all day breakfast

There has been quite a bit of shift in what is driving performance on the ASX since the 3rd quarter of 2016. At that time, I was surprised to note the extent of the outperformance of small caps compared to large caps for the previous year.

It came to my attention mostly by seeing so many fund managers in the financial media making an extra effort to highlight their performance figures for 15/16, and their positive start to 16/17 at the same time. If you were not an index hugging manager and often looked beyond the top 100 companies it should have been relatively simple to outperform the standard indices. It is not uncommon for some managers that invest in small to medium sized companies to still use the ASX200 as a benchmark.

I offloaded some stocks around this time. Looking back, getting rid of ELD & NUF looks pretty dumb. But with some of the smaller LICs like NCC, TOP & MVT it has so far proved not such a bad idea as they have underperformed since.

These were the posts I refer to when expressing a little caution on the great run small caps were having at the time.

Funnily enough, this time I don’t see the same excitement of some fund managers shouting out about their performance numbers. I now went and checked on how the returns have diverged from the ASX100 versus the small ordinaries (next 200 outside of the 100). I used the start of the fourth quarter last year as the reference point as that was close to my blog posts above. It looks like half of the major outperformance of the smaller index I referred to last year has been given back. That is, leaving aside dividends from both indices, I think the small ordinaries is about 5% weaker in price terms whereas the ASX100 is up 5%. This is an underperformance of around 10%, if anything it may be larger if I accounted for the dividends. This is despite the most recent month being horrible for the big banks. Now quite possibly it could be simply company specific reasons driving this dispersion, but I suspect some other forces may be contributing.

I keep hearing noises about forced selling from some small cap managers losing investment mandates. This wouldn’t surprise me considering the media sentiment has been highly critical of the active management community of late. This in itself can potentially lead to some small stocks getting hit severely, as the level of liquidity in some stocks can make selling down a small cap portfolio very difficult. Then the month of June can be tough for stocks from tax loss selling that are already trending down. The current year is such that it is likely many investors still have plenty of stocks showing good paper profits, so it may be tempting to cut your ties with a small stock underwater and match it off with one of the winners so you don’t have to pay tax on that one. The third factor that may potentially affect some smaller stocks is if they are possibilities to be demoted out of popular indices such as the ASX200 or ASX300. If you believe index tracking ETFs are growing strongly still it should perhaps exacerbate such moves, as these passive trade decisions from such rebalances get larger versus traditional decision making from active fund managers. All three are examples of trading that are somewhat forced and done in some cases with total disregard as the true worth of the stock price in question. It is such forced trading that I look to hunt for potential opportunities to go against. At the very top of the blog I have a link to a post made last year about areas I like to examine and touched on some of these factors. Here is the link.

This may all sound great in theory but I must admit so far I am not sure if I have found anything exciting in the small cap space because of this type of thinking this June. I thought I would share anyway and maybe readers can write about some small stocks that have been hit unfairly hard this month that may provide opportunities. I soon hope in a future blog post to go through any company mentioned on this blog in the past that is down quite a bit, and highlight some small dogs in the portfolio in terms of performance. Without checking yet I know that REF may fit in that category. I still hold and probably expect the company to announce some difficult trading conditions soon, but the stock is very illiquid and has the feel that some investors may already have a good understanding of such difficult conditions and hence have smashed down the price already. Then again it is still conceivable that it may be victim of some mandate loss or tax loss selling so I just wait this out. This can make this time of year tricky in the Australian small cap space. I wrote on the blog last year to give any tax loss selling plans serious consideration in April, by mid-June it probably is mostly factored in and time to hunt for opportunities. This looks to be taking shape again. I considered selling some REF in April but probably made the wrong choice and held!

If WAM Microcap are lucky they may get their capital raising done at an opportune time. Maybe one implication from all this is if I do receive an allocation then to give them some time to take advantage of the current conditions.

How about the US market?

Another implication I see from the popularity of ETFs is that large companies in the US get driven up to extremely high multiples, whilst earnings growth is almost non-existent. The media attention surrounding the famous Warren Buffett bet on a simple cheap index tracking fund beating the hedge funds certainly hasn’t hurt flows into such ETFs. As some of the mature companies in the US market begin to look expensive I imagine many value orientated managers get out of them altogether and there needs to be large falls for them to get back in. Once they are out, more of the average day’s turnover may be made up of whatever the flows are in the big index tracking ETFs. Whilst exuberance may not exist in the old sense of the shoe shine boy or taxi driver talking about spectacular gains in individual stocks, maybe it is a quieter style of exuberance. One that is more about a huge contingent of smaller investors drip feeding money into the big ETFs, with an unwavering belief in the passive strategy. After all they probably have 8 years of beating the so called smart money managers to back up this belief. Yet how strong would the newer wave of these investors be during a correction even as mild as 10%? We haven’t really had much of a chance to see, I suspect they will have weak hands and many have probably undertaken their strategy with no thought of any research into valuations.

McDonald’s was a name that caught my attention, mentioned I think from a Livewire interview with Nathan Bell from Peters MacGregor Capital. I remember back in 2010 looking at some of the large multinationals thinking that wasn’t a bad place to put some money. With all the uncertainty about in the world at that stage, if you could pick up big names on P/Es around 12 it was a fair bet. More defensive names that even if global economic growth faltered, should still come out ok. Ok so I couldn’t go back beyond 2012 in the case of my data here as it wouldn’t allow me access to the 10-year range. I don’t know whether the P/E was 12 in McDonald’s case but it looks like on the graph it was at 15 and has expanded considerably.

maccas pe

I am not going to profess I am an expert on the stock, but I have eaten far too much of their food during my lifetime. I understand amongst other things, the all-day breakfast as helped them. Maybe we can thank the movie Falling Down starring Michael Douglass for that one?

But I digress. The breakfast menu I admit I don’t mind so much, but I suspect that passive buying, or index hugging managers scared of underperforming may be leading to such price moves.

Let’s take a look at the revenue growth over the same period as above.

maccas revenues

Share buybacks have helped the stock, but do companies generally as a rule have a good record of knowing when to buy back their stock and when to raise capital? I tend to remember all the capital raisings at low prices on the ASX in 2008/09 and the buy backs occurring in later years at higher prices, sometimes with the same companies and sectors!

I made the title of this post as how to respond to this passive investing trend? In the case of the US, I can see more mature companies with no revenue growth on high P/E’s. The darling FANG stocks and others in the US make up a lot of the revenue growth with the average stats, yet I find the P/Es there just as frightening. If you love the story of the FANG stocks though maybe one should read up on the likes of Tencent which I don’t own by the way. It has surprised me reading occasionally about China & India and mobile payment technology. In the case of China, it just strikes me interesting looking at the forecasts of the likes of Tencent and Alibaba there and the multiples they trade on. Maybe there is more potential in those names in this area of the economy than in the US. It Is difficult for the average punter, myself included, to be on top of all these themes so LICs could be worth a look. I do see Tencent and Alibaba in the Platinum Asia LIC and others. I have recently bought some PAI shares at a $1 and at the same time shorted the US market for the same exposure. I may undertake this type strategy occasionally for modest parts of the portfolio. I just feel that the valuations between the different regions are extreme and the index investing fashion may be driving it. The negative views on Platinum Investment Management and active managers in general may also be at an extreme. At least with PAI it has some potential LIC catalysts. Recent option expiry is now out of the way, the first dividend shouldn’t be far away, and already being at a discount of more than 10% I am sure the manager is looking at the buyback possibility were it to ever extend to 15%. Not advice of course, just a thought.


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