• Not all areas of the market that are benefiting from the recent shift in market sentiment are good places to invest.
• A balanced view that includes assessment of value and quality in addition to sentiment points us to six sectors that are particularly attractive in this environment.

In recent weeks, market sentiment has undeniably shifted away from relatively expensive, high-risk, low-quality stocks. To illustrate the magnitude of this aggregate shift, it's helpful to compare our measures of sentiment with our assessments of value, quality, and risk.

The correlation between sentiment and value has shifted from negative to positive over the past two months; the already positive correlation between sentiment and quality has become higher over the same period. At the same time, the correlation between sentiment and high risk has plummeted. Figure 1 shows the extent to which investors recently have been turning their attention toward more reasonably valued, higher-quality, lower-risk stocks.

Figure 1

Correlation of Active Quantitative Equity's Proprietary Sentiment Scores with Proprietary Scores for Value, Quality, and Risk

That said, in our view not every area of the market with improving sentiment is a good place to invest, and not every segment with deteriorating sentiment should be avoided. Consumer Services and Real Estate both remain unattractive on our measures, despite their improvement in sentiment in recent months. In general, Consumer Services firms still represent very poor value (when taking quality considerations into account). And although many Real Estate companies continue to be of high quality, our signals - which quantitatively analyze the language used in earnings conference calls and in the explanatory notes of financial reports - are concerning.

The six market segments we most favor in this environment of shifting sentiment (in no particular order) are Health Care Equipment, Banks, Insurance, Technology Hardware, Autos, and Semiconductors. Our preferences are not always based on improvement in sentiment (see Figure 2). For example, although the broader Health Care sector has experienced heavy deterioration in market sentiment, we still like Health Care Equipment and Services, especially in the US. The language signals from Health Care Equipment and Services companies' conference call transcripts and financial reports are very strong, valuations are reasonable, and quality is high.

Figure 2

 AQE's Current Most-Favored and Least-Favored Sectors

Banks have benefited from improving sentiment in recent weeks. While we favor banks overall, that improvement in sentiment is not the sole source of that positive assessment. Drilling down to examine banks by region reveals some important distinctions. European banks have seen a much larger improvement in sentiment than their North American counterparts, but we view European banks as only neutral in attractiveness compared with cheaper North American banks.

The same multi-dimensional view informs our negative assessments as well. Sentiment toward real estate stocks across the developed world has improved a lot in recent weeks, but in Europe sentiment toward real estate stocks has actually gotten worse. Our language signals for European real estate names are also very poor.

Bottom Line

Sentiment has turned to favor attributes we like, including high quality and cheaper valuation. When choosing stocks, however, it's important to weigh all important attributes, including value, quality, and risk - as well as sentiment - in order to avoid simply riding the latest sentiment trends.

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Richard Ivers, portfolio manager for the Prime Value Emerging Opportunities Fund, has notched up his first three years in charge of the small caps investment fund.

Markets have thrown just about everything at investment managers during this time: from flat spots to record highs, and the 'fastest bear market in history', which happened as COVID-19 panicked investment markets.

Ivers steered the Prime Value Emerging Opportunities Fund to several key milestones, including being the second best performing Australian equities fund for the 2020 calendar year.

He has delivered returns well above the market by prioritising capital protection. "Protecting capital is the most important step for us because if we minimise losses we maximise opportunities.

"Every market event creates opportunities. The volatility we have seen in small caps across COVID has provided us with excellent chances to invest in quality companies poised to do well during the recovery and beyond.

"But it all starts with a commitment to preserving capital, which means avoiding the speculative stocks and looking through the hype to find real quality."

Key numbers for the Prime Value Emerging Opportunities Fund:

For the last three years the Prime Value Emerging Opportunities Fund has delivered 20.7% per annum to investors while the index returned 9.1% per annum - this means the Fund has outperformed the index by 11.6% per annum net of fees.

During this three years:

• The Fund has outperformed 87% of months when the index has fallen (13 months out of 15)
• Outperformed 52% of months when the index has risen (11 months out of 21)
• Outperformed 67% in total of all months (24 months out of 36).

The last time the Prime Value Emerging Opportunities Fund underperformed in a falling month was December 2018 - over two years ago.

For the year to 30 April 2021 the PVEOF has delivered 54.91%, outperforming the small ordinaries accumulation index by 15.14%, outperforming strongly during 12 months of rising markets.

The Fund has delivered 13 consecutive months of positive returns, while the index has had three negative months during that 13.

The Prime Value Emerging Opportunities Fund's last negative returning month was March 2020 (during the COVID crash).

Performance has been achieved at a lower level of volatility than the market: risk, as measured by volatility, (standard deviation) has been 13.8% below the index. This results in a far superior Sharpe ratio, which measures risk-adjusted returns.

Most articles we read are about hot stock tips to buy. Occasionally there are articles about "shorting" opportunities, albeit most are directed to sophisticated investors given the risks around shorting (i.e. a potential loss that exceeds your initial investment). Very few articles talk about when to sell.

However, it can be just as important to know when to sell as when and what to buy, a key skill in active management.

The Redbubble thesis revisited

Last year, we highlighted Redbubble as a COVID winner with global aspirations. The business was a significant beneficiary of lockdowns and stimulus payments - with their years and dollars of investment in the artist platform, logistics and supply chains - paying dividends during the global e-commerce boom, especially in their key US markets.

The company's execution during this period was stellar as it managed the significant spike in sales volume during the COVID work-from-home period. It was quick to take advantage of the boom in facemask demand - an entirely new product category - which immediately became a major contributor to revenue.

The marketplace platform also demonstrated the power of operating leverage, as 96 per cent growth in Revenue delivered 1,028 per cent growth in EBITDA (albeit off a low base) in the December 2020 half. Incremental margins of 25-30 per cent helped drive improved profitability. The Redbubble flywheel helped generate interest during lockdowns, with significant social media interest on Tik Tok and Twitter as well as more mainstream media articles drive users.

With all these positive tailwinds, why did we sell out of our holding in Redbubble?

In my previous article, the empirical paper "Selling Fast, Buying Slow" referred to three discrepancies between the buying and selling performance of investors:

• Investors displayed clear skill in buying - positions added to the portfolio outperformed both the benchmark and a strategy which randomly bought more shares of assets already held in the portfolio;

• Selling decisions failed to beat a no-skill strategy of selling randomly chosen positions - the level of underperformance was observed to be significant, such that it dragged down performance by 50 to 100 basis points; and

• Selling decisions coinciding with releases of portfolio-relevant information outperform - for example, following the release of company earnings announcements.

It is the final point which is relevant in our decision to sell our remaining holding.

Assessing earnings risk

At Montgomery, we not only focus on the price vs valuation of our investments but also the earnings risks - either higher or lower than market estimates. In many cases, it is these earnings risks that provide significant upside or downside potential relative to the current share price - especially for less mature businesses - as they drive the growth trajectory of future earnings.

For Redbubble, the share price faced its first significant road-bump following its DecH20 result released in February. The update revealed some additional costs related to paid acquisition and shipping, as well as reduced gross margins related to promotional activity in the December quarter. Some of these took the market by surprise, and the share price sold off ~15 per cent in the weeks following the release as it too caught up in the broader "rotation" out of e-commerce winners.

Earnings risk assessed for March quarter underpins exit thesis

The next stock-specific catalyst was the March quarter sales update. With the share price re-based to $5-6/sh after some margin-related earnings downgrades, it was important to assess the likely trajectory of earnings for the June half of FY21.

There were two key areas that underpinned our decision to sell prior to Redbubble's March quarter earnings release:

Contribution of face masks to revenue

While many investors were aware of facemasks being a significant contributor to revenue growth, there were few estimates of the quantum of revenue contribution.

After peaking at ~25 per cent of revenue in July, we assessed facemasks had declined to ~5-7 per cent of revenue exiting December. This has a significant impact not only for Redbubble's revenue for March, but also the difficulty in "comping" elevated face-masks sales that were unlikely to be repeated in the September quarter 2021.

We also assumed even if COVID did not recede, facemasks were unlikely to be a significant repeat contributor in the key US market due to i) greater competition in masks; and ii) warmer months in the northern hemisphere in conjunction with vaccine roll-out.

Impact of currency on revenue growth

Given the volatile moves in currency and the US' contribution to revenue, this represented a significant swing factor in our estimates of Redbubble's revenue trajectory.

With >70 per cent of Redbubble's revenue from North America and the strength of the AUD vs USD, this represented ~15 per cent headwind to its top line versus the prior comparative period, which we assessed had yet to be fully factored in market earnings estimates.

Where we could have been wrong

While the decision to sell ahead of its April earnings release may appear to be obvious in hindsight, there were factors which we had to consider where we may be wrong:

• The market may have looked through currency impacted growth - our assessment of 80 per cent top-line is still impressive;

• An accretive, complementary transaction given its extremely strong balance sheet - which we deemed lower risk given RBL's organic growth opportunities and relatively new CEO;

• Potential recovery in gross profit and EBITDA margins;

• Our sales estimates are wrong, and the company could deliver higher than expected.

All of these factors (and other unexpected positive developments) may have resulted in a higher share price. Despite this, we deemed the risk skew to the earnings and subsequent share price impact was to the downside.

Where to given sell-off?

With the Redbubble share price having re-based once again (more significantly than we had anticipated) - and with incremental new future sales targets, earnings and profit margins and investment focus areas, it may be worth re-assessing the shares once again as an investment opportunity.

Many of the aspects which initially attracted us to the Redbubble business - the flywheel, operating leverage, investment in supply chains, global reach and aspirations - remains intact.

There is also increased awareness of the Redbubble brand given the spike in website viewer traffic and new customers acquired during COVID.

It is also clearly a much more valuable company coming out of COVID than it was going in, and should new CEO Michael Ilczynski and the Redbubble team start delivering on its aspirational targets, will likely become more valuable over time.