More rotation

September didn’t quite live up to the optimistic outlook I had at the beginning of the month. It turned out to be decidedly more wobbly, with a Chinese corporate debt crisis added to the familiar old spectre of rising interest rates and a fairly severe profit warning hitting my portfolio.

Inflation is still the main game in town. There is plenty of evidence that supply chain and labour market disruptions are pushing up input costs in all sorts of markets. Many businesses have been warning about this recently and the effects of the haulier crisis in the UK are all over the news. The Federal Reserve has started to signal that monetary policy may need to be tightened sooner than expected. This is a concern for higher rated quality stocks. However, the questions remain about how long term these effects will be and how difficult it might be to get inflation under control if it does get going.

The stock market has been starting to look weaker over the past couple of weeks and then fallen dramatically this week, apparently as a result of this. Quality shares in particular have suffered – there have been sharp pullbacks in many of the shares in my portfolio and watchlist. It seems we are going through another rotation away from quality. This is concerning and will negatively affect my portfolio if it goes on. I’m hopeful that I’ve sufficiently limited my overall exposure to very high rated stocks not to get too badly affected but am continuing to look for opportunities to do this further. At the moment I’m still reasonably optimistic that the rotation will be short-lived.

There has also news that the huge Chinese property developer, Evergrande, is about to start defaulting on its more than $300bn of debt. This has raised some concern about the possible effects on the Chinese financial system and economy and whether there might be global ‘contagion’ from the ‘Chinese Lehman’. The mechanics of such a chain reaction are complex and I don’t have any particular insight, but I’m skeptical that this should be a major concern for investing in the kind of UK and US businesses I favour. However, even aside the concerns about the slowing growth and exposed financial system, it does seem that China has become a rather toxic place to invest in general. The regime has been heading in an increasingly authoritarian direction, cracking down on tech and western companies. This doesn’t affect my investments a great deal but I’m getting more wary of luxury brands, which are quite heavily exposed to Chinese demand.

September also brought my first profit warning in a while from CMC Markets, which updated that trading activity was more subdued than expected and sharply cut its revenue guidance. It was common knowledge that trading was going to come down after the pandemic-induced boom in volatility last year, though I did not anticipate the extent outlined in the profit warning. It was especially surprising given the management had issued a confident trading update only a month before. The share price had been weak for a number of months prior but this hadn’t seemed especially alarming and the valuation looked cheap. Notably CMC’s peer IG Group did not seem nearly as badly affected by the drop in volatility in its subsequent results. I ditched my holding straight away as it was a profit warning and the cheap valuation didn’t seem a good enough reason not to.

I also reluctantly decided to sell Canada Goose based on its weakening share price and potential exposure to both supply chain issues and China.

To replace these sales I bought Alpha FX and Keystone Law after both released excellent results. Alpha FX was one of a few investments I mistakenly ditched last April at the depths of the market crash and briefly wrote about.

Keystone Law

Keystone is a UK legal business worth around £250m. It is only fairly recently that it’s been possible to invest in legal services businesses in the UK. ’Alternative Business Structures’ (ABS), which are allowed to take on external capital in contrast to the traditional partnership law firms, were legalised with the reform of the Legal Services Act around the time of the Financial Crisis and it took a bit of time for this model to gain any traction. Keystone had been around for a few years before that in its previous incarnation, Lawyers Direct, but converted to an ABS structure in 2013 and floated in late 2017.

Keystone operates in the ‘mid-market’ part of the legal services sector – this largely serves SMEs and sits below the large Magic Circle (and Silver Circle) firms that provide services to large corporations and above high street legal services to consumers. Keystone’s business model is to recruit experienced lawyers from other mid-market law firms and offer them high quality back office infrastructure and support and more flexibility and autonomy than they would have enjoyed previously to focus on doing work for their clients and achieving a better work-life balance.

Quality

  • Business economics: the business model looks very solid. Keystone doesn’t pay salaries to its lawyers, instead directly paying them a share of their billings. Its overheads are not that high and economies of scale continue to be realised as they are spread over an increasing number of lawyers. While it needs to ensure the infrastructure it offers its lawyers is top-notch, there is very little capital expenditure required to achieve this. This means Keystone has predictable margins, is highly profitable and highly resilient to any downturn in activity.
  • Track record: Keystone hasn’t been around very long but ao far it has an excellent track record of consistently growing revenues and profits.
  • Competitive advantage: Keystone is somewhat unusual as a business in that it competes primarily in the labour market to attract lawyers rather than for end customers. The core proposition behind Keystone’s business model is that best people to manage the operation of a law firm and back office etc. often aren’t the client-facing lawyers, particularly in smaller ‘mid-market’ firms. Keystone focuses on getting this right so the lawyers can get on with helping clients, earning fees and having a better work life balance. This doesn’t seem hugely insightful as a business model but it is disruptive of an inefficient and historically excessively regulated industry that is incredibly set in its ways. There is is plenty of evidence that Keystone is doing this effectively, with very high Glassdoor ratings and awarded recognition as a great place to work. Keystone will hopefully be able to cultivate its reputation and community further and in the long term its client-facing brand. This business model will almost certainly be copied by others but Keystone seems to have plenty of scope to exploit its a first mover advantage.
  • Growth prospects: the growth prospects look good. The addressable market is very and there seems to be plenty of scope for Keystone to continue on its current growth trajectory for a long time.

Price

Momentum is very strong. Keystone wasn’t too badly affected by the pandemic and just announced that it expects its full year results to be materially ahead of expectations. The share price has held up well in the recent volatility. The valuation is not cheap but I think seems reasonable given the growth prospects.

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