It feels that I may have tempted fate with the comment in my last post that I don’t think we are yet at a point where the quality momentum trade will start underperforming. Pretty much as I was writing it, the US stock market experienced a mini ‘momentum-crash’, as investors rotated from high growth stocks to cheaper plays. This may have been a one-off but it has given me pause for thought.
The conventional wisdom in investing is that you should identify a decent strategy and then have the conviction to stick to it through thick and thin, weathering the occasional periods of underperformance that may occur. I’ve always been a believer in this approach, but holding this position has undoubtedly been made easier by the fact that my quality-momentum strategy has been in the ascendance since I started investing. Of course, this hasn’t always been the case. Value had its heyday back in the early 2000s in the wake of the dot.com crash.
The ideal would be to adjust your strategy to suit the prevailing market conditions, but this is obviously much easier said than done. It seems unattractively complex to attempt to define variations in strategy and how to identify which market conditions they are best suited for. From what I observe it seems more common that attempts to shift strategy over time result in failure than in success. I’m sticking to my knitting for now! However, I’m keen to explore this subject in a further post as there may yield some valuable insights.
I made one new trade last week, selling out of my relatively large position in Paycom for a 50% profit. Paycom was one of the stocks hit hardest by the recent rotation away from growth and it was looking pretty expensive so I decided to take my profits and move on. I bought a new position in Arcontech.
Arcontech provides software for collecting, processing and presenting real-time financial market data. It is a tiny business with market capitalisation of about £25m, the smallest on my watchlist. Given its small scale it is naturally relatively unproven compared to many of the other businesses in my watchlist, which tend to be clear market leaders with compelling competitive advantages. The shares are also very illiquid. This makes it a relatively riskier prospect than many of my other investments.
- Business economics: Arcontech has excellent economics. It is very capital light and profitable with high operating margins (35%) and decent returns on capital (18%). It’s nice to see a busy of such small scale already demonstrate strong profitability (and there is always the opportunity to invest in scaling up should the opportunities arise).
- Track record: Arcontech has a decent track record. It has been profitable for quite a few years now and has grown revenues and profits at a decent rate.
- Competitive advantage: Arcontech doesn’t have as compelling a competitive advantage as some of the larger members of my watchlist. However, while it does face competition from larger more established players, a little digging around suggests it has a good niche with a well-differentiated and decent product. I’m particularly encouraged that its main customers are rolling out licenses of the product much more broadly across their businesses. The main challenge for Arcontech at the moment seems to be in distributing their product to new customers – a fairly common challenge for small software businesses. Customer concentration is a significant risk as Arcontech only have three main customers. There is also some risk that Arcontech is out-innovated by a larger competitor with better distribution.
- Growth prospects: the flip side of customer concentration is that the signing of a new major customer would generate lot of growth. This is amplified by the fact that Arcontech has scope to benefit further from operational gearing as revenues grow, while most of its costs are fixed (and low). Arcontech is starting from a small scale and the market for financial data is likely to grow for years to come so there is ample room for growth provided it executed successfully.
Momentum is excellent, with Arcontech’s recent results looking very promising and the share price recently breaking to new highs. The valuation seems reasonable.