Sage Capital emphasises style neutral portfolio construction, encompassing both quantitative and fundamental analysis and an ability to take long and short positions. We have a very liquid, diverse portfolio and are focused on a repeatable investment process that we expect to consistently generate returns through time, including through volatile markets. The two thematics that demonstrate how we are applying our thinking at the moment are first, our approach to growth stocks and secondly our approach to yield.
Markets have rebounded strongly from a sharp collapse in March, with many stocks now trading at new record highs. This has been driven in part by central bank stimulus, but also substantial fiscal support from governments. Much of this liquidity has found its way into growth stocks and the technology sector in particular. Valuation multiples have expanded significantly and while it is tempting to describe this as a bubble in the making, it actually makes sense in an environment where central banks have cut cash rates to zero and driven bond yields down to similar levels. This drop in discount rates has made growth stocks incrementally more valuable.
While growth and technology stocks have risen strongly on this thematic, this doesn’t mean that they are low risk investments. For instance, good news in markets and stronger growth could cause central banks to pull back on liquidity and taper bond purchases. This could prompt volatility across high growth stocks so it’s prudent not to have too much exposure to this dynamic. Instead we conduct deep analysis to identify the better stocks within our broad market sectors. Our fund structures allow us to take advantage of these insights by taking long positions in the most attractive stocks and short positions in the least preferred. This allows us to generate returns from a broad range of stock positions across the portfolios.
Within the Sage growth sector there are two stocks, global artificial intelligence (AI) pioneer Appen and online recruitment firm Seek, that demonstrate why it’s important to understand the fundamentals that drive earnings and valuations. It’s important to understand that, when we set our long and short positions, we’re not necessarily looking for stocks that will fall and rise in absolute terms, we’re looking for relative performance.
In Appen’s case, we believe it demonstrates superior relative value compared to Seek. Appen provides human annotated data sets to help companies like Facebook and Google constantly improve their AI algorithms for search optimisation, e-commerce and speech recognition. Appen utilises over one million contractors who annotate data in relevance, language, video and image sets. Some forecasts estimate AI data spending will grow by up to 40 per cent a year to create a US$17 billion market by 2025. Appen, by far the biggest player in this market, is itself growing organically at 30 per cent a year. On top of this, it has made a number of smart acquisitions, which have supercharged growth to 59% p.a. since 2014.
Another reason we believe this company is relatively attractive is because it’s building on its competitive strengths. It has access to 5 times the data of its nearest competitor and it’s using this advantage to train its proprietary learning tools. As Appen processes more data, its own algorithms learn and become more efficient, giving the company a pricing advantage over smaller peers. Near term, the US election is an opportunity for the business given social media platforms are an important client for Appen. The Cambridge Analytica scandal marred the outcome of the 2016 US election after Facebook failed to adequately monitor its algorithms, a failure political interest groups then exploited. Going into the US election, we expect strong demand from the major social media platforms for Appen’s services as avoiding a similar scenario this time is top priority.
Appen is trading on a price-to-earnings (PE) multiple of 47x. This may seem extreme, but it has re-rated less than many other growth stocks and is relatively cheap compared to Seek. Seek has a one year forward PE multiple of 64x, which is far in excess of Appen’s, but it isn’t generating the same growth.
Recruitment firm Seek is a long-term growth stock, which has benefited as job ads have transitioned from newspapers to online. But earnings haven't grown since 2015 and the company has been beset by a series of downgrades which the COVID-19 pandemic has accelerated. Seek has also been affected by the maturation of the migration from print to online, as well as increased competition from LinkedIn and aggregator sites like Indeed.com.
Seek does have some potential to generate growth. It is pursuing new, offshore markets and it has had some success in China with Zhaopin, although this business’ shift to a freemium model has generated revenue growth that hasn't translated into bottom line or EBITDA growth. It also has the ability to pursue value-added opportunities, such as charging higher prices for high-paying jobs listed on its site, which is a trend among similar domestic portals. In our view, there isn’t sufficient visibility around the success of such changes in the business model to justify the valuation multiple in the share price.
When we compare these two stocks, Seek’s share price growth has outpaced its earnings-per-share (EPS) downgrades, with the falling cash rate and quantitative easing inflating its valuation. In contrast, Appen’s EPS is continually growing, supporting the re-rating of its share price upwards.
The following chart of share prices highlights that Appen (green line) has delivered far greater capital growth despite Seek (white line) enjoying a larger valuation re-rating.
From both a quantitative and fundamental perspective, we look for companies that are going to deliver the most earnings growth over time. Comparing these two stocks, Appen is becoming a better quality business with more competitive advantages and more repeatable earnings growth than Seek.
Across the Sage yield sector, we also see opportunities. We think Credit Corp, a debt collection company with operations in Australia and the US, is relatively attractive. The experience of the GFC highlights that debt collection companies do well immediately following a recession as banks sell off high volumes of bad debts, creating a buyer’s market for companies like Credit Corp. Indeed, Credit Corp’s strongest returns on invested capital came in 2009-11.
This opportunity couldn’t have come at a better time for Credit Corp. The business has net cash and has plenty of capital to deploy. Its Australian competitors, such as Collection House, Pioneer Credit and Panthera Finance are all in serious trouble. Even before the crisis hit, they were all over-geared. Indeed, in the last 12 months both Pioneer and Collection House have been in a trading halt pending debt restructuring discussions with creditors. These peers make up more than 50% of the Australian debt collection market. To satisfy their creditors, peers adopted aggressive collection practices which has led to increased customer complaints and angered major debt sellers. This environment has shifted seller preferences towards Credit Corp. Over the next few years, it should be able acquire debt books at attractive prices from receivers, grow its market share in Australia and generate high returns. There is a lot to like about this business.
Banks are the relative losers in this space, particularly Westpac and Bendigo Bank. One of the core drivers of bank profitability is net interest margins (NIM) which is the spread between what banks lend at and the cost of their sources of funds. NIMs have been trending down for many years as competition has whittled away at them, but the COVID-19 crisis has seen this pressure intensify. Banks traditionally have some very cheap sources of funds from transaction accounts that pay little interest, but as the RBA has driven cash rates down towards zero, lending rates have fallen faster than their cost of funds (because part of that funding source was already near zero). This places pressure on NIMs. Changes in the regulatory approach from APRA also means there is intensifying competition for high quality low risk borrowers. This has been a key source of profit for the major banks and is coming under increasing pressure from non-bank lenders.
There are also some tail risks for the banks around bad debts. With 10% of home loans and 30% of small business loans in forbearance due to the COVID-19 disruption, they are all increasing provisions for bad debts, but it very unclear how bad it will be. With significant change in spending patterns across the economy there are many winners and losers. The banks generally have downside risk to the losers through bankruptcy and credit losses while they gain little from the stronger profits of the winners. These structural and cyclical pressures make banks a good source of funding for a long position like Credit Corp. Those banks with greater exposure to NIM compression like Bendigo Bank or a higher proportion of investor lending like Westpac are our least preferred amongst the banks.
The experience that comes with managing money through different cycles means that we are able to quickly recognise new and emerging risks. At the moment, we remain intensely interested in the balance between economic growth and central bank and government support that is driven stock performance across the market. We manage this risk, along with many others, dynamically, by ensuring there is adequate diversification in the portfolio and getting the right position sizing on stocks.
This involves being broadly neutral across our eight Sage Sectors to avoid any style bias and minimise the impact from economic shocks. We also maintain a broad range of active stock positions to reduce the reliance any particular stock idea. We increase or reduce position sizes in line with our conviction, taking into account liquidity. We tend to take bigger positions in larger stocks and take smaller positions in less liquid stocks. Overall market volatility will also strongly influence our position sizing. In the current high volatility environment, we are able to take smaller individual stock positions and still meet our return targets. The sweet spot for the portfolio is in the top and middle part of the S&P/ASX 200 where there is a good blend of liquidity and potential for strong stock performance.
In today’s complex and changing markets, we continue to use both quantitative and fundamental inputs to deliver the breadth and depth of analysis necessary to drive insight across our investment portfolios. This allows us to offer a genuinely style-neutral investment portfolio that we believe is appropriate for current market conditions.
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