Asset Allocation:
Momentum: Where should your assets be allocated?
Robert Swift​​

​One of the most important decisions is how to allocate your money across different asset classes – property, bonds, equities, or cash. This is because a combination of these assets will be less volatile than simply holding equities, and the returns, although lower, will be safer and reduce the chances of a nasty surprise to your pension pot.

This is probably now consensus thinking and all the major banks, financial planners, and investment management companies produce regular reports giving their views of both HOW you should make the allocation decision and WHERE you should currently be invested.

We believe that there a systematic process of asset allocation that actually works. Over the last 20 years or so a number of the investment team have worked for some of the biggest multi asset investment funds in the world which have struggled with this question of how to develop a systematic, repeatable process of allocating between asset classes that added value for clients over time.  We have been involved in the formulation, development, and testing of many of these models. A lot of quite sophisticated “fundamental” approaches were tested but none seemed to last the test of time.

Perhaps worryingly for some, what did seem to work best (most consistently) was a technical analysis model – simply following a set of rules based on price momentum using 10 day, 50 day and 200 day moving averages of the prices. Only holding above average exposure to those assets that met the criteria and avoiding the others that did not meet the criteria, led to significantly superior results than simply holding a benchmark of all the assets without making any changes.

This seems remarkably simple, possibly even stupid, and runs counter to the view that forensic accounting and meticulous predictions of GDP figures add value in making asset exposure timing decisions! Actually, the phenomenon known as momentum has taxed the financial academic world for quite a while and much work has gone to show that price momentum or trend following, adds value not just across asset classes but also within. In other words, even buying equities whose prices are rising, regardless of their valuation, will make you money relative to equities whose prices are falling.

Psychologically this “momentum factor” actually makes sense. Human beings like to be with crowds, in popular trends and don’t like the ridicule with being unfashionable, or to be too different. Consequently, there is an opportunity to simply jump on a trend and enjoy the ride. This human fallibility is what makes markets inefficient and active management worthwhile.

Think. If momentum exists as a way to make money, which it does, then it can’t be the case that ALL information in the market is instantly discounted so that the relative prices have instantly adjusted to their correct level. If prices instantly adjusted, as efficient market proponents argue, then there would be no momentum. Prices would move instantly and not over a period of time. It is this slow upward and downward movement that allow us to get set and make money.

We use a stock selection model which also incorporates momentum or trend following. In a way acknowledging the impact of price momentum is the ultimate acknowledgement that other people may know more than you. If valuation is acceptable then better to go with what other investors see as attractive?
​
It is rather ironic in a business where people attempt to develop very sophisticated models that closely fit with financial theory that it is often very simple things that work! This simple price momentum, had it been followed in 2008/9 financial crisis would have avoided much of the damage to portfolios that people incurred by switching out of the falling assets (equities, commodities) and in to the rising assets (bonds). In a business where there is so much information being thrown at you, it is important to be able to separate what’s relevant and what is simply a distraction. We have never found predicting GDP is productive for asset class forecasts. Plenty of firms do but we think they’re wasting their time.

So what is the price momentum model telling us now? Over 2016 the model gradually sold out of all form of bonds – both government and corporate – final sales being in September 2016. These have been gradually replaced by increasing exposure to equities – firstly US equities – then a gradual spreading throughout most of world equities.

This purely price momentum model also fits in with our fundamental view. Following the 2008 financial crisis a large proportion of money was switched out of equities into bonds. Relative to history over the last 5-6 years there has been an over-allocation to bonds over equities. The Bank Credit Analyst a well-respected research group recently released a report where they argued that the world economy was in a synchronised growth stage and this was leading to a general improvement in company earnings. Furthermore we are started to see growth in company capital expenditure which is a sign of more confidence amongst companies after years of below average expenditure on capex. M&A is also starting to picking up – which is something we discussed a few weeks ago.

So with positive technical indicators and encouraging fundamentals we could eventually see more decisive switching out of bonds in to equities.

Equities – overweight with a bias towards Value

Bonds – underweight especially net debtor countries such as Australia, Turkey, Spain

Understanding what the market is expecting from a company is a key input in our investment process. We are looking for under-appreciated stocks where the valuation reflects the market’s low expectations for the business. As a result, we look to gauge market expectations before investing and look to forums, broker reports, investor discussions and subscription research services to better understand what the market is really expecting from a company. In our experience, understanding behavioral finance allows for a more accurate interpretation of market commentary.

The market’s opinion on any given stock is clear for all to see in the form of the current stock price which in theory represents the current value of expected future cash flows. As a result, we view a stock’s current valuation as a great starting point in gauging what the market is expecting from a company looking forward.

As passionate value investors we are always looking for stocks which are trading significantly below their intrinsic value, which encapsulates that company’s future cash flows discounted back to a present value. Stocks which trade well below their intrinsic value generally do so because their shareholders have low expectations of future cash flows, and thus value the business accordingly.

As a result, gauging market expectations is a key part of our value investment process.

​One of the great attractions of investing in smaller companies is the inefficient nature of the smaller companies’ market. There are far fewer analysts and investors looking at each stock at this end of the market, which creates a significant opportunity for smaller companies’ investors who are prepared work hard to fill in the information gaps themselves. These market inefficiencies mean we need to work harder than just looking at the stock price to gauge what the market is really thinking. We need to listen to the market…

We are believers in the power of using behavioral finance to your advantage when investing. In our experience listening to market voices can add significant value when gauging market expectations. However, not for the reasons you may think.

Any psychology graduate will recognise that when people are expressing particularly loud and strong opinions about something there is generally a deeply held personal reason for it. In our experience, when someone is talking particularly positively about a stock, it generally means they are invested in the stock and are thus comfortable to “talk the stock up”. And conversely, when someone is negative about a stock, it generally means they aren’t invested in that stock and thus feel comfortable to “talk the stock down”, possibly so they can buy the stock at a lower price in the future.

Knowing why people are broadcasting their opinions can be a useful tool when gauging market expectations, particularly in the small world of smaller companies investing. If, for example, five of Australia’s leading smaller companies fund managers are all invested in the same stock (which is incidentally a more common occurrence than you may think!), and have all published positive research updates recently, the chances are high that expectations are high. Those five fund managers are likely to have already built their positions in this stock, and by broadcasting their opinions loudly across the market, the chances are high that some retail investors have followed the “smart” money into this stock as well. In this scenario, we would be cautious regarding the stock’s short and long term potential knowing that the incremental buying is likely to slow down looking forward, and also that once that happens some of the more short-term focused retail buyers are likely to sell down once the stock starts under-performing, leading to further under-performance.

By knowing that expectations were high in this example, an investor would have been in possession of a significant advantage versus the broader market.

We pay attention to the opinions from across the market and see 4 main communication channels as worth factoring into expectation analysis:

1. Read stock message boards like Hotcopper – Hotcopper provides a fascinating insight into what people want you to think they are thinking, and provides a forum for the loudest opinions to be broadcast across the market. In our experience, stocks which have many Hotcopper postings each day tend to be followed closely by short term focused investors/traders. The more people are discussing a stock, the more they are generally hoping from that stock in the short and long term, and vice versa. We tend to be invested in stocks where there is minimal commentary on Hotcopper since few people follow or understand them.
2. Talk with other investors – Similarly to Hotcopper, it is interesting to talk with other investors and take what they are saying with a grain of salt. Of particular interest to us is when many investors are talking about the same stock/s, which tends to indicate expectations are rising.
3. Follow broker analysis – At the smaller companies end of the market it is generally uncommon for brokers to write regular research updates so following broker research can be of marginal use. However, in the rare cases it does happen, we are aware that expectations may be rising as a stock continues on its journey from undiscovered to discovered.
4. Follow subscription research services like Motley Fool – Some of these subscription research services advise many thousands of investors, and they are often looking at the smaller companies end of the market. It can be worth being aware of their recommendations in stocks you are following because they can significantly impact upon expectations and the type of shareholder on the register.

Management engagement and communication.

We have noticed that management communication is also very important when gauging market expectations. There is a spectrum of management communication styles across the market, and in our experience management teams which focused on under-promising and over-delivering tend to do just that. And they also tend to attract stable long term shareholders who are taking a truly long term view on the investment, rather than aiming to trade in and out around results. In our experience this is the ideal type of shareholder register to support long term value creation.

We encountered an interesting example of management communication behavior we aim to avoid recently when we noticed the CEO of a company we were analysing (who will remain nameless) was communicating directly with investors through Hotcopper on an almost daily basis. The following quotes are indicative of his communication style:

“It’s time to put your seat belts on and enjoy the ride and for those that got in at these price levels…… well done!”

“Further news flow should see this break out.”

Needless to say the stock has attracted a highly speculative and short term news-flow focused shareholder register. We believe this may create challenges for the stock’s short and long term outlook as expectations are already high, with many shareholders in a hurry for results.  ​

Buffet’s famous quote couldn’t be more accurate in our experience. Markets will always be driven by greed and fear, and it is only by mastering our emotions as investors that allow ourselves to be exposed to significant wealth creation opportunities in the equity markets.

We believe being aware of market expectations and the behavioral finance implications are powerful tools investors can use to ensure they are exposed to the right type of stocks which they are able to think long term about, and ultimately ignore all the short term noise.

​Gauging expectations is core to value investors’ psyches since we are looking for stocks which are largely ignored and under-appreciated, and thus under-valued. Low expectations is near the top of our shopping list of the attributes of high quality, under-valued smaller companies we are looking for. We will continue to focus on stocks where expectations are low.

Reporting Season Analysis: Telstra & Brambles
Guy Carson

Telstra’s problems are largely not of their own doing. The industry is coming through significant change with the rollout of the National Broadband Network (NBN) and the end of Telstra’s natural monopoly. The NBN is publicly owned and levels the playing field in terms of competition. Hence, Telstra will potentially suffer the most from its introduction. Despite this assessment, last year we saw a significant selloff in the price of their competitors TPG Telecom and Vocus. Of course those companies were trading on significantly higher valuations, but nevertheless Telstra seemed to get off lightly.

The major reason Telstra is set to be the big loser from the NBN is that it effectively loses its place as the lowest cost participant in the market. This will have the impact of reducing margin both through having to pay connectivity fees to the NBN and increased competition. Telstra has historically enjoyed significantly higher margins than the industry and they are clearly set to fall.

Now in the case of Amcor, the rerating was justified as the operation performance of the company improved significantly but in the case of Brambles we don’t think this is the case.

The first warning sign with regards to Brambles was the Free Cash Flow (FCF). Whilst the company has reported reasonable profit outcomes since 2013, the FCF has lagged significantly. This is particularly the case in the last 18 months.