This week we present an article by friend of TAMIM Sam Ferraro as he examines the subdued volatility the Australian market has been experiencing.
Market volatility conditions have remained subdued for some time. Daily return volatility of the Australian dollar Trade Weighted Index has dropped to its lowest level in a decade despite the recent appreciation of the Australian dollar against the US dollar. Volatility in the 10 year CGS yield has exhibited a regular cycle since the financial crisis, but the the peaks and troughs have tended to trend down. While stock market volatility is close to a decade low (see chart).
Although not shown here, global macro volatility is not as benign in Australia. Although return volatility of the S&P500 is anchored to its lowest level in four decades, volatility of the US dollar has been rising and volatility of US Treasury 10 year yields is high by historical standards. So the persistently low level of stock market volatility in Australia probably reflects an exposure to a global volatility shock, while subdued volatility conditions in the TWI and Australian bond yields may have arisen thanks to domestic developments.
The benign stock market volatility in the United States has coincided with a drop in the expected risk premium (ERP) to its lowest level since 2010 (see chart). Even at current levels, the ERP remains higher than the levels that prevailed during the credit boom. The implied volatility of index puts on the S&P500 also are low by the standards of the past decade (not shown here). Evidente has previously suggested that if the ERP in the United States continues to trend down, it would be expected to precipitate a revival in animal spirits and business investment, and ultimately sew the seeds of the demise of the profit boom.
The Australian experience differs from that of the United States. Although stock market volatility conditions are subdued, the implied ERP has been broadly unchanged over the past five years (see chart). The ERP divergence between the United States and Australia might have contributed to the multiple expansion of the S&P500 to close to historical highs, while the ASX200 continues to trade in line with historical norms. Evidente believes that a renewed drop in the ERP is necessary to revive animal spirits in the corporate sector and kick-start growth of capital investment.
One of the key macro risks in Australia remains the historically low rental yields in residential property. The gross yields on apartments and detached houses have dropped to 4% and around 3% respectively. Evidente has previously suggested that when net rental yields and the lift in lending rates for investors are taken into account, the economics for new property investors are becoming more tenuous.
Investors appear to be alive to the risks associated with historically low rental yields, with the Australian bank sector currently trading on a 35% book discount to non-bank industrials (see left panel below). This represents the largest discount since 2000 and comparable in size to the discount that prevailed in the late 1980s and early 1990s. The size of the discount might also reflect negative sentiment surrounding what many consider to be bad bank behaviour. Higher capital requirements have probably played little role since the sector continues to post higher profitability – in terms of return on equity – than non bank industrials (see right panel below).
Investors also seem to be alive to the risks associated with high and rising corporate debt in China, particularly in the construction sector. The metals & mining sector is trading on a book discount to non-bank industrials of around 35%, which remains low by historical standards (see left panel below). The size of the discount persists despite the fact that the profitability of the metals & mining sector has recovered from its recent trough and is now comparable to non-bank industrials (see right panel below).
Against this backdrop, Evidente has re-balanced its thematic, high conviction model portfolio, which under-performed marginally in the September quarter and out-performed marginally in the twelve months to 30 September. Given the size of the sector discounts, the model portfolio retains an overweight in banks, and metals & miners, funded from an underweight in non-bank industrials. Despite some of the macro tail risks discussed in this post, Evidente believes that the risk-reward for these two sectors remains attractive for now.
Evidente is an independent financial consulting firm managed by Sam Ferraro that delivers innovative financial advice to wholesale investors, including active long only funds, hedge funds, pension funds, and sovereign wealth funds, in Australia and globally. Drawing on academic research in asset pricing, behavioural finance and portfolio construction, Evidente provides wholesale investors with commercial solutions to stock selection and asset allocation decisions across equities and other asset classes.
Sam writes as a freelance journalist for The Age, Sydney Morning Herald and Australian Financial Review, was a member of the advisory board of API Capital, teaches business finance and international finance courses to undergraduates at RMIT, and most importantly Sam is a well respected source of information and friend of TAMIM.
This week Guy Carson reviews the IT services sector which is a sector typically overlooked by the Australian market.
When an investor thinks about the Australia equity market, they typically think of Banks and Resources. They may also think about supermarkets, Telstra and one of the more advanced REIT markets in the world. One sector they typically won’t think about is Information Technology. This is with good reason; Australia is not home to Apple or Google, and even the more exciting businesses which have begun in Australia such as Atlassian choose their future abroad. In fact, the largest IT company listed on the ASX is Computershare which arguably could be classified as a Financial. As a result it’s a sector that largely gets ignored by Australian investors. If one has no international exposure, they are unlikely to have much exposure to IT at all and this is likely to be costly. IT is the fastest growing sector globally and this is likely to be the case for years to come.
To illustrate the likely road ahead for technology, it is helpful to consider the fable of the chessboard. The story goes that an ancient King played a game of chess against a wise man. When the King lost, he offered this wise man a reward of his own choosing. The wise man, who was also a wise mathematician, told the king that he would like just one grain of rice on the first square of the chess board, double that number of grains of rice on the second square, and so on: double the number of grains of rice on each of the next 62 squares on the chess board. This seemed to the ruler to be a modest request, so he called for his servants to bring the rice. The King was then surprised to find that the rice quickly covered the chess board, and then filled the palace. The amount of rice grains on the last square is 2 to the power of 63 or 18,446,744,070,000,000,000.
What does this have to do with technology? Well, Moore’s Law is that computer processing speed (transistors per square inch) will double every two years. This law has been remarkably accurate to date and at this point we are roughly half way through the chess board. The growth in technology has been exponential and this growth is set to continue. The ideas of virtual reality, self-driving cars and artificial intelligence are becoming more and more prevalent. So how does an investor in Australia benefit from this global phenomenon? Well there are two ways, firstly one can buy overseas shares directly or one can search through some of the lesser known Australian companies operating in the technology space. When one does search you can find companies that are leaders in niche products globally.
Whilst some areas of the Australian technology market such as the internet companies and some of the midcap software companies have seen significant rallies in recent years, one sector that investors are still a little wary of is IT services. Historically, this sector was built on a consultancy model that saw earnings dependent on the number of consultants and the utilisation of their time. However the rise of cloud technology has changed the dynamic significantly. Small and medium businesses have recently been moving away from on premise servers and are shifting to the cloud. This effectively means firms have outsourced their IT to a specialised building called a data centre. Providers such as NextDC have exploited this opportunity and are in the process of rolling out further capacity. There is a missing link, with the vast amount of cloud software available and the complexity of managing a remote IT network, a need for an external management party becomes essential. That is where the services sector is evolving, away from a consultant coming to your premises to the ongoing management of an external network. The advantage of the new model is a proportion of your revenue becomes recurring, meaning profits are less lumpy and less vulnerable to economic downturns.
Three companies that are benefitting are Data #3, Melbourne IT and Dicker Data. All of these companies are similar in they have historical businesses with large client bases and have utilised this advantage to roll out service offerings. Data #3 was an IT distribution that has expanded into services, the latter of which is now larger the first thanks to strong growth. Dicker Data is also a distribution business that has recently signed an agreement with Hitachi Data Systems to launch a new Enterprise Data division. Melbourne IT was a domain registry business that expanded into enterprise services.
Despite the change in business model, the market is still reluctant to pay too much for these businesses. All three trade on Price to Earnings multiples in the mid-teens despite strong earnings growth in recent years and paying out strong dividends. If the recent trajectory growth continues (and with the continued adoption of cloud technology it’s not hard to see how it could), then a case can be made for higher multiples. If we consider that some of the software companies trade on multiples up to and in some cases north of 30x, then if a services company sees similar growth rates should they not trade on a similar multiple? The answer is probably not and we don’t expect these companies to rerate that significantly. Service companies whilst having improved the quality of revenue in recent years are still more vulnerable and subject to downturns. Despite that we do see upside if the current growth rates are maintained. For example, if we look at the current share price of Data #3 and use a simple dividend discount model with a discount rate of 10%, we find the market is factoring in growth of around 5%. This is despite the fact that dividends have grown at an annualised rate of 25% over the last three years. If the company can continue to grow at a rate of above 5% over the coming years then there is significant upside available for patient investors.
Note: Data#3, Melbourne IT and Dicker Data are current portfolio positions.
This week, as a follow up to a recent telco article, Guy Carson takes a look at Inabox.
Recently we wrote an article looking at the Telecommunications industry in Australia. Our main premise was the introduction of TPG Telecom into the mobile space would cause problems for the existing players and lead to lower margins across the industry. We received a lot of feedback on that article and the most interesting aspect was the amount of readers who had started to move on from the large Telcos and look elsewhere for cheaper alternatives. As a result of this, our belief that the smaller players will continue to rise has been strengthened. These players are typically large non-Telco companies that wish to cross-sell to existing customers and it creates an interesting dynamic in this market. Access to customers is a crucial element that these new competitors have over the incumbents and could lead to a substantial shift in consumer behaviour.
One company that will potentially benefit from this trend is Inabox (IAB.ASX). Whilst the company only has a market cap of $20m, it has a surprising amount going on under the service. The core competency of the business is its Telco-in-a-box platform. This platform allows anyone to become a Telco reseller and they currently have approximately 450 out of the current 1,200 National Broadband Network providers as customers. This means they are exposed firstly to new entrants wanting to setup a Telco capability, and secondly to the growth in subscribers amongst those non-mainstream brands. They also have exposure to the top end of town, as their platform is used by Belong which is Telstra’s low cost brand.
One of the keys for the company is their ability to white label a Telco offering. This means they can partner with non-Telco retailers to enable them to provide these services. The potential here is large. When we look experience offshore we find that retailers have had significant success. For example in the UK, Tesco is now the 2nd biggest Telco provider. The possibility here is that Woolworths, Coles, Aldi and other major retailers can use a platform such as this to add an additional revenue stream from existing customers and capture more of their wallet. The nature of the Telco market hence has the potential to change dramatically over the coming years. Whilst Inabox has a number of strong and significant clients already, the announcement of a blue chip retail client could be a real turning point for the company and its profile.
Source: Company filings
Inabox is largely unknown at the moment and their financials appear messy at first glance. They have been consistently profitable since listing but despite that they have struggled to gain any significant momentum. The acquisition of Hostworks this year could potentially change that. Hostworks was acquired for $7m from Broadcast Australia, who paid $69m for the same business back in 2008. The acquisition adds a cloud services capability to the business in addition to its Telco operations; as a result the company is able to service firms across the entire spectrum of communications and technology. When we add in the runrate EBITDA of the acquisition to the Inabox business we can expect a meaningful step-up in FY18.
The acquisition though did bring some one-off costs and as a result EBITDA and NPAT fell this year. Stripping out those costs, underlying EBITDA rose to $6.1m on flat revenues as low margin operations were exited. As mentioned above, the full year contribution from Hostworks is set to boost this number further in FY18. The company has spent a significant amount of capital building out its platform capabilities and potentially has one more year of circa $4m spend ahead of it. Post this spend a majority of the EBITDA will fall to the bottom line, after some tax of course. Recent guidance is for $100m revenue in the next year, up from $90.1m this year. If EBITDA margins are maintained (and in fact we believe there is the potential that they expand), the company will achieve EBITDA in the order of $6.8m. With a current market capitalisation of $20.1m, the shares are currently trading on a very undemanding multiple.
It must be pointed out that this is a very small company with a little bit of debt so an investment is certainly not without risk. However, given the nature of their platform and the fact that 76% of their revenue is recurring we believe the company is significantly less risky than most other microcap companies. In addition, it operates in the area of connectivity which is a growing sector and has structural tailwinds that should support it over the coming years. Whilst it may not be our largest position, we believe it is worthy investment for part of our capital.
This week the Small Cap team provide a profile on one of their portfolio holdings, Elanor Investors Group (ENN.ASX).
Property and hotel/tourism fund manager and investment company, Elanor Investors Group (ASX:ENN), is a core long term holding of the fund that we believe represents compelling value at current prices. We have been adding to our position in ENN recently.
ENN ticks a large number of boxes for a high quality business including:
Strong management with a proven history of operational out-performance;
High levels of recurring income;
A strong track record of buying assets well, adding value and then realising the asset value;
Favourable tailwinds in the form of growing long term investment demand for high quality, high yield, tourism and property assets; and
An exceptionally strong balance sheet.
In terms of value, ENN is currently trading broadly equal to the market value of the various real estate, tourism and investment assets that it owns. In addition to the ‘hard’ assets that it owns, ENN is building a very successful and profitable funds management division that the market is attributing limited value to. In our experience, this is an unusually attractive opportunity for a high quality, well run business.
The funds management business
ENN’s funds management business currently has around $800m in external funds under management, and generated segment EBITDA of $8m in FY16 and $11m in FY17.
The business has powerful leverage to ongoing funds under management (FUM) revenue growth and significant potential performance fees. ENN’s management are optimistic about converting their strong pipeline of new fund initiatives which should support good growth into FY18, following a significantly increased origination and capital raising capability.Management’s ability to purchase assets well, and to add value to assets through active and astute management has also resulted in significant embedded performance fees (off balance sheet) that will accrue to ENN as assets are realised over the coming years.The key funds that ENN currently manage include:
Elanor Retail Fund (ASX:ERF) – listed on the ASX in 2016 with gross assets of over $250m
Elanor Hospitality and Accommodation Fund – unlisted fund formed in March 2016 with gross assets of over$100m
Elanor Metro and Prime Regional Hotel Fund – recently announced unlisted fund with gross assets of $73m.
As illustrated below, the growth in FUM over the past several years has been impressive, however the emerging funds management business being developed by ENN has yet to be properly recognised by the market.
Source: Company reports and DMXAM estimates
The chart above sets out the growth in assets both owned by ENN and externally managed by ENN, together with our calculation of the business value (enterprise value) as a proportion of external funds under management – a metric that highlights the relative value the market is applying to ENN’s fund management business.
When ENN listed on the ASX in 2014, its funds management business was valued at 10% of its FUM at the time. This metric has been reducing and sits at c. 5% today, which indicates the business is cheaper now relative to any other time in its trading history. Further, if we were to adopt our estimates of the market values of ENN’s investment assets, rather than the audited book values (with some key assets recorded at cost) used in the analysis above, then the business would appear even cheaper, at less than 2% of its FUM.
The market has been attributing less and less relative value to ENN’s funds management business, over a time when the business has been generating increasing profits and scale and a track record of strong performance outcomes – this represents a compelling opportunity for us. ENN’s underlying funds continue to mature and provide potential for ENN to capture material performance fees.
Valuation
As value investors we are focused upon identifying the most compelling under-valued high quality smaller companies on the ASX. ENN currently stands out as a particularly compelling value opportunity based upon its asset and earnings base.
As a result of recent valuation uplifts to its Hotel and Tourism assets, and forecast mark to market values of its real estate (e.g. ENN’s Merrylands property) and co-investment assets (e.g. ENN’s Belly City fund investment) we estimate ENN’s underlying NAV is now approximately $2.00. With its current share price at around $2.10, this implies very limited value is being applied to ENN’s funds management business. We view the current opportunity to buy a share of a high quality funds management business with a top class management team for next to nothing (and where the share price is supported by the value of its assets) as unusually attractive. Catalysts to potentially unlock this value include the sale of non-core assets, new fund initiatives and asset realisation / generation of performance fees. We remain committed long term investors and look forward to seeing this value being unlocked over time.
Everyone has been obsessed with the FAANGs, FAAMGs or “Sexy Six” for a while now but Robert Swift, manager of the Global High Conviction strategy here at TAMIM, only holds one. Robert takes a look a one of his better performing stocks of late to help explain why this is while examining the fallacy that stocks can be defined by a singular sector.
We often show investors our sector and region weights. These are important aspects of our portfolio construction process because ensuring a wide spread of sector and country exposure is a sensible way to diversify and control exposure to a detrimental event in any one country or sector. The sector definitions make intuitive sense, as do the regions or countries into which the companies are placed, but companies are often classified as one type of company when they are really another. Understanding what drives a company’s profitability, and where the risks lie, is important and to that extent it is important to not just passively accept the classifications given to you by convention.
This is why a sophisticated risk model is critical since many companies classified as one type of business actually contain elements of others. Put together in a portfolio these elements can combine to produce large unintended and undesirable characteristics. Portfolio management is more than picking stocks one by one – you have to know where the aggregated risks are and how big and how to measure them.
A current example of a technology stock which perhaps isn’t, would perhaps be Apple, which is increasingly a consumer goods company? Most of its manufacturing is outsourced although it designs the items and operating system; it relies heavily on constant fashion cycles to drive revenues; and it sells directly to the consumer from its own branded stores. If it were a French luxury goods company such as LVMH or Hermes, would it be treated and rated differently by the stock market? Quite probably. Similarly, Google, while definitely still a tech stock, could also be considered one of the world’s premier advertising companies.
A technological advantage is worthwhile because it protects margins and the business franchise. One of our investment themes is that technology is increasingly to be found everywhere and as a key source of competitive advantage, is not just in semiconductors or circuits, but also in supply chain logistics, or heavy equipment manufacturing, and resource exploration and extraction. As technology enters more industries we ask why do tech stocks (hardware and software), command a premium P/E multiple?
Technology can fail and be subject to intense competition and regulation. Furthermore the capital investment required by technology companies to stay ahead, can be enormous and single failed product cycles disastrous. Nokia used to be THE dominant mobile handset company but missed a couple of product cycles and is now an ‘also ran’. Before then came Sony which really should have invented the iPod or generic digital portable player, since it had been first with The Walkman. For whatever reason it became side tracked and missed the shift to digital. The list goes on. Companies with such requirements to keep spending exposure should arguably trade at a P/E discount to reflect this risk?
Consequently if you can invest in technology without the high P/E then why wouldn’t you? Such opportunities exist and they exist outside the sector classified as “technology”. Our favourite example would perhaps be Gilead, the bio technology company. This is now our largest holding after a decent rally in the last few months.
Following the Kite acquisition we have looked at what the acquired cancer technology does and it is pretty astounding. Just as clever as placing binary code on a graphics chip and sound card to make a mobile phone – or at least we think so.
Kite, now owned by Gilead, specialises in oncology or cancer treatments. They have produced a new way to fight certain types of aggressive cancers by reprogramming the body’s own auto immune system. CAR-T or Chimeric Antigen Receptors are programmed onto T cells which are taken from the blood of the patient. T cells do the fighting against foreign cells for the body. These receptors are programmed to fight the specific cancer and are consequently a much less traumatic process then radiation, surgery, or chemotherapy which are the other options.
The best analogy we can think of is the training of special police forces to drop into a crowd riot and identify and take away the key agitators. Up until now, the only option has been to isolate and contain the whole crowd and be prepared to arrest everybody and anybody.
Adding to the complexity is the fact that the blood has to be reprogrammed in a laboratory and then taken back to the patient. This has to be done quickly since these cancers are often aggressive. Think of this as supermarkets running logistics to get fresh food from the farm to your table in a few hours or days. And yet supermarket multiples are higher than GILD which trades on a P/E of less than 12x.
CAR-T is applicable in other areas than oncology so Gilead have potentially bought a complete drug delivery system. Currently it is dealing with blood and potentially lymphoma cancers, but tumours in pancreas or liver or auto immune diseases like type 1 diabetes or lupus are potentially treatable and curable with this CAR-T approach.
For all those ESG investors out there it also does some real good since it actually cures people, it isn’t just a treatment. Hence the shrinking market for some of Gilead’s original drugs which cured Hepatitis C.
For certain there are risks, as with any investment. Gilead needs to grow its other drug treatments offshore and incidentally has just won approval in China for its Hepatitis C drug. Additionally, Gilead and Kite won’t be the only pharmaceutical company developing this treatment, and Novartis, a Swiss based company, is already out there with an approved product, but it trades on a multiple of 30x. There will also be an issue with the cost of CAR-T, since treatment is expected to be c.$500k for a one time attempt.
However, we think that buying cutting edge technology on a P/E of 11x is a pretty good price and notwithstanding the challenges with its existing drug pipeline, as well as obtaining US government approval for this therapy, GILD looks to be up with Novartis and ahead of the crowd, and as worthy as Facebook, Apple, and Amazon as being considered a technology leader: at a fraction of the valuation.
