Checking in on the fallen angels

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Q: Nearly all the 2016 ‘BITBAD’ stocks suffered a material downgrade after you identified them in February. Why did you go through the exercise of identifying those vulnerable stocks?

We're constantly trying to work out where we've made mistakes; what's cost us, and what's gone wrong? One of the filters that’s easy to do is to look at the best-performing stocks for the last year and look at their PE ratios. Then start to question; "Do we really understand these business models? Is there a crack appearing in the business model or will there be a potential for an earnings miss? Given that they’re on very high PEs that makes them potentially vulnerable."

That's the process that we went through, and that gave us that list of stocks that over the years de-rated. The last one to crack potentially, the last domino to fall will be Domino's, but that could be a while off.

Q: Following the de-rating that the ‘BITBAD’ stocks experienced, some are among the worst performers of 2016. Have you revisited some of these stocks?

Yes. We went back in December and looked at some of the businesses to try to discern whether the fall was a result of over-valuation or whether there's a fundamental business issue there that makes them questionable or fragile business models. We think that some of those businesses have had the fragility of their business model has been exposed, so the PE can never re-rate.

In other cases, there's a good business there. For example, TPG has some good assets. It still comes down to a question of valuation, and you've seen some big pull-backs. We're still not dipping our toes in yet because we think there's still a significant rotation out of these types of stocks.

Q: How long do you expect that rotation to take?

It depends on a couple of factors. The rate at which interest rates normalise and the rate at which the share prices decline, such to the point that they become fundamentally attractive. We think that the interest rate tightening cycle will be good for that reflation trade; banks, resources for a little while.

Until people start to question; "When does the rising interest cost actually become a burden?” Over the next 18 months, we typically see that rotation play out because there's been a huge weight of money that's been invested in this sector of the market, hiding. Now they have to move that money out. It just doesn't happen overnight.


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