader weakness.

Clearly, there is a linkage between these darlings and the US market, particularly names in the technology sector. We believe the fundamental link is tenuous, however, with the majority of small cap and mid-cap market darlings in Australia and New Zealand a function of a narrow universe and excess demand for anything resembling growth.

Our quality filters ensure that the companies we invest in have genuine cash flows that match earnings and we avoid companies whose strategy is to recklessly acquire growth. We believe these kinds of companies will come unstuck in the next few years as liquidity recedes. The market is brutal to even the most celebrated companies when the integrity of the business strategy and financial reports comes into question. We remain positive on the outlook for our portfolios as valuations are appealing.

Key Decliners

Note that we do not own any of the following companies.

  • Kogan (KGN) fell 50% after a significant profit warning. Its share price had ridden the Amazon wave over the last couple of years, only to be dumped in the last few months by management and now by its investors. It is down over 70% from peak to trough.
  • WPP is a media agency group that also had a profit warning due to structural and cyclical issues. Its share price fell 35% and its long serving CEO announced his intention to retire.
  • Corporate Travel (CTD) declined 34% after the release of a critical research report from a hedge fund that had shorted the stock. Regardless of the substance of the report we expect travel related companies to struggle in the next few years as technology and macro-economic factors affect demand for their services.
  • Afterpay (APT) fell 30% after a spectacular re-rating in the last couple of years driven by strong uptake of merchants and consumers for its layby product. Given it earns very little and has an extremely high valuation, a lot can go wrong and just about everything has to go right to justify its rating.
  • Domain (DGH) fell 29% after a major profit warning due to weakness in its print advertising and digital display, which is a function of a deteriorating housing market thus illustrating the cyclicality of the business. It is not priced for cyclicality given its high rating nor for structural headwinds facing its print advertising exposure.

The top ten performers for the month in the index included a number of gold companies and a couple of companies subject to takeover proposals including MYOB (MYO) and Navitas (NVT).

Focus on Navitas (ASX:NVT)

We are a large shareholder in NVT. We were not surprised by the takeover interest given it is a global leader in its field and is a fantastic cash flow generator. The derating witnessed in recent years was due to the loss of three profitable contracts. In spite of this earnings headwind the company has grown earnings on an underlying basis and is one of the few truly global growth businesses in the Australian market. We also believe there is a significant cost out story and potential to streamline the group with SAE generating EBIT losses in several regions. The divestment or exit of SAE in those markets would therefore be addition by subtraction for NVT. Our fundamental valuation is slightly higher than the takeover offer price of $5.50 per share, and therefore we believe the bidding consortium should pay more for control. We are surprised the share price is trading at a material discount to the bid given the valuation appeal and the fact an insider is party to the deal.

Focus on Vita Group (ASX:VTG)

Outside of takeovers, there was a bright spot in the Fund with Vita Group (VTG) significantly upgrading its profit guidance with 1H19 EBIT expected to grow 15 to 24%. We believe this illustrates an unappreciated strength of VTG’s business in that its store network is skewed to regional areas where Telstra’s network is unrivalled. Unbelievably, VTG is trading on only 3.5x free cash flow, which equates to a three-year and a half year payback for shareholders assuming no growth. With Telstra completing its 5G rollout in the next 12-18 months there will be a significant upgrade cycle for handsets, which means the assumption of “no growth” could be seriously conservative. The consumer obsession with their handset is unlikely to subside anytime soon. We believe VTG is well positioned to benefit from this trend.

In Summary

We remain positive on the outlook for our portfolios as valuations are appealing. Furthermore, our companies have relatively strong balance sheets and robust cash flows. A downturn will affect them, but they should come out the other side stronger by taking market share from weakened competitors. Our quality filters ensure that the companies we invest in have genuine cash flows that match earnings, we avoid companies whose strategy is to recklessly acquire growth. We believe these kinds of companies will likely come unstuck in the next few years as liquidity recedes. The market is brutal to even the most celebrated companies when the integrity of the business strategy and financial reports comes into question.

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