A liquidity-fueled rally with classic late-cycle markers

Ben Griffiths

Eley Griffiths Group

The continuing rally in equities of all stripes is increasingly being greeted with catcalls and market dissidents declaring the advance outsized and illogical. Media commentators are becoming intensely irritated by it and seasoned equity market confreres have been heard openly denouncing the rally.

What we can say with certainty is that plentiful and essentially free liquidity is fueling a stockmarket rally where classic late cycle markers are now beginning to emerge. The rise of day-trading appears to be the latest iteration of the gig economy. The GameStop market putsch featuring ‘Roaring Kitty’, flash mobs and ‘Short squeeze Astronauts’ indicates that the household investor is becoming increasingly self-assertive, even brazen, with their market sorties. In the US, the arrival en-masse of SPAC’s or cash box companies (outlawed in Australia) suggests an equity product created for the investing masses. March quarter saw US$100bn raised for SPAC investment, equivalent to monies raised in total for CY2020.

Stocks have shifted to Sir John Templeton’s 4th quadrant market stage-Euphoria (Pessimism-Scepticism-Optimism-Euphoria). Problematic? Eventually but I contend that markets can remain this way for some time. It should be noted that credit markets (including CDS pricing) remain benign and the VIX futures curve remains in clear contango.

Technical summary

  • The US 10 year note finished the quarter at 1.74%, a long way from the 231 year lows of 0.31% struck on March 9 2020.
  • The S&P500 continues to make new highs on tremendous breadth with ~ 93% of companies in the S&P500 are trading above their 100 day moving average.
  • US Small caps, as defined by the Russell 2000 have stopped rallying and have been consolidating their 2020 advance. It may of case be consolidating for an up leg but this should be discounted somewhat given how late in the trend this congestion is occurring.
  • Across the broader Australian market, traders patiently await reclamation of the old highs, with both ASX 200 and All Ordinaries indices within line of sight. Clearing February 2020 highs for the market will be an elixir for share prices, with the latter index chalking this milestone up this week.
  • Mid Caps continue to notch up all-time highs and remain one of the local market’s sweet spots.
  • The Small Ordinaries Index at 3311 is trading at levels last enjoyed in June 2008-a period not easily forgotten by stock owners. It has been a move to date on fair to reasonable stock participation, with plenty of scope for rally breadth to improve. Further, it is reassuring that the benchmark is trading high above the ‘investment line’ (100 day moving average)
Investors need to appreciate that the Small resources subset of stocks is at the early stages of an unfolding rally whilst their industrial brethren appear unstoppable and about 7% shy of their all-time highs.

Three small cap portfolio additions and one disposal

One or both Eley Griffiths Group funds held the following stocks during the quarter and changes may have been made to portfolio positioning.

Pro Medicus (ASX:PME)

We recently initiated a position in Pro Medicus, a leading health imaging technology provider. The company’s software solution, known as Visage, provides one of the most comprehensive technology solutions to the global radiology market. Visage is typically used by radiologists and other medical imaging professionals to interpret images created by medical imaging equipment such as X-Ray, Ultrasound, CT and MRI Scanners.

Based on our internal research we believe the company is significantly ahead of peers with regard to viewer speed and efficiency for clinicians. The recent contract momentum appears to validate this view with $155m in contract awards in FY21 YTD. This compares to ~$50m p.a. of contract awards in FY20 and FY19.

PME is an expensive stock but with 20% compound revenue growth over the next 5 years and EBIT margins of ~60% it is in rarefied air. The company has one of the highest Return On Invested Capital (ROIC) metrics in the market and most importantly plenty of opportunity to deploy its capital as it continues to win share and implement its software solutions across the US.

Pentanet (ASX:5GG)

During the quarter your manager participated in an IPO for an emerging Perth Telco. Pentanet. The group was founded by two brothers, Stephen and Tim Cornish and is a Internet Service Provider (ISP) commercialising high bandwidth fixed wireless technology pioneered by Facebook known as Terragraph. The Terragraph will allow for lower network latency effectively enabling greater capacity/bandwidth for data consumption.

Pentanet is winning subscribers at significant pace in their home market of Western Australia with capital only employed as customers sign up. A customer centric offering with some similarities to iiNet from the early 2000s including having the former CEO as Chairman. Pentanet also has a significant gaming opportunity with its partnership with Nasdaq listed Nvidia, which will allow for multiple use of bandwidth within a single household and delivering high processing power to any laptop or standard PC. We understand registrations have been strong for the technology’s beta trial.

Betmakers (ASX:BET)

As an early backer of Pointsbet, we have become very familiar with the US sports gaming market. State based de-regulation opens the opportunity for US consumers to embrace the ease of mobile sports betting in a sports obsessed market. With the graduation of Pointsbet into the ASX200, the Emerging Companies Fund has turned its attention to other players with exposure to the same market.

We recently added Betmakers to the portfolio. In July last year Global Tote Operator BET secured the rights to provide fixed odds on horse racing in New Jersey, creating the perfect entry to sell their bookmaker and racing operator technology to US operators.

The acquisition of SportsTech late last year, has rapidly expanded its presence across 36 states in the US, and positions BET as the pre-eminent operational partner for US racing bodies. Despite horse racing’s relative low profile in US vs Australia and other US sports, the advent of mobile sports betting will no-doubt draw more attention to this exciting pastime, as sports-betting companies look to capitalise on the high CACs and provide opportunities for their customers to bet when major sport seasons have come to a close.

A difficult 12 months ahead for Netwealth (ASX:NWL)

We have long been advocates of the platform disruptors, owning HUB on a number of occasions early in its journey and participating in size at the IPO of Netwealth in October 2017 at $3.70. The thesis has been compelling – legacy financial platforms with significant share of Funds Under Advice, have fallen foul of their customers due to years of underinvestment and dissatisfied customers. At the same time we have seen the disaggregation of financial advice, and the emergence of the independents.

Netwealth’s state of the art solution has been sector leading, and subsequently seen fund flows swell to >$40bil and gain 4.3% market share. Despite the long runway ahead and a very strong management team, Netwealth has a difficult 12months ahead as it seeks to reprice its back book during this half, continues its investment and attempts to renegotiate its next deposit arrangement.

With multiples still elevated, we felt it prudent to sit on the sidelines until clarity on the above issues, quitting our holding during the period in review. We will be watching with interest for a better entry point in the future.

Outlook

As I write, we are moving into the teeth of the US first quarter reporting season which should see corporates report well and confirm 2021 as a year of strong earnings growth. Credit Suisse Strategist J. Golub talks of a ‘GDP to Corporate revenue’ multiplier of 2-3x, setting the stage for around 16% top line growth and appreciably higher for earnings.

We have talked in previous Encyclical’s of the looming US consumer revival that pent up household savings is set to unleash and its likely headlong collision with an inventory shortage of housing, consumer durables and motor vehicles. Further, it is logical to expect business capex to increase in response.

Locally, the economy is enjoying a ‘miracle rebound’ with the labour market (including participation rates) repairing itself faster than expected. The consumer remains high-spirited too.

The NAB March survey of business conditions hit a record of 25.2, nicely eclipsing the 1989 high of 17.

Anecdotes from EGG analyst company contact supports the buoyancy across many sectors but do note some stresses appearing in the system around sourcing labour, stock shortages and with freight/logistics.

On valuations, Goldman Sachs point out that a US 10 year note at 2.0% simply restores the yield gap (Earnings Yield less 10 year bond) to long term averages. That’s another way of expressing that equity risk premiums continue to be fully supportive of an allocation to stocks. 

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Eley Griffiths Group is a specialist at focusing on small and emerging companies in Australia. Their investment process and team have delivered consistent outperformance through all market conditions for 15 years.

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Principal and Portfolio Manager
Eley Griffiths Group

Ben Griffiths is the managing director and a senior portfolio manager at Eley Griffiths Group and has over 30 years of financial markets experience. He Co-founded Eley Griffiths Group in 2002 with Brian Eley following a successful career as joint...

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