“These moves in the market are like a tale told by an idiot: full of sound and fury, signalling nothing”
The quotation is attributed to Jack Bogle (paraphrasing Macbeth, although he never mentioned markets!) the octogenarian founder of Vanguard Group, the world’s second largest asset management group. Jack has a habit of bringing a good degree of common sense during times of stock market stress and in his 86 years has seen a great deal. Furthermore, with US$3 trillion of passive funds under management at Vanguard, he is well placed to assess markets more objectively than the active funds that are causing the current upheaval with their manic trading.
Jack urged investors thinking of selling amid the current market turmoil to sit tight commenting “This is speculation that we’re seeing out there, and you can’t respond to it.”
While the share prices of some stocks had clearly risen too high, corporate balance sheets are, for the most part, in excellent shape with plenty of cash. The exception is the beleaguered oil and gas sector which has been a primary beneficiary of cheap money over the past few years and is now paying the price. However, even in oil and gas world there are plenty of well capitalised businesses that will exit the current maelstrom in terrific shape.
The recent fall in stocks and commodities, particularly oil, has raised questions as to whether or not the economy is at risk of entering a recession. In the short term this market mayhem has been for the most part about the oil price which permeates all aspects of the global economy. Until the oil price displays a degree of stability we foresee the speculators will continue to run riot. Saudi Arabia is intent on breaking the back of US oil and gas production to secure its own market share and place at the head of the global oil and gas table. With the price now below US$30 per barrel, and no doubt set to fall further still, we sense that the time approaches when US production will fall materially as higher cost US producers throw in the towel. Up to now technological advances have helped the US producers drive down costs and improve production, but geography will ultimately win.
Returning to the 86 year old Bogle he concludes that: “In the short run, listen to the economy; don’t listen to the stock market,” he said. “These moves in the market are like a tale told by an idiot: full of sound and fury, signalling nothing.”
GH commented how value investing has been out of favour with investors for a number of years, effectively since the financial crisis, and that the material underperformance of “value” stocks versus “growth” companies is comparable to levels last seen at the peak of the TMT boom in 1999.
With investors focusing on growth and momentum companies over the past few years the recent market activity reflects a reality check for the momentum trade.
We are now hopefully returning to a time when the proper analysis of fundamentals will be rewarded and with this in mind it is worth casting a glance at US technology giant International Business Machines (IBM). As was the case with Microsoft several years ago, many commentators appear to be doubting the long term prospects for this previous bellwether of the technology sector. Over the past few years shares in IBM have tumbled 43% on fears that the group has lost its way in the fast moving technology world, with momentum firmly to the downside. While earnings have indeed stumbled, as the giant group goes through one of its periodic transformations, ‘real’ cash returns to shareholders have actually been rather good, to say the least. Over the past 5 years IBM has generated average ‘annual’ free cash of an eye popping US$14bn. It has used this cash to pay substantial annual dividends (Dividend yield is just over 4%) and buy back a colossal US$65bn+ of shares over 6 years. In its recently reported results ‘accounting’ earnings fell again but the total ‘real’ capital return to shareholders during the year was still US$9.5bn, consisting of dividends of US$4.9bn and gross share repurchases of US$4.6bn. Shares in this high quality business, which still generates operating margins of 20% and returns on equity of over 90%, trade at modest 9x forecast earnings for 2016. Transforming a business of this size is bound to take time and in the interim patient shareholders are being rewarded. More positively for the technocrats out there, its expansion into cloud services looks quite encouraging
Investors have also questioned the business prospects of UK listed WH Smith with its dull portfolio of high street stores. WH Smith has also been going through a transformation with the high street operation essentially being run for cash which is subsequently being reinvested in a growing portfolio of ‘Travel’ venues. It’s hard to visit an airport or train station without coming into contact with WH Smith. Much like IBM, the UK group has been returning cash to shareholders through dividends and share buy backs. WH Smith is a much smaller business than IBM and its metamorphosis has taken less time with the share price reacting very positively over the past few years as the transformation starts to deliver.
We anticipate investors will need to pay greater interest to ‘value’ investments like IBM in the coming years and focus on real cash returns, high returns on equity and capital and sustainable dividends.
So what does it mean for our client portfolios?
Many of the small caps we follow have benefited from the momentum trade with valuations becoming more stretched; although quite a few are also substantially less expensive following the falls of the past few days! However, unlike their blue chip peers, these businesses are also demonstrating real growth, generating plenty of cash and possessing the desired balance sheet strength. While large well established businesses have been the major beneficiaries of quantitative easing and low cost debt, UK small caps have, for the most part had to tread more carefully with debt less freely available. Don’t be put off by the violent share price swings of small caps during heightened periods of market volatility such as the one we are currently experiencing; that’s the nature of small cap investing and its important not be sucked in Mr Market’s dark mood!.
We have maintained a generally defensive stance over the past year or so with a strong weighting in Pharma, Tobacco and Telcos and higher yielding equities with limited exposure to financials. We remain on the look-out for real value and businesses that are able to demonstrate an ability to generate meaningful free cash and a willingness to return this to shareholders in some form.
Real news from AIM quoted companies since the start of 2016 (it’s a busy period for AIM results) has been overwhelmingly positive. News from AIM can also be a good gauge of the state of the UK economy with the majority of AIM companies more reliant on the UK economy than blue chips. We summarise below recent news from some of the companies we follow, across a vast array of sectors and industries:
Majestic Wine (wine retailer)
Encouraging Christmas Trading Statement
Majestic Retail like for like sales grew 7.3% in the Period (versus decline of 1.7% in comparator period)
Breedon Aggregates (Quarrying of aggregates and the production of added value products)
Largest ever contract award
KBC Advanced Technology (Software technology and consultancy for hydrocarbon industry)
Takeover at a 50% premium, look out for more like this in the oil and gas sector
Shoe Zone (Low cost footwear)
Results in line with an additional proposed Special dividend bringing yield to 6.8% at current share price
Quartix Holdings (Subscription-based vehicle tracking systems)
Trading statement confirms revenue and profits are anticipated to be ahead of market expectations.
Smart Metering Systems (Integrated metering services company)
New domestic smart meter contract wins as part of the UK Government programme, requiring domestic energy supply companies to provide all of their customers with a smart meter in homes and small businesses across the UK by 2020.
XLMedia (Provider of digital performance marketing services)
Trading update confirms that the Company expects to exceed current market expectations with the dividend materially increased
Plexus Holdings (Oil and gas equipment provider)
New customer contract and region win worth approximately USD$0.6m.
Quixant (Specialised computing platforms for gaming and slot machines)
Trading update confirms profitability over the 12 months ended 31 December 2015 was comfortably in line with market expectations. The Company has started 2016 well, with a healthy order book which underpins their confidence in achieving market expectations for 2016.
We would urge investors to focus on real news and the real economy and ignore the market noise and actions of speculators. Long term investors (and real investment is all about the long term!) should view the current sell-off as a potential buying opportunity to acquire interests in good businesses at much fairer prices.