The Quarterly – October 2018

Market Review & Strategy

The Small Ordinaries Index eked out a modest gain in the September quarter with a spirited rally in mid August failing to sustain a 7 year high (2931) in the benchmark. Small and big cap indices had level-pegged 2018 performance by September end, both +5.8% CYTD. Interesting that small cap outperformance reached a 5 year zenith in June but began conceding ground as big cap resource names (BHP, RIO, STO) extended their lead over small resource names with devastating effect (relative performance differential ~ 12.6% CYTD). Nevertheless, the annual Diggers and Dealers Mining forum held in Kalgoorlie in August, boasted the biggest turnout since 2012!

The quarter in review was an exceptionally busy period for small cap investors. The FY18 reporting season dominated news-flow and proved to be largely about earnings momentum rather than stock valuation. Revisions (downgrade/upgrade) occurred in the ratio of 2:1 and expectations for FY19 were shaved by ~ 2%, an innocuous outcome. JP Morgan observed that 80% of stocks upgrading rallied while 50% of those that downgraded fell. A growing number of companies recognised the impact of rising input costs (power, labour, oil, A$) and challenging retail conditions whilst several noted stabilising (rather than negative) economic activity in WA.

However what was extraordinary about reporting season was that ~ 60% of the small cap market’s August return came from the performance of 4 stocks in Info Tech-Wisetech, Altium, Appen and Afterpay (an EGG holding). These names rallied ~34% (on average) on upward earnings revisions of ~ 4-5%, in hindsight euphoria that was unsustainable.

The tempo of merger and acquisition activity lifted through the period in review. Fairfax Media announced a merger with Nine Entertainment (EGG holding), Santos acquired Quadrant Energy for almost $3bn and TPG Telecom moved on Vodaphone Hutchison Australia. Drilling contractor Ausdrill (EGG holding) bought Barminco, Affinity Private Equity bid for Scottish Pacific (EGG Holding), Bingo purchased Dial-A-Dump for $425m and Capilano Honey found itself in a hive of activity as a private equity syndicate positioned itself alongside Bega Cheese as suitors for the apiarist. A2 milk bought an additional 8.2% of Synlait and the convoluted manoeuvrings between Propertylink (EGG holding), ESR Real Estate (Asia) and Centuria Capital continued.

We devoted some airtime to the pending initial public offering of Viva Energy ($2.65bn raise and biggest in 4 years) in the June quarter Encyclical. The issue proved to be a tremendous disappointment for investors arriving sans pulse and trading poorly (below $2.50 issue price) thereafter. Its reception not helped by an underwhelming H1 (refining) result, a continuation in deteriorating industry fuel volumes, a State Revenue Office (Victoria) penalty and the weight of stock supply from jaded early investors. Buying related to the stocks inclusion in the S&P/ASX 200 index in September provided fleet-of-foot investors with a timely exit pass.

Visit to the Middle Kingdom

A recent EGG visit to China/HKG proved timely. Some key take-outs to note:

  1. Chinese C2C daigou channel will begin to shrink with legitimised cross border ecommerce operators in the ascendency eg TMall.com (Alibaba) and Kaola as well as several sizable B2C daigou. Watch for the growing importance of the ‘mother & baby store’ specialty retail channel.
  2. Private surveys point to a property sector at the early stages of correction. Central Government (CG) to maintain oversight here as nil appetite for a deep retracement.
  3. The CG underestimated the US resolve to impose an aggressive tariff regime and are scrambling. They realize a softer Yuan will be key to their response. The process of Yuan ‘weaponisation’ has begun.
  4. Environmental management a CG priority post 2017 ‘winter shuts’ success but 2018 programme will be subject to trade war disruption. Demand pull post shuts?
  5. Money supply/fixed asset growth continues to decelerate with the market incredulous about likely CG intervention. Expectation of infrastructure investment (short term via bond issuance) and potential fiscal-pull via tax reform (medium term) to assist.
  6. Metal demand. Traders overly pessimistic. Metal inventories (all exchanges) -26% since 3/18 suggest demand real. Demand/supply dynamics supportive (ex Ni) with many at/near cost support.
  7. Cost of equity rising (stockmarket PE sold off) + weaker currency will suppress the international corporate ambitions of Chinese corporations.

The Shanghai Composite Index has fallen ~ 23% this year, its third significant retracement since 2010. There was a sense of foreboding amongst the business leaders we met in Shanghai.

Technical Summary

At the time of writing this issue of The Encyclical, a violent downdraft in the US market had commenced. Readers of the June quarter technical summary might recall the following paragraph, in particular the S&P500 Fibonacci resistance level identified (2940), which is precisely where the index stalled this month following 2 attempts to break out, “…Bullish that the S&P 500 index has managed to hold its uptrend from February 2016 and a weekly close > 2780 clears the way for an assault on the January 26 high of 2872. Traders should pencil in 2833, 2940 and 3290 as Fibonacci projected S&P 500 levels post the benchmark clearing 2872”.

Reclaiming the January high was a clear market imperative and small caps (Russell 2000/S&P600) managed this by May but began to falter by the end of August. Big caps lagged but broke new ground by the August close, only to post ranging price action into the October 4 sell-off.

In fact, looking across the 7 US stock indices I monitor closely, all of them (ex the NYSE Composite) took out January’s historic high, only 2 qualified as weekly key reversals (S&P 500 and 100) but all have now broken their 100 day moving averages to the downside (on unremarkable trading volumes) indicating a short term trend change is at hand (market down ~10% from early October highs). Investors should expect a test of the January lows in the weeks ahead and enhanced volatility around this move. That said, I contend the bull thesis for the market remains intact (refer Outlook commentary).

It is instructive to note the deterioration in market breadth (advancers v decliners) post the January rout. Coming into the January high, between 15-30% of the S&P500 was making a 52 week high on a daily basis. Since July between 1-10% of the benchmark was achieving same (NB strong breadth is an important ‘internal’ element to good market health).

Interesting the ASX 100 rallied within 300 points of an all time high in August and that’s with a languid banking sector! The index continues to impress, being decisively on trend from 2009 but having just this week completed a return move back to a market resistance line drawn from the 2007 highs. 4762 needs to hold for the ASX100 bull campaign to sustain. The Small Ordinaries Index (XSO) finds itself precariously poised on support at 2700. Similarly, this chart level needs to adhere or risk marked downside price action. The number of small cap names > 100 day moving average (ie positively trending) had pulled back to 51% (from ~58%) by September end. A relative chart of the ASX100 v the XSO advocates small stocks over large and has done so since mid 2015. This series is pausing and needs to be monitored for a possible sentiment shift.

The message from base metals markets is patent. Current levels across the complex must hold or the constructive bull campaigns active since mid 2016 will close. Aluminium continues to look positive. Nickel bloomed late (Jan 2018) and tired quickly whereas copper has confirmed its 2002 bull market uptrend but in a textbook-like flourish, fell foul of a 50% Fibonacci level (of the 2011-2016 bear market move). Prices > US$3.32/lb are required for commencement of the next leg-up in momentum.

Crude oil continues to gather momentum, with 3 resistance fans yielding to aggressive upside price action. This commodity looks set for further gains but the latest CFTC data on trader positioning has longs to shorts running at a ratio of 6:1-somewhat unsettling if you are pitching a bull case! Our bullish view on oil stocks doesn’t require further crude upside, rather it is supported short term by mark-to-market upgrades.

The Portfolio

The Small Companies Fund was positioned as below:

…and the Emerging Companies fund:

During the September quarter, our Small Companies Fund (SCF) enjoyed the rallies from Afterpay Touch Group (+91.98%), Pinnacle Investment Management (+49.05%) and Ebos Group(+24.15%). Our positions in Saracen Minerals (-14.85%) and Arb Corporation (-16.06%) detracted from performance. In the Emerging Companies Fund (ECF), positions in Noni B (+20.08%), Alliance Aviation (+32.06%) and Afterpay Touch Group (+91.98%) provided a strong updraft. West African Resources (-26.32%) and Emeco (-8.00%) dragged on the portfolio.

Your manager initiated a position in Nearmap during the quarter. They are a digital aerial photomap company that captures, processes and delivers high resolution imagery via its Hypercamera 2, to an assortment of private/public sector customers. They estimate the current addressable market to be c. US$2.7bn, with present market shares of 25% of Australia and 1% of the US. The company’s FY18 result highlighted a business not yet profitable (at EBIT level) but growing its revenues faster than its costs and forecasting cashflow neutrality in FY19, succour for a high growth emerging company. A recent $70m equity raising has recharged the balance sheet and will assist the company’s international ambitions, notably in the US market where the prize for the group will be substantial if they can execute.

A holding in New Hope Coal was added to the portfolio recently. The small company fund is already well positioned in Whitehaven Coal. Thermal coal markets continue to be well bid, supported by exceptional regional demand from SE Asia and escalating coal quality requirements from customers. This appears set to continue for the foreseeable future. New Hope posted a strong FY18 result and delivered ahead of expectations despite the onset of cost inflation across group operations. An extension to the groups Acland stage 2 and an approval for Acland stage 3 are being pursued with some prospect of an end of 2018 announcement. Importantly, conclusion of the Hunter Valley, Bengalla JV acquisition (to 80%) will see the group drawdown ~ $400m in debt and push net debt out to c.$250m by end of CY2019. Management’s conservative style will dictate that the balance sheet is expeditiously de-levered over subsequent years.

We continue to hold a position in Peet, one of Australia’s largest property groups. The company delivered a strong FY18 result to a largely apathetic local market. Net tangible asset per share (nta) at 30 June was $1.18, below todays $1.13 share price. This nta is conservatively stated as it assigns nil value to Peet’s funds management business (30% of group earnings) and values lots at the groups Flagstone (Qld) development at ~ $7000/lot compared with a market valuation closer to $30000/lot. No surprise that the board announced a 5% stock buyback. The outlook for the groups east coast activities remains firm and the WA portfolio acts as a useful diversifier, with stabilisation in property being seen there for the first time in several years. At 12.0x FY19PE and a 17% discount to the Small Ords Index, Peet is a sensible portfolio sleeper that will eventually attract wider investor support.

EGG quit its holding in Propertylink during the period as the convoluted manoeuvrings, referenced earlier, of both a bid for the company and the cancellation of its own bid for Centuria Capital, muddied the waters somewhat. The position was acquired in the aftermath of an underwhelming and at times spiteful IPO in 2016 and has seen patient investors nicely rewarded.