Why I don't think we're headed for a correction

Roger Montgomery, Montgomery Investment Management

February 2021

Over the last few months, increased risk-taking by investors has led to ballooning prices for loss-making businesses, IPOs in unprofitable firms, and speculative 'assets' like cryptocurrency. This is usually a signal that the market is too hot, and is due for a correction. Is the market at risk of an imminent collapse? 

There's no doubt pockets of exuberance exist. The recent activity in GameStop, the gold rush in electric vehicle and battery makers, and the surge in bitcoin more recently point to some seriously illogical, if not stupid, behaviour. Even in Australia convincing evidence of euphoria exists. The "buy now, pay later" sector here trades on a combined market capitalisation of $40 billion despite the requirement for dilutive future capital raisings to fund book growth and despite generating an annual loss of $82 million.

US-based billionaire futures trader Paul Tudor Jones, recently observed more US companies are currently priced at greater than 100 times earnings than ever before and the number exceeds, by half, those that traded at more than 100 times earnings during the dotcom bubble.

Bubbles deflating in isolation

Despite the clear evidence of bubbles in certain pockets of the market, however, I believe they can inflate and deflate in isolation. Indeed, we have already seen this occur. Last year, Hertz, Kodak and Nikola all rose between 600 and 1600 per cent in just a few months before crashing between 80 to 90 per cent. The bubbles inflated and burst and yet the broader market was uninterrupted. Similarly, the current bitcoin mania can crash without dragging the equity market down. It's done it before. It crashed - falling from nearly US$20,000 in 2018 to $4000 in 2019 - without any impact on the stock market.

Provided the entire market is not in a bubble, and the bubbling assets themselves are not held on the balance sheet of systemically important financial institutions, these bubbles can burst without wiping out the financial system or the returns for sensible investors who refrain from gambling.

What does a high PE ratio mean?

Speaking of the broader market, Robert Shiller's CAPE (Cyclically Adjusted Price Earnings) ratio for the S&P500 currently sits at its second-highest level in 150 years. The only time the ratio has been higher was during the tech bubble in 1999. Some commentators note that the elevated PE ratio is not only a sign of overvaluation but a warning of an imminent crash.  Robert Shiller himself, however, has noted the ratio is an unreliable tool for the prediction of crashes and prefers it to be used to estimate the average annual return for the forthcoming decade - something it is more reliable at predicting. Its lofty status suggests the next 10 years' average annual return for the S&P500 might be in the low single digits.

Of course, whether the market is overvalued or not depends on which measure you use. On standard PE metrics, the S&P 500 is trading at about 22 times predicted earnings for 2021, higher than the long-term average of about 16, but lower than the 30 it reached before the dotcom bubble turned into DotBomb.

25 per cent of the S&P500 is weighted to just six names

And before concluding the market is at risk of an imminent collapse, one must appreciate the fundamentals supporting the constituent companies, remembering 25 per cent of the S&P500 is weighted to just six names -- Facebook, Apple, Amazon, Microsoft, Google and Tesla - known as the FAAMGT stocks. The FAAMGTs are collectively worth more than $US8.1 trillion ($10.7 trillion), and account for almost one quarter of the $US33.3 trillion S&P 500.

For decades Warren Buffett espoused the importance of owning companies able to sustainably generate high rates of return on equity, noting that such performance could only be driven by the presence of a sustainable competitive advantage. Anyone who understands competitive advantages knows the most valuable is the ability to raise prices without a detrimental impact on unit sales volume. With the arguable exception of Tesla, in these monopoly companies inheres the most valuable of all competitive advantages.

Our own analysis reveals these companies to be incredible wealth creation machines. In almost every case their returns on equity are higher today than when they were smaller enterprises. The bigger they get the more profitable they become. Today's internet giants enjoy the benefit of infrastructure, such as computing power and storage, mobility networks and data speeds, that was inadequate back in 1999 when the first internet boom crashed. And there's a long runway for growth ahead.

Growth companies have simply seen more economic value accrue to them relative to more traditional companies with lower valuations, and unless antitrust legislation stops them, more value will accrue to their owners.

So, while the market does seem overvalued overall, there is merit in the idea that the companies driving the market higher have powerful economic moats and are themselves individually inexpensive -- excepting again perhaps Tesla!

Finally, as we discussed here, based on current bond rates (which of course could change - keep an eye out for a steepening yield curve) the Australian market appears to be fairly valued rather than expensive.

The market might be expensive but it is being driven by a serious weighting to companies with highly desirable and prized characteristics. Pockets of irrational exuberance do exist and they're easy to find but they can inflate and deflate without upsetting the rest of the market. And finally unless bond rates start to ratchet up, the market appears to be about fair value.

Australian Fund Monitors' CEO, Chris Gosselin, speaks with Dean Fergie from Cyan Investment Management about the Cyan C3G Fund's recent and long-term performance.

Since inception in August 2014, the Fund has risen +16.52% p.a. versus the ASX200 Accumulation Index's annualised return over the same period of +6.81%. The Fund has also achieved a down-capture ratio (since inception) of 58.2%, indicating that, on average, it has significantly outperformed during the market's negative months.

Funds operated by this manager: Cyan C3G Fund

The AIM GHCF investor presentation briefly covers how the Fund performed in 2020; Charlie Aitken (CIO) and Etienne Vlok (PM) also discuss where they see opportunities in 2021 and how they are thinking about market risk. The stock discussion focuses on a relatively unknown Japanese vision sensor business that is incredibly high quality with a concrete runway for growth.

Summary
1:15 CY2020 performance summary
9:47 Top 10 holdings at 31 Jan 21
11:43 Sector allocation at 31 Jan 21
13:10 Geographic revenue allocation 31 Jan 21
14:24 Portfolio characteristics
16:10 Stock discussion: Keyence
27:20 Biggest risk for markets this year
36:54 Where we are seeing opportunities
39:11 Our focus: returns on capital
45:59 Our views on currencies
48:00 Are markets speculative at present?
50:28 What are the policy risks under a Biden administration?
53:49 Why doesn't the Fund invest in banks?

AIM Global High Conviction Fund

Bingo catches a bid. Who could be next?

Dominic Rose, Montgomery Investment Management

February 2021

Bingo Industries (ASX:BIN) confirmed in late January that it has received an unsolicited, indicative takeover proposal from a consortium led by private equity firm, CPE Capital (formerly known as CHAMP Private Equity), and including a Macquarie Infrastructure Fund (Macquarie Infrastructure & Real Assets, MIRA).

The cash offer price of $3.50 per share (representing a 28 per cent premium to the pre-bid closing share price) values the waste management company at $2.6 billion, equating to c.15x FY22 consensus EBITDA ($169 million) and c.10x BIN's medium-term earnings target ($250 million).

We are not surprised to see corporate interest in BIN's long-life, infrastructure assets which are strategically leveraged to attractive themes like recycling, population growth and government stimulus. In the low growth, low-return world we find ourselves in (where global interest rates are approaching zero!) large global investors with very long-term investment horizons and very low costs of capital are increasingly bidding up long-life, cash generative assets across sectors such as waste, utilities, infrastructure, telcos, and datacentres. Consequently, a competing bid for BIN can't be ruled out.

Founded in 2005, initially a family-owned skip bin business based in Western Sydney, BIN listed on the ASX in 2017 and has grown to become a vertically integrated waste management company with the largest network of recycling and resource recovery centres in NSW and VIC with 4.6 million tonnes per annum total network capacity.

Timing of the CPE Capital proposal appears somewhat opportunistic considering the bid comes ahead of an anticipated cyclical upswing and benefits from the optionality associated with developing the recycling ecology park at Eastern Creek. The domestic housing market is showing strong signs of recovery while Federal and state governments are looking to lift recycling rates in Australia, which remain well below other developed nations, and to stimulate the economy by fast-tracking the infrastructure project pipeline.

Further, a privatised Bingo could potentially be used by the Consortium as a platform to further consolidate the fragmented domestic waste management industry, particularly if the competition regulator forces various asset divestments should Veolia Environment (PA:VIE) be successful in its hostile takeover of French waste rival Suez (PA:SEVI).

The implied 10x valuation on BIN's medium-term EBITDA target compares to the 9.6x (pre-synergies) BIN paid for Dial-a-Dump in 2018 and the 10x (pre-synergies) Cleanaway (ASX:CWY) paid for ToxFree in 2017.

CPE Capital is no stranger to BIN having acquired the company's Banksmeadow facility in Sydney for $50 million in September 2019 after the ACCC forced the sale of the asset following BIN's $578 million Dial-a-Dump acquisition. We also note Macquarie's infrastructure investment arm, MIRA, is one of the biggest infrastructure investors in the world with more than US$130 billion in assets under management and waste management investments in North America and Europe.

The proposal is currently being considered by an Independent Board Committee and the company has granted the consortium due diligence. If the deal goes ahead, BIN's largest shareholder, the Tartak family, will potentially roll its stake into the bid vehicle, effectively allowing them to invest alongside the PE led consortium and share in the upside potential of the business. CEO Daniel Tartak holds 19.8 per cent of the company while Director Bill Malouf speaks for a further 12 per cent.

We expect opportunistic bids like this to become an emerging theme in Small Caps over the coming years. So the question then becomes who else could catch a bid?

There are plenty of companies within our investable universe with highly strategic, high quality, long-life assets which could catch the eye of large investors in a low-growth, low return world. Two that spring to mind (that we own of course!) are Macquarie Telecom Group (ASX:MAQ) and Uniti Group (ASX:UWL).

Datacentres and telco fibre are digital infrastructure for tomorrow's economy. Evidence of recent appetite for such assets includes Aussie Super's proposed acquisition of Infratil (NZX:IFT) (whose biggest asset is Canberra Datacentres, a close peer for MAQ) and Aware Super's bid for Opticomm (which UWL ultimately secured). We think both MAQ and UWL remain materially undervalued for their quality and growth characteristics...and given recent interest in the sector, perhaps private investors will see what we see?

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The Most Volatile 12 Months in the Last 10 Years - How Did Active Managers Fare?

Australian Fund Monitors

25 February 2021

The 12 months through the end of January marks one of the most volatile periods for equity markets in the last 10 years.

• In March 2020 the ASX 200 Total Return Index recorded its largest single monthly fall in 10 years falling -20.65%, while February 2020 it fell by -7.96%, the 3^rd largest fall in 10 years.
• Fortunately for investors, the last 12 months also included the 2 largest single month gains over the last 10 years with the ASX 200 Total Return Index bouncing back in April by 8.78%, and again in November by 10.21%.
• For all that volatility - or perhaps because of it - the ASX200 Total Return Index fell by -3.11% over the 12 months.

While not quite as volatile, global markets returned similar statistics.

• In 2020 AFM's Global Equity Index had 10-year record monthly loss in March of -8.07%, and -5.57% in February.
• As expected, the Global Index also bounced back in April by 4.15%, and then had the second-best month in the last 10 years in November.

The bulk of investors in Australia get exposure to these 2 markets via both passive and active fund managers. The outcome for passive equity investments is shown in the points above - in other words investors in a "passive" ETF will broadly match the index, after allowing for fees, but how did Active Managers both globally and domestically perform through this period? Looking at Long Only Managers we note the following points:

• 79 of the 97 or 81% of Australian Equity Funds beat the index through the 12 months, and all but 11 of these funds beat the index over the last 3 years, showing they have been able to sustain outperformance through the cycle.
• 23 Australian Equity funds lost more than 25% in March 2020, but 18 of these went on to record an outperformance over the index over 12 months.
• The defining statistic for those Australian Equity funds that outperformed was their "Up-Capture Ratio" which measures their cumulative performance during the market's positive months. The average Up-Capture Ratio for the top 20 performers was 193.6 (any number over 100 shows outperformance, so 193.6 means they rose at almost double the rate of the market, confirming significant value can be derived from active management.
• Global funds found the going far more difficult with 36 out of 53 funds outperforming the global market (68%). However, one third of the funds that outperformed in the last 12 months failed to beat the benchmark in the previous 3 years.
• As with Australian Equities, many Global funds - 33 in total - underperformed in March, while only 22 of these went on to outperform over the full 12 months.
• One of the key statistics for Global funds that did outperform was their Down-Capture Ratio, which measures their cumulative return when the market is falling. Unlike Australian Equity Funds, their most successful Global peers were those that gained against the market during the negative months. The average Down Capture Ratio for the 15 best performing funds was just 43.4 showing that these funds on average only fell less than half as much as the index when markets were negative.

The data shows that volatility can be a friend for Australian Equity funds, although that volatility may test the mettle of many investors. For Global fund investors it may be useful to note the quote from Warren Buffett - "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1".

Of course, we all know that's easier said than done. However, one way to reduce volatility, or avoid large losses, is to ensure diversification across markets, strategies and asset classes, and ensuring that the correlation of those diversified funds is as low as possible.

Australian Fund Monitors' CEO, Chris Gosselin, speaks with Robert Swift from Delft Partners about the Delft Global High Conviction Strategy. Since inception in August 2011, the Strategy has risen +14.93% p.a. with an annualised volatility of 11.78%. Over that period, the Strategy has achieved Sharpe and Sortino ratios of 1.08 and 1.97 respectively, highlighting its capacity to achieve good risk-adjusted returns while avoiding the market's downside volatility.

Longlead was founded in 2014 and is a specialist long/short equity manager with a core focus on Asia & Australia. The team at Longlead have recently released and Australian Domiciled Wholesale Unit Trust based on their existing Longlead Absolute Return Fund.

The Longlead Absolute Return Fund was started in July 2017 and has returned 29.24% per annum since inception. For most investors the proof of an absolute return manager is in their performance during down markets, and Longlead have provided investors with a positive return 64% of the time when Asian Pacific markets are negative, generating significant outperformance.

Bubble, bubble, toil and no trouble!

Montgomery Investment Management

February 2021

There are a number of arguments being advanced to suggest the stock market is in a gigantic bubble that is at risk of bursting imminently. Some of the arguments relate to broad overvaluation, the tidal wave of overpriced IPOs that double on listing, and the observation that interest rates remaining low forever is tantamount to the unrealistic, and previously unrealised, expectation of high rates of earnings growth being sustained forever.

For this article however I want to look at the market's valuation compared to bond yields to help understand the extent of any euphoria in markets that may cause them to be at risk of imminent collapse.

Australian ten-year bonds have traded almost in lockstep with their global peers over recent decades, and since the early to mid 1980's bond yields have been in inexorable decline.

Source: Tradingeconomics

According to Bloomberg, the ten-year Australian bond yield is 1.17 per cent. The bond yield will move independently of short-term cash rates set by the Reserve Bank of Australia, so while the RBA Governor Philip Lowe has made it clear that the overnight cash rate of 0.1 per cent will not be moving for some years or until inflation is "sustainably" in the target band of 2-3 per cent, that does not mean the yield curve cannot steepen with ten-year bond yields rising.

Nevertheless, the starting point for one method of assessing equity market valuation is the ten-year bond yield. To that yield we add an equity market risk premium. On this number there is much conjecture. The equity market risk premium is the average return that investors require over the risk-free rate (ten-year treasury bonds for example) for accepting the higher variability in returns that are typical of equity investments. In other words, the Equity Market Risk Premium reflects a minimum threshold that motivates investors to invest.

Investors and academics have long debated this number, which of course changes over time. Turning to the RBA again, and its June 2019 Finance Bulletin - The Australian Equity Market over the Past Century[1], reveals the following:

"Using the updated dividends data, the new historical series (extended with available data for more recent time periods) imply that the total nominal return on equities (i.e. the sum of capital gains and dividends) has been around 10 per cent, per year over the past 100 years (based on a geometric average which allows for compounding over time). In real terms - i.e. after accounting for inflation - the average annual return was about 6 per cent. There have not been material differences in returns across sectors over this time, although of course there have been periods in which sectors have performed differently. Over the same period, the total nominal return on long-term government bonds has been around 6 per cent, implying an average equity risk premium (excess return of equities over safe assets) of around 4 per cent."

So, to the bond yield of 1.17 per cent, we should add four per cent for the equity market risk premium. The product of the two is of course 5.17 per cent. This is the theoretical fair value Earnings Yield for the market.

The Earnings Yield is of course merely the inverse of the Price Earnings ratio so, by dividing 100 by the earnings yield we can arrive at a theoretical fair PE for the market of 19.34 times earnings.

If the 1-year forward PE of the market is much higher than this, investors are willing to accept a narrower than reasonable future return above bonds, given the risk of investing in equities.

According to Bloomberg at 12.17 pm on 3 February 2021, the 1-year forward PE for the ASX200 (excluding loss making companies) is 19.26.  By including loss making companies the 1-year forward PE is 20.55 times suggesting there is only marginal enthusiasm for equities overall.

This picture of course changes throughout each day. As bond yields rise, the fair value of the market falls, and the reverse occurs when bond yields decline. If bonds yields do begin marching materially higher the risk for the market rises, even if the market itself does not rise. This is because the fair value PE would decline moving further below current levels.

Today, as it stands however, on this measure at least, it doesn't appear that the Australian stock market is in a bubble.

[1] https://www.rba.gov.au/publications/bulletin/2019/jun/the-australian-equity-market-over-the-past-century.html