The case for equities (and 3 recent additions)
The path forward for equity markets will be dictated by a number of cross currents that we are well prepared for. April is a seasonally strong month for equities, historically the best performer in any given year.
The highly publicised (and over-analysed) US yield curve flattening process, and subsequent inversion between 10-year bonds and three-month treasuries, has likely played on the minds of investors. Despite its reliability over time as an indicator of recession, the inversion’s transience (< 24 hours) has ushered in dismissals of its validity from all corners rather quickly!
Irrespective of the debate about the onset of recession, remember equity markets customarily enjoy robust trading in the aftermath of an inversion. The inversion that occurred in September 1998 saw the market peak in March 2000 and the one in January 2006 saw the market top in November 2007 (before the GFC cataclysm). Both enjoyed substantial lead-up rallies.
Despite the outsized rally in stocks, equity risk premiums (4.8% in the US and 7.4% in Australia) continue to convincingly support the case for equities over bonds. A substantial margin of safety exists here for investors.
Further, the Fed’s late March change of heart saw the nine-member committee decide to play it safe – no rate hikes in 2019 (previously two expected) and one in 2020, with further balance sheet run-off to stop by September 2019. This is unequivocally supportive of equities.
In China, an EGG analyst reported sightings of economic ‘green shoots’ in response to fiscal and monetary accommodation from the central government and its instrumentalities. There is a growing confidence that a US-Sino trade deal is at an advanced stage and likely to be consummated pre-June 30, but there is the risk that it underwhelms given heightened expectations.
The Shanghai Composite Index has been a significant outperformer through 2019, correctly anticipating an improving outlook for the China economy.
Offsetting these developments, US corporates are currently reporting their Q1 earnings. Companies will be cycling a challenging comparative period and also a three-month period of restrained economic activity.
Outlook commentaries will be closely scrutinised for clues on how the US profit cycle is shaping up for 2019, where expectations range from 0-6% profit growth versus ~22% booked in 2018.
The first major US IPO of the calendar year, ridesharing provider, Lyft Inc, disappointed all by finishing its first week of trade down 20%. Uber is not far away, nor is Pinterest and AirBNB among others prepping for IPO. A series of high-profile but poorly performing floats would not be helpful to market sentiment.
The looming Federal election and change of stewardship will generate headlines but do little to derail a local stock market that is intent on tracking higher. It is, however, important that Wall Street’s September 2018 highs do not curtail the vigorous but maturing US secular bull market.
Charter Hall Education
We initiated a position in childcare REIT, Charter Hall Education (CQE) during the period in review. The group owns a sizable portfolio of childcare centres throughout south-east Australia. The sector is in the throes of a recovery from a multi-year supply/demand imbalance that has heavily impacted the profitability of operators.
CQE has proven adept in managing the cycle lows with essentially full occupancy of its portfolio, static earnings per unit and modest growth in distributions. Management are inherently conservative and announced several acquisitions in March, coincident with a $120m equity raising.
EGG recently returned to the InvoCare (IVC) register. The company reported a marginally better than expected CY18 result in the face of what has been a tough operating environment, including not insignificant disruption to the groups asset portfolio as the company progresses its Protect-and-Grow refurbishment programme.
Management expect the number of deaths in FY19 to increase, following a fall in the death rate in FY18. The company enjoyed better trading in its Australian funeral business in Q42018 and into January 2019, so signs of normalisation are at hand.
History has shown that a year of lower deaths versus the prior corresponding period (two consecutive years is rare and the volume recovery from negative years is pronounced) has resulted in share price underperformance and an attractive medium term buy set up.
When combined with the benefits accruing from Protect-and-Grow (35% of footprint complete and trading inline or above expectations) and the unfolding regional acquisition and greenfield strategy the stock feels sufficiently de-risked to be added to the portfolio.
A recent addition to the portfolio was capital markets and wealth management software player GBST (GBT).
Over 18 months and ~35% into a major investment cycle to re-platform the core architecture of its legacy wealth management system – Composer – green shoots were starting to emerge in February 2019. After a false start with a third party, GBST came clean to the market in August 2017 and flagged a $50m investment over three years was required to ensure the sustainability of its wealth business.
Fast forward to February 1H19 results and green shoots were beginning to emerge. A new client in Canada Life had been won on the premise of what the new version of Composer might look like when the investment phase had finished.
It also appeared the legacy Australian capital markets business had turned the corner with clients now willing to consider technology upgrades.
With the strategic R&D spend still on budget, albeit only just over a one-third done, the market began to give management the benefit of the doubt that guidance would be achieved.
Concurrently, its Australian-listed UK peer Bravura had benefited in the past two years from GBST’s misfortunes, winning new platform business in the UK. With currency in its own stock, and looking for the next leg of growth, it lobbed an opportunistic bid for GBST at $2.50, valuing the business at just over 1.7x EV/sales.
With the board recommending no action, and earnings only just emerging from the trough, it appears the auction may only just be beginning.
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Eley Griffiths Group is an independent fund manager specialising in listed Australian small companies. Our investment team has been uncovering hidden opportunities in small caps since 2003.