Good afternoon,

The ASX200 had another pretty solid week, up 0.74% and now trading at near enough 10 year highs. Last week’s rally was led by Resources stocks, +3% for the week and Energy +2.5% with Woodside (WPL) up 14% in the last 2 months  (We talked about the opportunity in WPL 13.6% ago in the note from 16 April, read it here).

And I haven’t spent the last 5 years of my life talking to clients 8 hours a day, to not know that the common response to “the market is at a 10 year high” is “well, is it time to sell?”

The answer is as always, nuanced. And I don’t feel like getting into too much of this behaviour/investor psychology/grey area stuff today (we do it pretty regularly so you all probably know my spiel on this by now).

Earnings expectations have increased for Resources since the end of calendar year 2017 (the lime green line) by 14%. This has resulted in ASX 200 Resources index increasing 35% in value.

Meanwhile, everything else (blue line) has been pretty steady, earnings have been revised down 2% whilst and the stocks are flat.

This tells us that the recent rally in stock prices has been largely driven by a significant increase in the price as well as the earnings expectation for resources companies, post the EOFY results in 2017 and then again recently after the half year updates in February as the forward period estimates and valuations rolled forward to 2018-2019 fiscal year.

This is pretty simple from my perspective. (chart is in absolute cents per share)
You can see a nice trend of higher earnings (all the lines going up)
You can see the FY1 earnings (green) are smaller in quantum than Next 12 months (NTM) earnings (blue) and then FY2 is larger again (maroon).
This implies 2.7% EPS Growth over the next 16 months (as FY1 is just in the bag, and half year FY2 and full year FY2 still to come)
The time to buy resources (the bottom) was at the end of March when year on year EPS growth was revised down from 32% at the end of Nov’17 to 10% at the end of Mar’18.

It’s currently forecast at 18%. So what valuation have we paid for 18% earnings growth in our resources businesses in the past… that should give us a good idea of what we will pay in the future.

WRONG! Over the last 10 years, on occasions where resources EPSg was forecast to be between 15-20%, we have paid 14x, 14x, 7x, and 16x for those companies in aggregate. So maybe 14x is the number, but as below shows, it’s not a lot of confidence as we’ve also paid 14x for everywhere from 189% growth to -40% declines in earnings.

In fact, as the above chart shows, over the last 10 years we’ve seen everything from 28x to 6x forward earnings paid for resources companies. And in fact, we pay more for companies with less forecast growth. This is very counter-intuitive.

Contrast this to the ‘look’ of non-resources companies, you can see the distinct difference. A pretty clear 2-tier system. Stocks we are willing to pay a lot more for but for relatively low levels of growth (high quality, defensives) and those businesses where we will only pay up to a certain price for and can have high growth (cyclicals, value).

Sorry, I’ve kind of gone down the rabbit hole here a bit, however I think it’s interesting to show the difference between the main categories of companies, the nature of their business and subsequently their earnings and share price returns.

In answer to the question, is the market going to turn nasty? Well, maybe. I think if resources take a turn for the worse, the index will follow. However I’d expect non-resources stocks to significantly outperform during that period, despite overall returns moderating. It’s really no different to my views earlier this year and what my ‘base case’ has been for a couple of years now.

My concern will rise if we see another decline in the US Manufacturing PMI next month (chart below vs yoy% returns for resources companies). We’ve seen the start of a potential reversal in trend so if that is confirmed, I think it will be time to reduce exposure to cyclicals/resources and increase defensive exposures and expect a currency adjustment against the USD.

US Reporting Season Update

I suppose that gives great context to why I’m unusually focused on reporting season in the US this year. The folks at Morgan Stanley tell me that “80% of the index has come in above expectations on EPS and 14% below expectations, which is a better beat rate than the historical trend of 67% of companies beating” and on average, those companies were able to grow earnings by 7.7% more than analysts thought! Sounds pretty good to me.

Revenue was also strong, with 74% of companies beating market expectations.

Janus Henderson (JHG)

JHG has been a bit of a battler in the funds management game for a long time. A history of dodgy performance, not great marketing and resultant outflow leaves many with a low opinion of it…. just the kind of thing I like to dig around in!

I dig around, it’s all pretty benign. Synergy benefits, reasonable ambitions, favorable exposures, decent team, improving performance, doing all the right things… looks ok to me.

Analysts all like this thing, consensus price target has been steady around $48-50.00 and recommendations have been at least HOLD or BUY.

And I see the share price fall 23% whilst the earnings have been revised up 15%… That’s Christmas!

So when they come out and report 7.5% ahead of earnings estimates and an upsized dividend and show some really positive signs in the key areas of their business (like 75% of their funds beating their benchmark)… you know you are on a good re-rate story.

Sure enough, JHG rallied 10% last week (as you can see on the chart.). Anyway it might still be cheap, I won’t bore you with the detail but if you want to know why I think  JHG could be a $60-70 stock (currently $45), you can give me a ring.

I’m not going to have time/words to do this properly this week however, I saw the below image on Instagram and it just reminded me of how big E-Sports is going to be. If you don’t know what E-Sports is, it’s essentially watching other people play video games. You can read a bit more about it here

When you have the most famous, highest paid athlete (Christiano Ronaldo) being less popular than an eSports star (Ninja) you know you’ve found the start of a mega trend.

If you don’t know what  Twitch is yet, go and find out. It’s going to be the next ESPN. It’s way more important than YouTube already. A few growth stats from last year on Twitch vs YT.

How can you make money out of this kind of growth? Well, Hollywood has already worked it out, anyone seen the movie“Ready Player One”  ?

But as always, I’d be looking to the large incumbents, I’ve talked previously about EA Games EA Games (EA, +21% in 2018) and TakeTwo Interactive Software (TTWO, +71% in 2018). There are others, but I’m keeping them to myself (and my clients) for the time being until I can firm up my position!

I think this plays out on mobile as well. We have really made a habit of watching TV on our phones now, especially given data is so cheap (I get 22GB per month for $70 from Vodafone). This is a negative for the telcos, the traditional media and positive for the original content manufactures (like the two gaming houses listed above and Netflix) as well as the data infrastructure providers (HELLO, THE DATA EXCHANGE NETWORK (DXN, +60% since listing)

Grocery Shopping

From exciting ESports to about the dullest activity on earth, grocery shopping.

Food is about the only category with decent inflation across the consumer spending mix at the moment with the ABS reporting supermarket sales up 5.7% in March.

This is good short term for WOW and WES (though WOW reported the growth, Coles unable to capture much) but medium term, Kaufland is arriving in 2019 with their fleixble format offering which will be quick to roll out and add to the already stiff competition from Aldi.

MS research tells me that 68% of Australian now shop at Aldi vs 56% in 2015 and penetration has reached 75% on the east coast. This doesn’t surprise me. Claire has been hitting up our local Aldi and bringing home the nicest food. Cheese board bit and pieces, wine, figs (oh my, the figs at Aldi get 5 stars) and I prefer the greek yogurt from there too. Claire reckons she’s saving $50 a week shopping for some of our stuff (only 2 of us) at Aldi.

Market Whip Around

CleanTeq (CLQ) bounced back after presenting at the Macquarie Conference and allaying fears around construction costs of their nickel-cobalt mine and processing facility.

BT Investment management (now called Pendal Group, PDL) bounced on better than expected inflows.

Reece (REH bought a complimentary business in the US. Continues to be one of the best run businesses on the ASX.

Elsewhere Challenger (CGF), Janus (JHG), Ooh! Media (OML)  all had good weeks.

Greencross (GXL) got slaughtered on profit warning, cost cutting and essentially just proving that roll up stories are great until they aren’t. 30% downgrades across the board.  Beware if you’re a National Vets (NVL) shareholder… your time too will come. Same dog, same fleas.

Link Admin (LNK) lost another contract and faces significant policy risk from proposed changes to the treatment of inactive pension accounts. Citi downgraded price target by 18%.

Elsewhere CSR looks to have reached peak earnings after a modest outlook.
Idea of the week
I did a bit of work during the week looking for companies I can buy with ROA% above 10%, ROE above 20%, EPS growth above 10%, No debt, sales growth average over last 5 years of 5% and mkt cap over $300m. Fair to say, the pickings where slim. But here’s the list. Probably fair to say that Breville (BRG) caught my eye, particularly given concerns around potential impact on BRG of the “Trump Tariffs”.

Have a good week,

The information contained in this email is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser.