Money is no longer free, investor risk tolerance has come right back, we’re living with higher rates and then there’s the cost-of-living crisis. So how have mid and small caps been impacted in the most recent reporting season?
James gives his insights into February’s reporting season, covering the companies that disappointed and why quality businesses have been rewarded.
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Andrew: Welcome to Fidelity Sound Bites. A straight to the point, monthly podcast where some of Australia's leading portfolio managers share with you what's happening in markets, how they're positioning their portfolios, and the outlook ahead. I'm your host, Andrew Dowling.
Once again James Abela joins us as we look back on the February reporting season. How did mid and small caps perform? And what's the latest news?
Thank you, James, for joining us.
James: Thank you, Andrew.
James, so how are you feeling? It's a big month. There's always lots of news, lots of obviously meetings that you guys have with companies. How did how did the markets perform over the month, particularly on the mid and small cap front for yourself, and did reporting season goes as expected?
James: it's always a very, very busy month, I call it the tsunami of information here in February reporting season. The tsunami definitely did come in, and came in hard. It was a bit of a softer month for the market. The market had a lot to worry about, a lot to absorb. So it's still all those things that the market was worrying about what kind of confirmed in the reporting period. So inflation was there, cost pressures were there, consumer weakness was there. And I feel like the market really wants to be positive. It wants to be hopeful, where there was good results, where there was earnings growth and earnings certainty the market rewarded it. But when there wasn't, the market really punished it. So stocks, like Dominoes and Downer or where there was real disappointment, they were down over 30%.
Andrew:And Downer has a big Downer.
James: Yeah a big downer. Confidence was really, I guess, softening. Recession fears are still there now. So you're generally really positive. Everything was very up, markets were up, confidence was up. But February was much more sort of Reality Bites month. And that's what really happened. So it was much, much weaker. And yeah, consumers I think are really starting to feel the pinch now. So yeah, just an anecdote. I went to Aldi on the weekend and it was packed. I mean, they're very busy whenever I can find a bargain or find a discount offer. Even lining up the petrol around the airport, there was a line of about 30 or 40. Cars lining up petrol was about 10 to 20% cheaper than sort of normal. So it is really hurting and I think consumers are feeling it and you saw the results right across the board.
Andrew and to that point, if I think back to the last reporting season, the RBA cash rate was 1.85. It's now doubled, as you mentioned earlier.
James: Correct.
Andrew: It's a huge impact on households across the board. Paul and I were discussing earlier how some households have gone from a feeling like they're living to existing. Whereas, depending on, you know, if you've got term deposits out there, you've seen a massive increase in the income generated from those. So how do you then think about that, in terms of your portfolio, the company's? What have you observed from reporting season? And, you know, how does that then play out as to what you decide across the portfolio changes if that's, that's relevant?
James: Yeah, didn't actually make any huge portfolio changes during February. But the reality of the cost of living crisis, I guess, Australia is quite late to the cycle. But London, and Europe really felt it straight from when the when the gas price lifted from the Ukraine war. We were quite late, we're really only feeling it because of interest rates and housing, and so much debt in our country. So really, we have been delayed. So we are really behind the EU or the UK, and somewhere also behind the US. So when you think about a portfolio really pricing power is really what you need to focus on. Can you pre price your product? reprice your service for that increase in costs? Increasing inflation, increasing cost of capital, all these are going upward right now. And if you can't price, you are getting a margin squeeze. And then also the competition is also increasing as well. Because of that reason, the intensity around margin, trying to maintain margins just becomes more focused. And I think that's what you really need to focus on. So the market structures and pricing that was really, really important. And wages are also coming up, there's a lot of talk of turnover, there's a lot of talk of labor being very tight still - which means if you have a very high turnover, productivity falls, so you know, there are knock on effects. And that's, I think, where you know, where you really need to be focused. On the other side of that is, is really the value rally started to wane now. That was huge I guess, six or seven months at the end of last year. And that has now started to wane, because if companies don't have the earnings growth to justify the valuations that are just run because of value rally, they need to be running on earnings; earnings and certainty. And that's what you really need to be providing. So that's where quality stocks did pretty well, in this reporting season.
Andrew: And just on that, sort of, in the context of your QMTV process: Quality, Momentum, Transition and Value. Certainly since the inception of the strategy, nearly 10 years ago, you've had different quadrants that have been at different extreme points, anything at the extreme at this point, either positive or negative direction when it comes to those quadrants?
James: Yes. It's very interesting now.
Quality is now pushing into the 45%. So heading towards the maximum of 50% of the portfolio. If you roll back six months ago, that was at 40, because valuations were incredibly high. Now it’s moved back as we've moved into good results, they've got good earnings, good certainty. I've topped back into quality, so it’s sitting around that 45-46 level where the model is around 40.
Value is still at around 12 to 15%. So it's still quite high. Momentum is the extreme. So momentum is absolute minimum 20%. And only choosing those stocks in momentum where there is good cyclical certainty, good cyclical growth, and the valuations are quite reasonable. So there's none of that. All of those sort of momentum parties or bubbles happening over the last few years in terms of e-commerce or buy now pay later, all those momentum clusters have really, really shrunk or disappeared. So I don't own, I didn't own any of those are the through cycle through that big bubble, period. But now there is not a lot of momentum in the marketplace. So in terms of weights, that's really where we are.
Transition’s quite high. Transition and Quality is about a third. Momentum is quite low, and quality is nearly half.
Andrew: So going from momentum to no-mentum?
James: Correct. There's really, really no momentum and that's a very, you know, comical but very topical thought process right now, because there is no real momentum rally in the marketplace. Money is expensive, everything is expensive because of inflation and cost of capital. So the hurdles now are much higher. So you can't just be a cool sock in a cool theme and rattling at five or 10 times price to book, or 10 times price to sales. You need to be giving the market earnings and certainty and if you can't do that, you don't have any price momentum or holding a valuation right now.
Andrew: And to your point earlier, one of those very big momentum clusters was the buy now pay later sector. Is that more like buy now, pray later? What does that model look like as we move forward with the cost of money?
James: What's caught up with those three, that that sort of stock concept is really three things.
One is the cost of money has gone up a lot. So the hurdle is much higher, that it is affecting their funding costs. And then also, the second part of it is valuations are a lot tougher. You need to provide that earnings and certainty, and those stocks often not provide any earnings or certainty. So that's also caught up with them.
And then thirdly is just really the attitude towards risk has changed very dramatically, and the attitude towards momentum and themes has changed very dramatically. So there's nothing really in their favor.
And then finally, to wrap all that up is regulation is now coming in. And regulation are now more focused on classifying these things as credit, whereas before they weren't, that could work around those regulations. And now they're being brought into the fold, which was talked about two years ago, that didn't end up happening. But now it's much more advanced, and it's a bigger part of the market and the regulators are now moving towards it. So it's become a much more challenging environment for that whole sector.
So more like giving credit where credit's due, as opposed to where we were a few years ago?
James: Correct. And credit it's no longer free, I guess, because money is no longer free. So it all sort of feeds off itself. And then like I said it’s Reality Bites in many respects for the market at the moment. And that is definitely one area where reality has been.
Andrew: And just in terms of where have we landed with reporting season, certainly some very material reactions across the board. Do you sort of feel that was pretty much in line with what you expected or was there any sort of major surprises?
James: The really good results were in the sort of technology space. So Altium, WiseTech for example, they had strong rallies that didn't move very much, but they did recover their losses or volatility, so they've held their ground quite well. So Altium and Wisetech did well. Hub and Netwealth also did well, so FinTech. So technology was also quite strong. The other area was travel. So COVID recovery themes, so Flight Centre, and Auckland Airport both had good results, so that was quite positive. And financials as well, so insurance brokers and the insurance sector overall has also done quite well. So those three were really positive. Then the negatives, I think were where they were expected. Consumer was quite weak, ecommerce was very weak. And then you had the significant negative surprises from companies like Dominoes and Downer, which, again, outlooks are weaker, management changes in Downer - it creates fear and uncertainty in the market. So if like I said, if you can't provide that certainty, especially in this market, stocks have been really, really sold off. So that's where that you know that occurred. But generally, if you're a quality business, and you're very stable, and you gave the market have a good feel of confidence, you've done quite well. And that's what really happened in those three areas of tech and insurance and COVID recovery travel.
Andrew: So the value of certainty has never been higher in some respects?
I completely agree. That's the big thing. The cost of money has gone up and now the value of certainty has gone up, which is where generally Quality and Transition do well because they have positive catalysts, they have outlooks, they have milestones, they have sort of visibility, the market is there. Whereas Momentum and Value tends to work on greed and fear. So when the markets are greedy, limited to really works, when the markets are scared, value really works. But in this axis of Quality and Transition, the markets is very idiosyncratic, very stock specific. Stock picking really, really matters. And it's it's much more idiosyncratic to those stocks.
Andrew: And just finally, as opposed to picking stocks, if you had to pick a song that sums up the February reporting season. What would it be?
James: I went to the Harry Styles concert with my family on the weekend. And it was it was phenomenal concert. Certainly that song, ‘As it was’ really running through in my head in terms of where we are in market right now. And he says in the song, “it will never be as it was”. And that is really, I guess the psyche of the market right now. We had money, you know, only a few years ago, which was free. Risk tolerance was really high. The cost of risks was really low, spreads were incredibly low. Everything's very easy. And at the moment is almost the opposite. It's not as as was. That was the past and now we have a reality bites from inflation, travel costs in terms of fuel, labour costs are higher, cost of capital as interest rates are higher, competition is higher or aggressive, consumers are weak, business confidence is kind of there, but it's not really strong. So I think it will definitely, the environment is not as it was, and that for me, that Harry Styles song sums it up really well.
Andrew: So as it was, to it is what it is. On that note, we'll conclude the episode today. Thank you once again for sharing your insights and observations, James. Great to see you again. And if you have enjoyed this episode, please share it with a friend and colleagues and subscribe to your favorite streaming platform for this podcast and we look forward to having you join us next time. Thank you.
James: Thank you
SS:
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