Two steps forward, one step back

After a decent July, this week was a pretty torrid one for my portfolio, which fell 3.4%. This was not really the result of any bad news for my holdings, but appears more due to wider sector rotation away from highly valued growth stocks to cheaper value stocks. Following a timely reader comment on a recent post, I’ve been wondering whether this could be the start of a more prolonged shift.

I follow a quality-momentum based investing strategy because I think it leads me to high quality businesses stocks that are perennially undervalued and should outperform the market over the long run. However, like every investing strategy it is likely to face periods of underperformance. I think it may come unstuck if we go through a prolonged period where either:

  • Quality stocks become overvalued, or at least perceived to be overvalued, and the market goes through a period of mean reversion.
  • Increased volatility in share prices undermines a momentum approach, as it ends up selling on dips and buying at peaks.

These situations are fairly likely to occur at the same time. Both could result from a shift in investor sentiment about valuations or from deteriorating economic prospects. However, knowing this doesn’t make the timing any easier to predict. It is true that the spread of valuation multiples between growth and value stocks has expanded in recent years and is well above historical averages. Following this, it seems quite possible that the market already judges the current spread to be too extreme and a ‘mean-reverting multiple compression’ is imminent. However, it also seems quite possible that quality businesses continue to outperform for some time yet. The spread of valuation multiples got a lot more extreme in the dot.com boom. As far as I can tell, there don’t seem to be serious economic threats on the horizon that would undermine the ability of quality businesses to continue to grow corporate profits.

I think it’s best to accept that I just don’t know when the market might turn. In general it should pay to stick to what I think will work in the long run i.e. remain near fully invested and continue to focus on high quality and momentum. It might be best to just stick to this and endure the inevitable periods of underperformance that follow. However, focusing on more defensive businesses and paying closer attention to valuations would probably also be prudent at this point and is not incompatible with my strategy.

This is reflected in my trades this week. I sold out of Moody’s in order to buy Apple, a share on a surprisingly lowly rating for the first $1tn company. I’ve written about Apple before here so won’t do so again. I sold Moody’s for a 10% return, simply because the opportunity to buy Apple after a cracking trading update when it was breaking to new highs looked too good to miss. I felt Moody’s was simply the weakest link in my portfolio at the time, rather than having any serious concerns.

On Friday I sold out of Keywords Studios for a 15% profit, following an ‘in-line’ trading update. While the update was fairly positive and I still think Keywords has excellent long term prospects, I was hoping for a bit more and am wary of its high valuation. In its place I bought Sopheon, which also seems to have good growth prospects but is on a cheaper valuation.

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Sopheon

Sopheon makes innovation management software for businesses. The jargon in its reports had put me off buying a position for some time, but on a closer look it doesn’t seem so hard to get a broad understanding of what it does. The idea of the Accolade software platform it sells is to help businesses more systematically generate ideas from within their organisation and manage the processes for developing and ultimately implementing them. Needless to say this is a pretty novel and niche area, but one in which Sopheon appears to be a market leader while still having a market capitalisation of less than £100m.

Quality

  • Business economics: Sopheon has a capital light and profitable business model. Its returns on capital and operating margins are increasing rapidly as it grows.
  • Track record: the current incarnation of Sopheon was formed in 2000 (dot.com boom) when it acquired Teltech and ‘fused their respective technologies and expertise’. Prior to that Sopheon focused on software to support language-intensive business processes while Teltech operated a platform for ‘expert networks’. Since then, Sopheon’s track record of increasing  revenues and profits has been very patchy and the share price has been pretty stagnant. Sopheon’s growth has only really started to take off in the last couple of years. It explains that this coincides with the need for enterprise innovation management becoming more recognised by business executives and with the refocusing of its marketing strategy to take advantage of this. The track record is weaker than most other businesses on my watchlist, but I’m prepared to give Sopheon the benefit of the doubt.
  • Competitive advantage: Sopheon does appear to be a market leader in its relatively nascent field. It is well represented in Gartner’s market analysis as a leader in various fields. I think the sustainability of its competitive advantage depends to a large extent on how business critical its software is to its customers. How much risk is there that they decide they no longer need it or can switch to a better alternative? I have mixed views on this. On one hand, it looks like Sopheon’s software becomes tightly integrated into business processes resulting in high switching costs. On the other hand, innovation management doesn’t seem as business critical as say something like payroll. This could mean that customers would be prepared to invest time, effort and disruption in switching to a better alternative if they came across one. It’s hard to judge but on balance my impression is that Sopheon’s software is important to the small niche of customers it serves and would be hard to replicate.
  • Growth prospects: given the nascent state of the market and Sopheon’s small size, the growth potential could be enormous. I think it makes sense to keep a high degree of scepticism with these sorts of early stage growth stories. There is uncertainty as demand establishes itself and Sopheon’s competitive advantage is developed. However, I think the current business momentum provides a valid reason to be optimistic overall.

Price

The current business momentum seems excellent with Sopheon very recently issuing an ‘ahead of expectations’ trading update. It is due to issue results around the end of the month. The share price is showing signs of being about to break out of a period of consolidation.

The valuation seems very cheap given its current growth trajectory. Its long term future seems more uncertain than most of my other investments, but I think the low valuation makes this a good asymmetric bet with a potentially huge but uncertain upside.

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