During the month of January, equity investors showed little apparent concern for value. As we write this report, the market is becoming increasingly concerned with nascent inflationary signs and rising interest rates. The momentum of investor fuelled, low volatility / low interest rate trade that has grossly inflated pockets of the market has finally begun to unwind. Against a backdrop of a world economy showing strong signs of synchronised global growth, this should be considered a positive rotation.
The magical elixir of high growth, low capital, large Total Addressable Market has been drunk by many.
As we have highlighted for 18 months (a bit early), this rotation will have very significant sector ramifications. Most at risk will be concept stocks that have huge valuations and no hard assets – think Tesla, think GetSwift in an Australian context.
During the past six months, we have had increasing concerns that markets have been willing to buy into the concept hype with scant regard for execution / likelihood of success / regulatory risks, etc. The standard playbook is to pitch an idea with a large total addressable market (TAM) and posit that your unique IP will allow you to grow into that market and you can do this without much need for capital (“highly scalable” is the expression). The magical elixir of high growth, low capital, large TAM has been drunk by many.
High prices are hard to justify
Stocks that have demonstrated that their concept / pilot has worked have often achieved exuberant valuations. We believe Afterpay is one such stock. If we assume every member of the 18-34 demographic in Australia (circa 5m people) uses Afterpay to buy $1,000 a year of goods on lay-buy, this would generate $200m in corporate revenue. We then assume Afterpay achieves this in three years, and there is only $30m OpEx to run the business (very conservative) and $20m funding costs, which gives $105m NPAT (vs factset consensus of $62m). Mature financials trade on 10-12 times giving an equity value of $1,050m–$1,260m three years hence, or a PV today of $830m–$1,000m versus a current market cap of $1,500m today (35-45% overvalued on the Australian opportunity only). So, to own it now, you really need to believe in domestic nirvana, coupled with unqualified success in the USA.
For the first time since inception, Avoca has gone overweight based on our bottom up intrinsic value.
What does have hard assets, and benefits from rising economic growth/inflation? Answer: Stocks that are leveraged to industrial metals, i.e. resource producers and their suppliers. Over the past year and for the first time since inception, Avoca has gone overweight these stocks based on our bottom up intrinsic value. By coincidence, Citigroup quant analysis has found during periods of solid global growth, and rising demand-led inflation, industrial metals have outperformed.
We also look for businesses that should experience improving conditions specific to their industry such as ARB Corp, Star Entertainment, Sky City Casino, Austbrokers and Worley Parsons to name a few.