Disruptors, the disrupted, and those immune from disruption

On my assessment, what we are witnessing here is the gradual but undeniable impact from technological disruption, regulatory scrutiny and increased competition; factors that within the Australian context were always going to impact hardest on sectors that not so long ago were dominated by well-entrenched duopolies that are by now forced to defend their turf, and to rethink their strategy.

Witness recent restructuring announcements made by Telstra, National Australia Bank, Santos, Origin Energy and AMP.

But, of course, none of the problems these companies are facing today started earlier in the year. In each case there is but a valid argument to be made the operational environment started to get tougher back in 2012. It takes a while before management teams acknowledge the new environment is here to stay.

Then they still have to formulate a response.

It would be premature to now take the view these companies will remain operating under a huge cloud permanently, but at the same time, keeping the fingers crossed that tomorrow everything shall be alright seems rather optimistic. Such challenges and processes take time and they seldom go hand in hand with excellent shareholder return in the meantime.

Which is why I am advocating investors adopt a risk-updated, three layered view of the local share market:

Group one: The disrupted 

Companies that are under threat and need to review their modus operandi and their strategy to stay relevant in the future;

Group two: The disruptors 

Companies that are not impacted by changing dynamics and might possibly even be beneficiaries;

Group three: Those immune from disruption

Upcoming companies that are inflicting the disruption to existing market positions and business models.

Different risk profiles

It goes without saying each of these three groups represents a different risk profile. In a generalised sense, companies in group one should de-rate until more clarity is forthcoming about how each company is dealing with the threats and challenges coming towards it. Companies in group two should trade at a premium. They represent the least risk from a sustainable operational point of view.

Is it coincidence then that quality healthcare stalwarts like CSL ((CSL)) and Cochlear ((COH)) are trading at a premium to the broader market, as well as to their own historical market premia?

Companies in group three offer lots of potential and excitement, but many are early stage development still and thus highly vulnerable themselves to sudden changes, incumbent responses and unforeseen pitfalls. Note that in some cases young companies that IPO-ed at the ASX only a few years ago have already been disrupted before they managed to fulfill the promises upon which they became a listed public entity. iSentia comes to mind, as well as Freelancer.

Most importantly, just like the Internet was real in the 1990s, but very few of the original Internet champions are still around twenty years later, it is not because innovation and disruption are tangible and real today that all emerging innovators and disruptors will by default prove successful. Surely the dismal experience with OnePage serves as a stern warning about the risks involved in group three.

The disrupted

For companies in group one, it's probably best investors resist looking over their shoulder into the past when trying to assess what the future might bring. On my observation, the past five years have impacted through two very different scenarios for companies and/or sectors affected.

Under a best case scenario, share prices carve out an extended sideways channel of multi-year duration on price charts. Probably the best example of this is being provided by Wesfarmers whose share price has traded between mid-$30s and mid-$40s since late 2012. It doesn't take much imagination to see a similar trend on price charts for Australian banks, with the exception of Macquarie Group ((MQG)).

The disruptors

Things look a lot worse in case of scenario number two whereby share prices end up being encapsulated inside a long term down trend. Take a look at a multi-year price chart of Coca-Cola Amatil and you shall have no problem understanding what I am talking about. FlexiGroup is another example.

The experience from mining and energy stocks between 2012 and early 2016 shows buying cheap stocks doesn't work when there's a persistent down trend. At least companies such as BHP, Fortescue Metals and Whitehaven Coal have since been rescued by a significant recovery in commodity prices. But what about Billabong? Myer? Fairfax Media?

Investors trying to scoop up cheap looking stocks better make sure they are not committing themselves to value traps dressed up like a long term opportunity. Telstra comes to mind too.

Those immune from disruption

As far as group three is concerned, here there are always plenty of promising, exciting stories, but many prove ephemeral as business models are immature and unproven and the future remains as unpredictable as ever. Yet, the years past have also proven Australia remains an outstanding breeding ground for high quality, fast growing, sustainable new technology companies. Names like Wisetech Global ((WTC)), Altium ((ALU)) and Appen ((APX)) are increasingly attracting widespread praise, and investor attention.

There is every reason to assume these companies will be around for a long while, and growing strongly for many more years. This is how micro cap stocks become small cap stocks, then mid-cap. This process is arguably well-advanced for the companies mentioned.

Admittedly, strongly rising share prices have excited ever more traders and investors and valuations seem a lot less attractive than they were only a short while ago, but an experienced investor knows the importance of patience and of being ready when opportunity knocks. I suggest keep a list, do your research, add regular updates and market observations.

But don't shy away as these companies represent Australia's, and the world's, future.

Other names that come to mind at significantly lower valuations include Integrated Research ((IRI)), Nanosonics ((NAN)), Class ((CL1)) and, of course, one of my personal long-standing favourites, TechnologyOne ((TNE)).

My positive views regarding TechnologyOne should be common knowledge by now. There are not many companies on the ASX that can boast double-digit growth in earnings per share in each of the years that make up the past decade, with notable exception of the financial year just passed when growth didn't exceed 9%. That was a bad year in TechnologyOne parlance (!).

And boy did investors take notice. TechnologyOne shares have thus far lagged the broader market in 2017. The shares go ex-div on November 28th and any weakness post this event will be used to add more shares to the All-Weather Model Portfolio where TechnologyOne shares are no less than a core holding.

Somewhat to my surprise, analyst Gareth James at Morningstar is of a similar mindset. Morningstar has a stringent valuation based rating methodology and at around $5.22 the shares are on the cusp of being upgraded to Accumulate from Hold, this despite the fact the PE multiple sits around 29.6x on FY18 estimates.

Apart from the company's 99% customer retention rate, and a conservative and lazy balance sheet (no debt), Morningstar suggests investors should zoom in on the projected 15% EPS CAGR for the decade ahead. That's even better than the 11% average that has been achieved over the decade past.

Focus on disruptors, or those immune from disruption

In terms of the three baskets of stocks mentioned, the FNArena/Vested Equities All-Weather Model Portfolio remains very much focused on opportunities inside groups two and three.

Despite having no exposure to mining and energy, and neither to any of the Big Four banks, year-to-date performance is better than the main index and we remain en route to achieving our longer-term performance goal after three years of operating the portfolio, including the significant set-back endured in the closing months of 2016.

No doubt, it'll come as a surprise to many, the portfolio's performance does not include any trading strategies or lucky windfalls, but is largely the result of owning high quality, sustainable, cycle agnostic, robust, multi-year growth stories; and of sticking by them whenever a manic and flighty share market goes temporarily off course.

Within this context, we remain confident in future growth potential for core holdings including CSL, Carsales ((CAR)), REA Group ((REA)), Link Administration ((LNK)), Ramsay Health Care ((RHC)), and others, including many of the future champions mentioned.

In most cases, short-term minded investors are probably underestimating the potential return the Model Portfolio is likely to achieve from these holdings in the years ahead.

By Rudi Filapek-Vandyck, Editor FNArena. Our service can be trialed for free and with no obligation for two weeks at (VIEW LINK)