Mark Draper

Mark Draper

Wednesday, 14 July 2021 07:53

Retail investors guide to IPO's

Every month, Mark Draper (GEM Capital) writes an article about investing for the Australian Financial Review.  

This  month he writes about how retail investors should think about IPO's (initial public offerings or floats).  This article appeared in the AFR during July 2021.

 

Every retail investor dreams about doubling their money on day one of a hot IPO (initial public offering).  But Myer, Dick Smith and Nuix demonstrate that not all IPO’s turn out to be profitable.  With the likelihood of a flood of IPO’s in the second half of the year, investors should dust off the IPO playbook to ensure they don’t end up owning the next Dick Smith.

Hugh Dive (Chief Investment Officer, Atlas Funds Management) believes that the most important question for an investor to ask is who is the vendor and why are they selling.  Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business, or the vendors are using the proceeds to expand their business.  IPOs, where the owners are looking solely to exit the business entirely (such as in the 2009 Myer IPO), tend to see poor outcomes for investors.

Investors also need to understand whether the vendor will continue to own any shares post IPO and ‘have skin in the game’ and for how long.  While continued vendor ownership doesn’t guarantee success, it does result in some alignment of interests with new shareholders at least in the short term.

Vince Pezzullo (Deputy Head of Equities, Perpetual) firmly believes that any IPO candidate must fit in with the investor’s usual investment strategy.  Retail investors in the past have been guilty of chasing a quick trading profit via IPO’s, often deviating from the types of investments they would usually make.  

Matt Williams (Portfolio Manager, Airlie Funds Management) agrees and says that while it might sound simple, the IPO has to be a good business with good prospects.  Some ingredients to determine whether the IPO is a good business would include the level of recurring earnings, debt levels and whether the industry sector has a favourable outlook.

The difficulty facing retail investors wishing to participate in IPO’s is access to information.  IPO investors are confronted with the task of understanding a new company with limited and often misleading financial data often referred to as pro-forma accounting within a brief marketing period.  Some of the accounting tricks that IPO’s have used in the past include amortising expenses so costs are transferred from the profit and loss account to the balance sheet, writing down of inventory pre IPO to artificially boost profitability post IPO, and cutting regular maintenance expenditure to boost profit.  Investors would be wise to read the cash flow statements and balance sheet positions in the prospectus to look for red flags.

The prospectus is generally considered an unfriendly document to retail investors due to its length and complexity.  Williams says that before investing in an IPO it is critical investors do their homework so they know what they are buying.  This involves reading the prospectus, particularly the ‘bad stuff’ including the Key Risks section.  Usually in the key risks section there is information showing the sensitivities to profitability should certain conditions change such as interest rates, currency, input costs etc.  Williams believes this is critical in assisting the investor make a decision on what to do next after the IPO lists.

If an investor can get comfortable with the quality of the IPO on offer, Pezzullo then suggests looking at whether the price is attractive.  Assessing the IPO price compared to other listed companies in the IPO’s peer group would be a useful measure of this.

Dive says there is a fundamental informational imbalance between the seller and the buyer of the IPO.  The seller knows the business intimately and is choosing the time to sell their stake in the business to be IPO’d at the time when conditions are most favourable to the seller.

Dive advises to ignore the hype around recent IPO success stories and look at every IPO from the initial position that the seller is trying to trick you into buying something that they are selling and then slowly work backwards towards a position of trust.

Finally, Warren Buffett says about IPO’s "It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller to a less-knowledgeable buyer."  When it comes to IPO’s - Buyer beware!

 

With some again calling for the re-introduction of a mining tax, does this signal the top of the iron ore price cycle?

Three of the largest 20 companies on the ASX are iron ore miners, so Australian investors need to be across the iron ore price.

For most of its traded life, iron ore was sold on a contracted basis and sales were direct between two parties.  This was a stable period for prices where they averaged between US $20-30 per ton until a spot market with daily pricing was introduced in the mid 2000’s.

Since this period, the spot price has probably averaged US$50 – 70 per ton according to Gaurav Sodhi (Deputy Head of Research, InvestSmart).  Today it trades at over US$200 per ton.  Sodhi says that this is an extremely unusual event to see iron ore at over US$100 per ton and has only happened once before.

 

The current high price is a result of rising iron ore demand from China, Australian miners operating at capacity and supply constraints from Brazil who is the second largest iron ore producer according to Hugh Dive (Atlas Funds Management).  The dam collapses in 2019 and COVID in 2020 removed around 85 million metric tons (MT) from Brazil’s annual production to around 300MT.  For perspective, China currently imports around 1bn MT per year.

The similarities to 2011, the last time the iron ore was very high, are that demand is being driven by a US$506bn stimulus plan announced by the Chinese Government in May 2020.  This is slightly smaller than the US$586bn package announced during GFC which saw the building of steel intensive bridges, rail lines and airports.  The difference to 2011 so far is that the supply response this time is slower.

During a boom though it is usually difficult to see what will bring it to an end.  Sodhi highlights producers in the Pilbara are currently trucking iron ore hundreds of km’s to port at a cost of US$100 per tonne and still making a very high margin.  

Dive believes that there are 5 events that could lead to lower iron ore prices.  He says that the period between 2012 and 2016 provides a good road map as to how the ‘air’ gets taken out of the iron ore price, though the situation is likely to unravel faster in late 2021/22.  

  1. Brazil moves back to full production of around 380MT pa with goals to increase to 400MT.  Current annual production is forecast to be around 335MT this year, and appears to be rising
  2. Chinese consumption of iron ore slows as the impact of stimulus measures fade
  3. High prices incentivise production.  Mt Gibson Iron recently opened up closed mines that had been flooded.
  4. New entrants into the market such as Mineral Resources expand from contract mining and mining services to producing their own iron ore
  5. In the medium term, China naturally shift to using electric arc furnaces (EAF).  EAF utilises scrap steel and electricity rather than iron ore and coking coal to produce steel.  As an economy matures it starts to generate scrap steel from things including buildings that are torn down and cars that are recycled.  In the USA, 70% of steel is produced by EAF, whereas in China, it is only 15%.

Should the iron ore price fall, all iron ore miners profits would be impacted, however Sodhi says that the most exposed are high cost producers who have entered the market to exploit current conditions.  He says that small producers like Fenix won’t be able to sustain operations in a ‘normal’ environment.

Dive highlights that iron ore accounts for 100% of earnings for Fortescue while only 79% for Rio and 69% for BHP.  Mt Gibson Iron generate all of their earnings from iron ore.

Low cost producers such as BHP are likely to be less impacted as they can still make healthy margins even when iron ore is US$50 - $70 per ton, but investors should ‘google’ BHP’s price chart during the 2012 – 2016 iron ore collapse.

Iron ore investors who are enjoying high share prices and dividends, should ask themselves whether the current iron ore prices will hold forever and, (here are the 4 most dangerous words for investors), whether ‘it’s different this time’.

 

This article was written by Mark Draper (GEM Capital) and was featured in the Australian Financial Review on Wednesday 16th June 2021

Tuesday, 18 May 2021 12:54

Semiconductors - the new oil

Semiconductors (semis) are to the technological revolution what oil was to the industrial revolution.  Today there is a severe global shortage of semi’s, and it matters.

The shortage has resulted from a combination of natural disasters impacting manufacturing regions on top of what was an already fragile supply situation.  Severe frosts in Texas saw Intel shut production for a few weeks, and Taiwan, which is responsible for over 50% of all semi manufacturing, is suffering from severe drought. Semi manufacturing is a very water intensive process according to Delian Entchev (Senior Analyst, Aoris Investment Management).  He says that up to 20 million litres of water a day is required for one factory.

The shortage matters not only to those investors with exposure to semi companies, but investors also need to think about the domino effect on other industries that rely on semis.

The obvious products relying on semiconductors are PC’s, tablets and smartphones but many investors would be surprised to learn that semis are in other household items such as a fridge, lawn sprinkler, tv and microwave. 

The auto industry is another large market for semis and has been one of the high profile casualties of the chip shortage.  Several car factories around the world were forced to temporarily shut down production due to insufficient supply of semis.  Ford Motor Co anticipates a $2.5bn chip shortage cost. 

Recently the CEO’s of Cisco and Intel, respectively major buyers and producers of semi’s, predicted that the shortage could last another couple of years because demand continues to increase and production can’t be ramped up overnight.

Runways for Growth

Entchev says that the average petrol engine car contains around $100 of semis while a full battery electric car contains up to $1,000 of them.  Clearly the shift to electric cars will provide a growth runway for semis.

Douglas Isles (Investment Specialist, Platinum Asset Management) says that other growth tailwinds for semis include the move to 5G, the Internet of Things, autonomous driving, artificial intelligence and machine learning. 

The semi design industry generated revenues of US $466bn in 2020 and leading IT research firm, Gartner estimates that the industry can grow on average by 5-6%pa over the next 5 years.  

Entchev says that there are many different ways that investors can participate in the semi industry growth including:

-       Suppliers of materials such as silicon wafers on which semis are built

-       Producers of semi manufacturing equipment

-       Companies that provide outsourced manufacturing of semis

-       Software used to design semis

-       Chip designers such as Intel and Samsung

Isles says that Platinum Asset Management has had a large exposure to the semi sector since 2018, but their investment in Samsung goes back over 20 years.  Samsung has evolved to become a dominant player and today adjusting for cash on its balance sheet trades on about 12 times forward one year earnings (source: Factset)

Entchev says that Aoris’ preference is to invest in businesses that indirectly benefit from the advancement in semis, as it is very difficult to predict which semi companies will win in the future. A good example is Accenture, the largest global IT consulting business, which helps its customers deal with the technological changes that semis enable, like cloud computing.

Investors could also gain exposure to the semi industry through global managed funds and global ETF’s.

Risks

The semi industry is fast moving where customer needs can change quickly resulting in today’s products becoming redundant.  

It is generally considered that this is a cyclical industry, with two of the largest end markets being to automotive and industrial customers, however Isles said following industry consolidation the economics of semis has improved.

And then there are the geo-political uncertainties surrounding Taiwan which dominates semi manufacturing.  One of the most important developments in the semi industry has been outsourced manufacturing.  In the 1970-2000’s semis were all made internally by the companies that designed them.  Taiwan Semiconductor Manufacturing Company (TSMC) with support from the Taiwanese government created the first company dedicated to manufacturing designs from other companies.  Today TSMC has 52% share of all semi manufacturing and over 80% share of the most advanced chips.

The electronic components of devices that we take for granted today are an important long term investment thematic.

 

 

The article was written by Mark Draper (GEM Capital) and appeared in the Australian Financial Review during May 2021.

In the last 5 years Telstra shareholders have had little to cheer about as they have watched the NBN punch a hole in earnings, resulting in a share price slide and dividend cuts.  That is now changing.

In the recent profit result, not only did Telstra forecast earnings growth for the first time in 5 years, but also outlined a timetable to change its legal structure by splitting the company into 4 parts.

The proposed legal structure within the Telstra Group, expected to be completed by December 2021, includes:

  • InfraCo Fixed, which would own and operate Telstra’s passive or physical infrastructure assets: the ducts, fibre, data centres, and exchanges that underpin Telstra’s fixed telecommunications network.
  • InfraCo Towers, which would own and operate Telstra’s passive or physical mobile tower assets, which Telstra is looking to monetise given the strong demand and compelling valuations for this type of high-quality infrastructure.
  • ServeCo, which would continue to focus on creating innovative products and services, supporting customers and delivering the best possible customer experience. ServeCo would own the active parts of the network, including the radio access network and spectrum assets to ensure Telstra continues to maintain its industry leading mobile coverage and network superiority.
  • International, will be established under a separate subsidiary within Telstra Group and includes subsea cables

 

After being negative on Telstra for years, Gaurav Sodhi (Analyst, Intelligent Investor) believes the new structure is a good move.  He says that there are a lot of assets within Telstra that aren’t being adequately valued.  Separating them will recognise the value of infrastructure style assets that can generate stable, recurring revenues, resulting in a far higher valuation than the present share price.  Sodhi’s sell trigger of $5 on Telstra provides some guidance on the value he sees.

The Towers business carries a modest asset value of just $300m on Telstra’s balance sheet after heavy depreciation.  Once towers are in place and connected to the fibre backhaul, they are expensive to replicate and therefore extremely valuable.

Experience overseas shows that Telstra is following a well trodden path as it seeks to increase shareholder value.  Will Granger (Analyst, Airlie Funds Management) says that mobile tower companies can trade at EBITDA multiples (earnings before interest, tax, depreciation, amortisation) ranging between 21-27 times earnings.  Telstra by comparison currently trades on an EBITDA multiple of around 8 times.  Granger believes through a partial or full sell down of these assets, Telstra can realise this valuation arbitrage and increase shareholder returns.

Gaurav supports this view by referencing American Tower which is listed in the US.  It is the largest tower business in the world which bought AT&T’s long distance phone lines years ago and used them to host mobile infrastructure and are today valued at over US$100bn.  American Tower trades at over 20 times EBITDA while AT&T trades at just 7 times.

Granger adds that Vodafone spun off its mobile tower assets in March of this year on an EBITDA multiple of around 20 times.

Granger sees few downsides for the proposed restructure other than Telstra risking their network advantage if the mobile towers separation is not properly structured.

Sodhi agrees and said that American Tower and Crown Castle have been so successful because they host multiple networks from a single piece of infrastructure.  They have been able to scale nicely.  For Telstra’s tower businesses to do the same, Telstra would have to allow other networks access to those sites.

There is a clear trade off here.  In order to maximise the value of its infrastructure, Telstra needs to allow other networks access to it.  If it does that, it risks its network superiority.  Sodhi believes that Telstra is likely to opt for a lower value for its infrastructure to protect its network superiority.

The ACCC is another risk to this restructure.  Sodhi says that while its been hard to predict the reaction of the ACCC in recent years, he doesn’t believe there would be too many objections.  A split of the towers and infrastructure assets potentially opens the door to other networks also utilising those assets which could even the playing field.

Telstra has been a serial underperformer over the past 5 years, but investors must be forward looking and responsive to new information.  The split is new and its happening this year, and investors may do well to reconsider Telstra.

 

 

This article was written by Mark Draper and appeared in the Australian Financial Review during the month of April 2021.

In the last 5 years Telstra shareholders have had little to cheer about as they have watched the NBN punch a hole in earnings, resulting in a share price slide and dividend cuts.  That is now changing.

In the recent profit result, not only did Telstra forecast earnings growth for the first time in 5 years, but also outlined a timetable to change its legal structure by splitting the company into 4 parts.

The proposed legal structure within the Telstra Group, expected to be completed by December 2021, includes:

  • InfraCo Fixed, which would own and operate Telstra’s passive or physical infrastructure assets: the ducts, fibre, data centres, and exchanges that underpin Telstra’s fixed telecommunications network.
  • InfraCo Towers, which would own and operate Telstra’s passive or physical mobile tower assets, which Telstra is looking to monetise given the strong demand and compelling valuations for this type of high-quality infrastructure.
  • ServeCo, which would continue to focus on creating innovative products and services, supporting customers and delivering the best possible customer experience. ServeCo would own the active parts of the network, including the radio access network and spectrum assets to ensure Telstra continues to maintain its industry leading mobile coverage and network superiority.
  • International, will be established under a separate subsidiary within Telstra Group and includes subsea cables

 

After being negative on Telstra for years, Gaurav Sodhi (Analyst, Intelligent Investor) believes the new structure is a good move.  He says that there are a lot of assets within Telstra that aren’t being adequately valued.  Separating them will recognise the value of infrastructure style assets that can generate stable, recurring revenues, resulting in a far higher valuation than the present share price.  Sodhi’s sell trigger of $5 on Telstra provides some guidance on the value he sees.

The Towers business carries a modest asset value of just $300m on Telstra’s balance sheet after heavy depreciation.  Once towers are in place and connected to the fibre backhaul, they are expensive to replicate and therefore extremely valuable.

Experience overseas shows that Telstra is following a well trodden path as it seeks to increase shareholder value.  Will Granger (Analyst, Airlie Funds Management) says that mobile tower companies can trade at EBITDA multiples (earnings before interest, tax, depreciation, amortisation) ranging between 21-27 times earnings.  Telstra by comparison currently trades on an EBITDA multiple of around 8 times.  Granger believes through a partial or full sell down of these assets, Telstra can realise this valuation arbitrage and increase shareholder returns.

Gaurav supports this view by referencing American Tower which is listed in the US.  It is the largest tower business in the world which bought AT&T’s long distance phone lines years ago and used them to host mobile infrastructure and are today valued at over US$100bn.  American Tower trades at over 20 times EBITDA while AT&T trades at just 7 times.

Granger adds that Vodafone spun off its mobile tower assets in March of this year on an EBITDA multiple of around 20 times.

Granger sees few downsides for the proposed restructure other than Telstra risking their network advantage if the mobile towers separation is not properly structured.

Sodhi agrees and said that American Tower and Crown Castle have been so successful because they host multiple networks from a single piece of infrastructure.  They have been able to scale nicely.  For Telstra’s tower businesses to do the same, Telstra would have to allow other networks access to those sites.

There is a clear trade off here.  In order to maximise the value of its infrastructure, Telstra needs to allow other networks access to it.  If it does that, it risks its network superiority.  Sodhi believes that Telstra is likely to opt for a lower value for its infrastructure to protect its network superiority.

The ACCC is another risk to this restructure.  Sodhi says that while its been hard to predict the reaction of the ACCC in recent years, he doesn’t believe there would be too many objections.  A split of the towers and infrastructure assets potentially opens the door to other networks also utilising those assets which could even the playing field.

Telstra has been a serial underperformer over the past 5 years, but investors must be forward looking and responsive to new information.  The split is new and its happening this year, and investors may do well to reconsider Telstra.

 

 

This article was written by Mark Draper and appeared in the Australian Financial Review during the month of April 2021.

Wednesday, 24 March 2021 08:07

Why the 10 year bond rate matters

The most important number right now for professional investors is the 10 Year Bond rate.

The 10 Year Bond rate is an important anchor point for investors as a ‘risk free rate of return’ that is used in valuation models to calculate the value of assets including equities, property, infrastructure and fixed interest investments.

In short, lower bond rates result in higher asset values and by contrast, higher bond rates result in lower asset values.  Since 1994, investors have enjoyed the tail wind of falling bond rates, but the tide has turned since the last quarter of 2020 which has seen Australian 10 year rates rise from around 0.7% to around 1.7%.  That is a 140% increase.

In valuation terms, Arvid Streimann (Head of Macro, Magellan Financial Group)  says that a 1% increase in 10 year bond interest rates generally result in a 9% decrease in the capital value for 10 year bonds and around 15% for equities.

The factors influencing movements in bond rates according to Streimann are expectations of inflation and real economic growth.  Rising bond rates generally imply increased economic activity.  In recent times however Central Banks have artificially lowered long term rates through their Quant Easing (aka money printing) programs.

The chart below shows the difference in government bond prices for both a 1% and 2% rise in long term rates.

 Source:  Bloomberg

Investors in funds that are called ‘conservative’ or ‘stable’ usually have a high exposure to bonds and are at risk of loss from rising rates and would be wise to review these investments given the landscape has changed.

Streimann says that the impact of rising bond rates on the equities market is more nuanced.  He points out that equity valuations fall due to rising bond rates but not all equities are treated equally.  Those companies with higher levels of debt suffer a double whammy as they also receive a drop in earnings as they pay higher interest costs over time.  Vince Pezzullo (Deputy Head of Equities Perpetual) says that expensive growth stocks are more vulnerable to rising bond rates as they have distant prospective profits that are now discounted at a higher rate than before.

Pezzullo believes that if rising bond yields are signalling economic recovery, then cyclical exposed value stocks including energy, financials and mining, are likely to be beneficiaries as their business models have the most to benefit from the upswing in the economic cycle.  Streimann highlights the banks as a potential beneficiary of rising bond rates as they tend to earn higher rates of return on their loan portfolios which can boost profits.

The other issue for equity investors is that not all investors use the same bond rate when valuing assets, and some investors don’t use this valuation method at all.  Investors need to have an appreciation of the bond rate assumption being applied when reading research reports.

History generally doesn’t repeat itself unless people have forgotten about it.  The last time bond rate movements caused extensive market damage was 1994 which is a long time ago.  Pezzullo says the similarity to then and now is that markets were relaxed about the low inflation economic recovery, while the US Federal Reserve decided to push ahead with a surprise interest rate rise as growth accelerated.  During 1994, the Australian 10 year bond rate rose from around 6% to  over 10% resulting in short term damage to bonds and shares.

Streimann says the main difference between 1994 to today is the level and speed of communication courtesy of the internet, from the Central Banks.  It’s all about expectation versus reality and the Central Banks are articulating the economic indicators such as the unemployment and inflation rates required to be reached before raising rates.  This lowers, but doesn’t eliminate the probability of a bond market led panic.

Bond markets are currently stating that they believe Central Banks are likely to raise rates earlier and possibly higher than Central Banks have said on the back of an inflation scare.  The question is whether the Central Banks are willing to view an inflation scare a transient and leave rates low.  Investors would be wise to stay tuned to the communication coming out of the Central Banks for any changes in message.   Either way investors must prepare for an investment landscape with rising long term rates.

 

 

The article was written by Mark Draper (GEM Capital) and appeared in the Australian Financial Review on Wednesday 24th March 2021

As Mayfair 101 investors can attest, there is no point chasing higher rates of income if it is not sustainable or results in capital destruction.  

Here are 4 key qualities that investors can look for when researching a company, infrastructure or property trust in order to assess the sustainability of income.

Dividend Payout Ratio

Hugh Dive (Portfolio Manager Atlas Funds Management) says that generally anything above 80% suggests that the current level of the dividend may not survive the inevitable variabilities in profits from the economic cycle.  Though this can be industry-specific, a regulated electricity utility such as Spark Infrastructure can handle a higher payout ratio due to greater certainty of earnings than a mining company such as Alumina.  Spark Infrastructure offers investors an income yield of around 6.3% based on the current share price.

Financial Health of the company

If a company is highly geared, there is a greater risk that the dividend may be reduced or cut to placate its bankers when economic conditions worsen.

Franked income = tax payments

While companies can make a range of aggressive accounting choices that can boost their earnings per share (and dividend per share), a company is unlikely to maximise the tax they pay to the government. Firms that pay franked dividends have significantly more persistent earnings than firms that pay unfranked dividends. It indicates that a company is building up tax credits by generating taxable earnings in Australia. This measure is not useful for companies such as CSL and Amcor who generate large proportions of their profits outside Australia and therefore cannot pay fully franked earnings.

Growing income

Roger Montgomery (CEO Montgomery Investment Management), sums it up by saying that the key is not the search for a high yield, but for a growing income.  There’s a very strong correlation between rising levels of income and share prices so investors who can put together a portfolio of businesses whose earnings march upwards over the years will find the market value will do likewise and they win twice.

SCA Property, a listed property trust with exposure to non-discretionary retail by owning 91 suburban shopping centres anchored by long leases to major supermarkets with low gearing, is an excellent example of an investment displaying these characteristics according to Dive.  Dive also points to packaging giant, Amcor as a sustainable dividend payer given it pays out 65% of profits as dividends and the nature of packaging earnings is stable. 

Montgomery highlights National Storage REIT, Waypoint REIT and Ingenia Communities as sustainable income plays.  He also suggests that Transurban and Sydney Airport will again provide high levels of sustainable income once the vaccine rollout becomes more advanced and economies reopen.

Listed investment companies (LIC), managed by high quality management teams with good performance track records should also be on the radar for yield hungry investors.  Many listed investment companies allocate profits from good years into a profit reserve account so that in poorer times, the dividend may be maintained.  The level of profit reserve account is freely available to investors in the financial accounts of the LIC published half yearly.  

Platinum Asia LIC and Perpetual Equity Investment Company LIC have rewarded investors with a 5% fully franked dividend in the last 12 months.  Both of these LIC’s have material profit reserve accounts established.

Care should be taken not to pay a premium for LIC’s which is relatively straight forward as most LIC’s publish their asset backing regularly.

Dive believes the biggest potential trap for investors is looking at a company's historical yield and making an investment decision based on this single measure. 

Telstra for many years paid close to 100% of its earnings as dividends and some years borrowed to pay its dividend.  This continued until the NBN blew a hole in earnings and Telstra cut their dividend from 31 cents per share in 2016, over time to 16 cents per share in 2019.  Those who invested in Telstra when it was around $6 in 2016 based on historical dividends have seen their capital dwindle in their blinkered search for income.

Better than cash yields are on offer in today’s market, but care needs to be taken to avoid the ‘dividend traps’.

 

Every month, Mark Draper (GEM Capital) writes for the Australian Financial Review.  This article appeared in the paper edition of the Australian Financial Review on Wednesday 24th February 2021

Tuesday, 01 December 2020 08:42

Sydney Airport / Spark Infrastructure

The Investment Case

The four most dangerous words in investing are “this time it’s different” (Sir John Templeton).  The ghosts of the last tech boom, referred to as the dot-com bubble in 1999 seem to be restless, with some eerie similarities to today’s obsession with technology stocks and high valuations.

Douglas Isles (Investment Specialist, Platinum Asset Management) says “the current mania in technology stocks is not about the big names but about the breadth of companies trading on high valuations.”  This is seen in the table below which shows market capitalisation compared to GDP in the US share market, and compares the record level 170% to previous bubble episodes.  This valuation indicator has become popular thanks to Warren Buffett who in 2001 said “it is probably the best single measure of where valuations stand at any given moment”.

The cyclically adjusted price to earnings ratio, commonly known as CAPE, is another valuation measure applied to the US share market.  CAPE is defined as price divided by the average of ten years of earnings, adjusted for inflation. 

Isles says “the maths tells us in aggregate there will be considerable disappointment. But also, like 1999, the more interesting thing is the opportunity in companies that are not part of the mania. In 1999, the sectors being shunned were labelled the old economy.  Today the shunned sectors include emerging markets and cyclical stocks”.

There are of course differences in today’s technology stocks according to Nathan Bell (Head of Research, InvestSMART), who says “the dominant tech companies are perhaps the best businesses that we’ve ever seen and are extremely profitable.”  

Hugh Dive (Portfolio Manager, Atlas Funds Management) says that “Apple, Amazon, Facebook and Google are actually generating revenues and growing profits”.  He adds “what we haven’t seen in 2020 is the plethora of concept companies raising large amounts of capital solely based on having an idea that is similar to a hot theme”.

That said, the seven Buy Now Pay Later stocks trading on the ASX could arguably be described as an example of this phenomen.

Bell sees the flood of Initial Public Offerings (IPO’s) of untested business models where the business owners are selling heavily as a sign of a heated market.

Other ‘red flags’ that investors would be wise to consider include the record fund raising in the US into SPAC’s (Special Purpose Acquisition Company).  A SPAC is a company with no commercial operations that is formed to raise capital through an IPO for the purpose of acquiring an existing company.  Bell says SPAC’s are where investors essentially sign a blank cheque in the hope that management will find something useful to do with the money while Isles believes they look very much like the ‘cash boxes’ of the 1980’s.

Dive’s key red flag is “the re-emergence of novel valuation methods such as ‘price to revenue’ in order to value companies that are generating losses, and are expected to continue to generate losses for the near future before miraculously swinging into steep profit growth”.

Highlighting Dive’s point about the behaviour of investing into loss making companies, US investor Joel Greenblatt says “If you bought every company that lost money in 2019 that had a market cap of over $1 billion, and so there are about 261 of those, and you bought every single one of those companies, you’ll be up 65% so far this year”.

Similar to 2000, in 2020 we are being told not to worry about valuations either due to the effect of lower interest rates, or that companies have a long growth runway.  Dive highlights “the valuations of AfterPay (61x revenue) and even more mature and widely used companies such as Zoom (136 x forward earnings) assume both that current growth rates are maintained for numerous years, consumer tastes don’t change and that new competitors won’t emerge.  The lessons of the previous tech boom showed these assumptions to be heroic”.

Bell believes that “low interest rates can justify somewhat higher valuations than the past, but not 100 – 150% in my view.  Valuation still matters and very few tech stocks will justify current expectations over the long term”.

Microsoft’s peak share price in 1999 was US $59.97 which implied a price earnings multiple of 76.  The following year the share price fell more than 60% and it took until 2016 for the share price to trade above the 1999 levels.  Little wonder the ghosts are restless.

 

 

This article appeared in the Australian Financial Review during November 2020.

Bell Potter have produced a special report on developments of COVID-19 focussing on the virus itself with particular reference to Europe and the US.

The report looks at infection rates and death rates, comparing the first and second waves.

The analysis considers the likelihood of reaching herd immunity.  Complete with statistics and graphs the report is designed to assist investors reach their own conclusions about what may be in store for the world with COVID-19.

Download your copy of the report by clicking on the report below.

 

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