Good afternoon,

The market has bounced back 41 points this morning, or 0.72% with the ASX 200 index trading at 5704 pts. It’s been a tough month, no sugar coating it, we are down 8% for the month, and there have only been four months in the last 20 years that have been worse (3 during the GFC in 2008 and also August 2015 – post-Brexit.)

Typical defensive/risk-off behaviour across the sectors due to what I think are fears that interest rates are rising. Property, Healthcare and Infrastructure came out relatively unscathed while small caps, energy, resources and discretionary stocks fared the worst.

The funny thing is, defensive stocks like Property and Infrastructure (Sydney Airport, Transurban et al.) are the longest duration, most predictable cash flow businesses on the ASX and as such, should be devalued the MOST by rising interest rates. Ironic? Moronic? Irrational? I’ll let you make up your own mind.

The million-dollar question

“Is this a buying opportunity?” As usual, “it depends” is the answer.

An opportunity to buy what exactly? What do you want to own; how much do you think it’s worth in the future; are you comfortable with the probability of being wrong? To be honest, the process today is no different to the decision process that I go through every day the markets are open.

Anyway, let’s start today by looking at the companies that have underperformed in this recent sell-off to see if there’s anything of interest to us.

I’m screening for companies:

  • Market cap in excess of $300m
  • That have had more than an 8% decline in October
  • With a forward PE of less than 30x
  • With a 5yr average PE of under 30x
  • That are profitable

This leaves us with 120 businesses. The average company in this list is trading at a 2.4% PE discount to its 5-year average. So let’s look at those companies trading at more than a 3% PE discount to average.

So, if it’s me working through this list, I’m looking for companies that are growing their top and bottom line, that have ‘brand power’ and that have been able to grow their margins. But I don’t think any of these businesses, particularly the stuff trading at significant discounts, are without risk.

And by risk, I mean that I’m uncertain on the probabilities of being wrong/uncomfortable with the probability I’ve ascribed.

Passive Investing Fallacy

I saw a beautiful piece of research from UBS last week highlighting the uniqueness of the Australian stock market. I’m sure it’ll surprise you to hear the Australian market has been the most attractive developed market globally for alpha generation since 2002.

Alpha, for the uninitiated, is excess return or outperformance: The return a fund manager can generate above and beyond the average market return.

So next time your financial planner is barking at you about the wonders of low cost, exchange-traded funds (ETF’s) and passive investing, quoting some outdated piece of research from 1990, flick them a copy of this email and feel free to give them my number… I’d be more than happy to bring them up to speed!
Adding Alpha – How to separate the expensive crap from expensive gems

The sell-off currently occurring has primarily been concentrated in those very high priced, high growth (not share price growth but high earnings/revenue growth) businesses. Goldman Sachs coined these stocks “GASP: Growth At Stretched Prices” and using factors (similar to what I do) to figure out which characteristics matter and what growth stocks are vulnerable to underperformance.

As you can see, price momentum, raising money (share issuance), low growth forecasts, revisions and goodwill/intangibles matter a great deal. As does quality and a lack of analyst certainty (high earnings dispersion). All of which (importantly) makes intuitive sense.

Management understands the value of the business better than the market (as a general rule), and as such, if they are selling shares for cash, they are probably getting a better deal than those people buying shares with their cash.

Similarly, high goodwill and issuing shares imply acquisitions have been made, which can result in lower quality earnings growth than say, a business organically selling more stuff every year. Paying high multiples for ‘sugar hit’ earnings is problematic, as you are ‘extrapolating’ that growth out in your valuation, despite the genuine possibility that in the future, those earnings won’t look like they do today.

What did Goldman find?

Well, when weighing each factor by its relevance (information ratio). GS found that Domain (DHG), NextDC (NXT), Tabcorp (TAH), Worley Parsons (WOR), Bega Cheese (BGA), Cleanaway Waste (CWY), Steadfast (SDF) and Seek (SEK) scored poorly and exhibited characteristics most common among underperformers.

Altium (ALU), A2 Milk (A2M), IDP Education (IEL), Domino’s (DMP), Appen (APX), CSL, ResMed (RMD, Aristocrat (ALL) and Fisher & Pykel Health (FPH) scored well.

The story of 3 banks

The banks report this week, and I thought I’d remind you all that the grossed-up dividend yield on NAB is nearly 11% for the next 12 months. The below chart has the net dividend yields (before franking credits – divide by 0.715 to gross up) for NAB, WBC and ANZ and all three are ex-dividend in November.

Movers & Shakers

Healthscope (HSO) apparently has more bidders than a meat tray at the RSL. Pretty sure it’s highly conditional and based on HSO achieving the unachievable. Anyway, whatever. I’m never going to buy it so I don’t care.

Lynas (LYC) provided a regulatory update on its Malaysia operations, again, couldn’t care less.

Good to see my old mate Ausdrill (ASL) swimming against the tide.

Lawd have mercy on the poor souls who are still insisting on holding AMP shares. Lawdy lawdy lawd its a basket case if I ever saw one.

And I did see one, BWX down 17% today on yet another guidance downgrade. Put that in a bucket with Axesstoday (AXL, suspended after falling from $2.60 to $1.62) and Australia’s most expensive, moat-less retailer Kogan (KGN, down 33% today), and you’ve got yourself a masterclass in how to do your dough!

Anyway, other big news was Worley (WOR) buying its primary competitor. Lots of M&A in that mining services/contractor space at the moment. Super Retail (SUL) reported weak like for like sales growth and the CEO quit. Elsewhere, just more high PE exodus with a bit of general risk off, “throw the baby out with the bathwater”, good ol’ fashioned, <insert more pointless turns of phrase here>, selling.

Have a good week,