Thursday, August 18th, 2016
The All Ordinaries Index has now rallied 864 points or 18% from its one-year low of 4,762 on 10 February. For those who call a 20% rally a bull market, their threshold is nearly reached. Offshore, a growing number of measures indicate declining risk aversion and growing confidence in the investing environment:
- US stocks are at record highs
- The price-earnings ratio on the S&P 500 is at its highest since 2002
- Measures of volatility in US equities remain close to all-time lows
- Overnight, emerging market stocks advanced for an eighth straight day. The MSCI Emerging Markets Index is at 13-month highs. The Russian equity market is at all-time highs (surely a sign of minimal risk aversion!)
- There is a buying spree in emerging market corporate debt, where yields are at 13-month lows. One year-returns on this asset class have been double-digit. Given the high risks in this asset class, the returns indicate investors’ comfort with taking risks.
For value investors, these are not attractive buying conditions. Less risk aversion gives way to confidence, which progresses to complacency. We prefer the fear, dread and panic of August-October last year and January this year, when the model portfolio aggressively bought equities. We did the same in the days after the surprise Brexit vote. Switching between cash and equities explains much of the portfolio’s outperformance of its benchmark index.
We also remain convinced the ASX is still in a sideways-trading market because:
- Most of the large companies which dominate the index are cyclical, earning lower rates of return on equity than they used to, are exposed to strong price competition and pay out high proportions of their earnings as dividends, which reduces value growth
- Outside iron ore and gold stocks, whose short-term earnings outlook improved this year with rallies in the respective commodity prices, the earnings outlook for most other important companies is mundane
- Despite strong US employment data in June and July, and better than expected earnings in the latest US company reporting season, much of the rally on Wall Street – a powerful tailwind for the ASX this year – is explained by deferral of expectations for interest rate increases by the Federal Reserve. This reduces the quality of the rally, seen in the 14-year high in the PER on the S&P 500
- Much of the buying of ASX equities is driven by a desperate search for yield given the paucity of fixed interest returns: cash at 1.5%, bonds at 1.9%. It does not reflect a rational search for earnings and value growth.
Also the ASX is trading towards the top of its earnings multiple range, as shown in last week’s report.
However, we are not fully bearish. It’s encouraging that, according to Bloomberg, 84% or 168 of the stocks in the S&P/ASX 200 are trading above their 200-day moving averages. This high percentage of stocks above the average indicates the rally has been broad-based. No small group of stocks or single market cap tier is driving the rally, as would be the case in a lower-quality rally.
The portfolio’s strategy is to raise cash and/or hedge (using negatively leveraged ETFs) as market sentiment becomes more optimistic and stocks become less cheap or more expensive. We decide how and how quickly to reduce our exposure to equities based on our views about the quality of the rally and how much value is left in the portfolio. Given the ‘medium’ quality of this ASX rally (little support from industrial earnings growth, but broadly based) we currently aim to maximise our gains from the rally by exiting stocks opportunistically rather than in wholesale selldowns, which we would do if we thought the market was about to collapse. We’re raising cash at a measured pace.
So it’s a good time to be selling something, but which stocks? The stocks to sell in this kind of rally are those where the investor lacks conviction due to lack of business quality, poor growth prospects, being wrong with the original thesis, or little share price upside.
So was the case with Ainsworth Game Technology (AGI), which we exited today at $2.40, our cost base and valuation, after a frustrating seven and half months since we purchased in early December. In mid-2015 we successfully bought the stock as low as $2.54 and sold as high as $3.12 and in December we aimed for another profitable trade after a selloff. We liked the strong financial health rating, the reinvestment of 11% of revenue in R&D and the exposure to offshore growth.
At least we got out without losing money but there was an opportunity cost from not investing the funds in something which appreciated. AGI didn’t work out as an investment because it became less profitable and riskier this year – see our declining adopted NROE and higher RR on the Valuation History tab. The buoyant Australian dollar also is not helping given international revenue, most of which is from the US, was 41% of total revenue in the last financial report. The market has not priced in a takeover premium from Austrian manufacturer Novomatic, which bid $2.75 for founder Len Ainsworth’s 53% share, and there is no telling if or when the Austrians will bid. Shareholders might wait a long time and we want to raise cash. The opportunity to get our cost base back today, after the stock dipped as low as $1.77 in February, was compelling.
This is how investors can decide what to sell when market sentiment turns substantially more positive but the investor isn’t ready to sell quality companies yet. Sell your trading exposures, stocks where you’re lucky to get your money back, stocks which are materially overvalued and stocks where your original thesis or views on profitability and risk were wrong.