The panic seems to be subsiding, well at least momentarily, after last week, though share prices still seem to be quite volatile. I’m surprised at how sensitive my outlook is to share price volatility, despite my better judgment. Last week felt like it could be the beginning of the end, even though the rational part of me reasoned that there wasn’t much to worry about. A small bounce and I’m already looking forward to a monster Santa Rally. Those emotions are tricksy little blighters.
I’ve warned about the danger of paying too much attention to to macroeconomic news previously on this blog. Macroeconomics is notoriously complex and difficult to predict. Prevailing narratives are often oversimplified and as a result can be wildly wrong. In macroeconomics the consensus view is mistaken more frequently than in any other field I can think of.
If you pay attention to the financial media, it’s very easy to become sucked in to the panic-du-jour. To guard against this, I think the simplest and best approach is to have an unrelentingly optimistic longer term perspective. It’s a decent bet that any macroeconomic concerns will be temporary, no matter how bad they seem at the time, and that the economy and corporate profits will continue to grow over the long term. At least that’s what’s happened before. Here is a (logarithmic) chart of what the US stock market has done over the last hundred years. Your main concern should be taking advantage of the rises rather than avoiding the occasional bump. Investing in high quality should make you even more resilient.
I don’t think it comes very naturally for many critically-minded people to be unwaveringly optimistic when faced with signs of danger – certainly not me. It’s something we have to work at for the benefit of our mental health as well as our investing returns.
As I mentioned in my last post, I took the somewhat exceptional opportunity of indiscriminate price falls last week to go fishing for some higher conviction investments. I offloaded Pharmagest (perhaps a bit pricey) and London Stock Exchange (just less sure) and bought into AB Dynamics, Kering and Beeks Financial. This week I also did my regular bi-weekly trade, swapping Auto Trader for Microsoft.
AB Dynamics is a long term favourite that I’ve held several times before and have written about here. I bought as it has just issued a very bullish ‘ahead of expectations’ trading update but nevertheless got caught up in last weeks falls. On to the others…
The main catch from my haul is Kering. Kering is a very large (£42bn maket cap) family-controlled French business that owns a large number of luxury brands, including most notably Gucci, Yves Saint Laurent and Bottega Veneta. Over the past decade it has shifted from general retail, offloading assets such as Volcom and Puma, to concentrate its focus on luxury brands only and take full ownership of the mega-brand Gucci.
The investment thesis here is slightly unusual for me, in that I’m following more a value investing philosophy, buying on the basis of the conviction that comes from an attractive valuation and concerns I see as exaggerated. More commonly, I look to take advantage of momentum and the market’s tendency to underreact to good news. In general, I find momentum to be a tactically superior strategy as it allows you to take a shorter time horizon, generating quicker returns that can be compounded more rapidly. It also means you need less conviction and can treat unexpectedly falling prices as a sign you may be wrong. However, as I mentioned last week, in the current market environment I think it makes sense to rely relatively less on momentum than I normally do.
- Business economics: luxury fashion is a highly profitable business and Kering is no exception with decent operating margins (26%) and returns on capital (21%). I think these are likely to improve further over time as Kering completes its transition to luxury fashion only.
- Track record: beyond the last three years, the recent track record of growing revenues and profits looks a little patchy if I’m honest. However, the figures are complicated by the Kering’s substantial transformation, including a number of big acquisitions and disposals. Prior to 2016 the share price hadn’t made much progress since the turn of the century – but this is true for a number of companies. The track record doesn’t really bolster the case here but I think there are sufficient reasons to give it the benefit of the doubt.
- Competitive advantage: this is a bit of a no-brainer. The luxury brands Kering owns, particularly Gucci, are very high quality indeed. Gucci is growing at a very fast rate and is taking market share from rival brands. I think the competitive advantage these brands provide should last a very long time.
- Growth prospects: the long term growth trends for the luxury market as a whole are very favourable. The big growth driver at the moment comes from Asia, and in particular China, where there is a rapidly growing demographic of affluent middle class millenials with a strong preference for luxury products. Longer term I would expect this narrative to play out across other parts of the developing world. The market for Kering’s products is fairly defensive and Kering was able to weather the Financial Crisis fairly well.
The underlying trading momentum is excellent, with Kering smashing forecasts in its last few results. On the other hand, the share price has fallen by about 30% since Kering’s last results. This has happened to a number of luxury businesses, including Moncler (which I also currently have some shares in), Louis Vuitton, Hermes and in the UK market, Burberry.
The reasons behind this all centre around China. There are general concerns about the reliance of luxury businesses on Chinese demand, in the context of a slow down in the growth rate of the Chinese economy and a US-China trade war that shows little signs of abating in the near future. There are also more specific concerns that the Chinese goverment is currently cracking down on the practice of “daigou” or parallel trade i.e. where Chinese traders buy luxury products abroad to resell in China, where the prices are more expensive.
Both of these concerns seem overblown to me. The crackdown on parallel trade seems like a fairly minor concern that if anything you would expect to benefit the luxury brands. If Chinese customers can’t purchase the luxury items they want more cheaply abroad, then they have to buy them in China at higher prices. Cracking down on parallel trade allows companies like Kering to maintain these price differentials and better exploit Chinese demand for luxury. It could always lower Chinese prices if it wanted to. Louis Vuitton put this view forward in its recent results conference call. However, analysts and the media seemed to seize solely on the confirmation that the crackdown was occuring as support for their existing bearish thesis.
The wider concerns about Chinese growth and the trade war also seem speculative and overblown. Tariffs have relatively minor impact on high value luxury products as they are based on cost and the margins for these items are so huge. In any event, I think it makes sense to be optimistic that the trade war will be short-lived. While Chinese growth is inevitably gradually slowing from the incredible rates of the last few years, there is little sign that the secular growth in demand for luxury from the growing middle-classes is likely to come to a halt any time soon. Louis Vuitton’s recent results showed strong growth in China against tough comparatives.
In this context, the valuation seems excessively cheap. My back of the envelope calculations suggest that the market is expecting fairly pedestrian profit growth rates in the low to mid single digits over the next few years, while recent growth has been around 30-50%. This seems like a fairly absurd valuation for such an obviously high quality business firing on all cylinders. The valuation also seems considerably cheaper than for other luxury companies for apparently no good reason.
Kering is due to issue its Q3 results next week. I think these will be good. I’m not sure they will provide a catalyst for an immediate recovery, but I anticipate that the current bearish consensus is likely to revert fairly soon.
Beeks Financial Cloud
Beeks provides cloud computing infrastructure to brokers and trading firms. It has a low latency trading network with direct connectivity to a large number of financial exchanges across the world. It has listed on the stock market fairly recently and seems to have become quite popular among private investors. It’s a small and relatively unproven early stage business (market cap of £60m). It consequently has somewhat more uncertain prospects but also greater scope for growth than a more established business.
- Business economics: given its early stage of development you can’t get a great deal of insight into Beeks’ future profitability from the accounts. Beeks has been making substantial investments in infrastructure to build its network, though should now have a very scaleable business model with low variable costs and high operational gearing. I expect it to become highly profitable in the near future and it is already showing signs of this in its recent results.
- Track record: Beeks doesn’t seem to have put a foot wrong so far but then at this early stage doesn’t really have much of a track record so to speak.
- Competitive advantage: Beek’s network seems to be a fairly unique asset. I like that it focuses on a niche customer type, where service quality is extremely important. The need for high service quality may make Beeks’ customers reluctant to switch away unless they have concerns with the service. A lot of revenues should be recurring. However, I do hae some doubts. There don’t seem to any obvious major impediments to competitors replicating it and I worry over the longer term that the barriers to entry are not that high given the service is quite commodity-like.
- Growth prospects: this is the main draw. The addressable market is growing strongly. Beeks has a highly scaleable business model and there seems to be a decent opportunity for it to make a land grab and experience some very rapid growth.
Trading momentum is good, with Beeks issuing decent results at the end of August showing rapidly growing revenues and a bullish outlook. I think there is plenty of scope for further upgrades to expectations.
The share price went on a big run after that, but then retraced during the recent market weakness. Small and illiquid stocks can get hit particularly hard by this sort of volatility, so it seems like a good time to be a buyer. The valuation seems pretty cheap to me given the growth I anticipate, but there is a reasonable degree of uncertainty to account for too.
Microsoft needs no introduction. Its Windows operating system is a textbook example of a monopoly product that was subject to antitrust investigation in the past. More recently, Microsoft is involved in many other growing business segments, including its cloud-based service Office 365, cloud infrastructure Azure, the social network LinkedIn, the search engine Bing, gaming and in producing devices like Surface.
The size and complexity of Microsoft’s business make it difficult to analyse very closely, but I don’t think the detail is so important in judging its quality as an investment.
- Business economics: As you might expect, Microsoft is highly profitable with high operating margins and returns on capital. Most of the markets it is in have attractive economics, with a lot of operating leverage and revenues from recurring subscriptions.
- Track record: over the long term, Microsoft has an excellent track record. It is a rare example of a technology market leader that is enjoying a ‘second wind’ after a period of stasis following the dot.com boom. Microsoft has grown very steadily over the last few years.
- Competitive advantage: Microsoft has a huge competitive advantage in pretty much all of the markets it is in. It has been very successful over time in leveraging the market position of Windows to dominate new markets. It seems to really dominate the enterprise IT market – I find it hard to see customers switching away from Office 365. Microsoft’s incumbent positions also give it a strategic advantage in exploiting new technology rather than being exploited itself. It can afford to spend a huge amount on R&D.
- Growth prospects: Microsoft’s growth prospects look very promising. I mentioned in this post that I see enterprise IT as a market likely to experience secular growth for years to come. Microsoft seems the most obvious candidate to take advantage of this. Obviously it is already a very large business, which limits how fast it can grow, but the growth seems fairly certain and should compound over time.
Trading momentum is excellent at the moment, with Microsoft reporting ahead of expectations for the past few quarters. Price momentum is also good with the share price in a steady uptrend for quite some time. It has been hit relatively mildly compared to other technology stocks in the recent volatility. The valuation seems cheap to me given the obvious quality of the business.