Stock markets seem to have taken a bit of a fright at news of a new Covid variant and the prospect of lockdowns rearing their ugly heads again. This news has unsurprisingly hammered the sectors most affected ie travel, retail and other cyclical sectors. My portfolio has fared relatively better than the indices in response to this news, though this is coming off the back of a week’s mauling by another short but sharp rotation from growth to value.

You wouldn’t have thought a new Covid variant should pose much concern now we have vaccines and treatments and are nearly two years into the pandemic. The early indications are that this variant may not be so bad. Friday’s panic is already looking like an overreaction. However, most of the pain suffered by my portfolio this week seemed to be precipitated by the reappointment of Jay Powell. It’s not clear to me exactly why the market had this interpretation, but the reaction of falling equities, rising bond yields and rising dollar seems to imply that investors think hawkish monetary policy under Powell is more likely. Inflation (and the painful policies needed to contain it) continues to be the main underlying risk.

It’s notable that many highly-rated large US growth businesses (of which I hold Microsoft, Etsy, Fortinet and Adobe) actually held up well, so far at least. In my portfolio it is the less liquid small caps that have borne the brunt of the damage over the past week. This is consistent with general market skittishness, which tends to affect more illiquid stocks more harshly in the short term. It could just be a matter of time before the large caps turn too. However, it’s also important to remember that inflation and rising interest rates don’t just punish the valuations of highly-rated, long duration stocks. The most direct victims ‘in real life’ are actually the poorer-quality businesses with limited pricing power and too much debt. This means that a ‘dash to quality’ has some fundamental justification. I think this last point tends to get a bit lost in much of the discussion I come across, which is overly focused on valuations and the dichotomy between growth and value. The sweet spot for investing in the current market situation may be high quality business which are resilient to the changing circumstances in the real world, but where the valuation is not predicated to such a great extent on long term growth.

In practice I think this basically includes Buffet-type businesses, the tech giants and the illiquid but nevertheless high quality small caps that have been inadvertently thrown out with the bathwater. My portfolio seems fairly consistent with this focus but could probably do with being a bit more ‘resilience’ rather than ‘growth’ oriented. Something to bear in mind for my upcoming trades…

I’ve still got some cash balance raised following the late September sell-off and have been wondering when might be a good time to deploy it. I try to be bullish by default and think it’s more likely than not that the current volatility will prove short-lived. However, I’m still feeling quite ambivalent about the medium term prospects for quality growth stocks given their relatively high valuations and the prospect of rising interest rates. So, tempting as it is to reinvest at this point, I’m minded to keep my remaining powder dry to deploy if things get worse.

On to the trades. At the beginning of the month I sold Activision Blizzard after it announced delays to the launches of some of its games. I took a 30% loss but thankfully it was a small position. There were some warning signs – that all the recent controversy around Blizzard’s toxic workplace culture would cause disruptions to its operations was fairly predictable. However, I failed to react because the business had been performing well and the valuation looked cheap. I seem to have fallen into this trap a few times and think I should probably be more cautious and ready to sell in these circumstances in the future. I replaced Activision with Canada Goose, buying it back again after it issues some very positive results.

I made one more trade earlier this week, replacing IG Group with Cerillion. Cheap as IG Group appears, momentum has been weak and the risk of an upcoming profit warning seems fairly high (and I’m chastened by my experience with CMC Markets earlier in the year). I thought safer to replace it with a business more clearly performing well.

Cerillion

Cerillion is a small (market cap of £250m) UK-headquartered business that provides billing and CRM software to the telecoms sector around the world. It makes money from software licenses, SaaS and software implementation and development services.

This joins several other investments in my portfolio in the communications sector: Gamma, Calnex and Beeks. I think this seems like a particularly attractive sector with strong growth tailwinds that are likely to endure for some time and stable and defensive demand.

Quality

• Business economics: Cerillion is capital light and profitable with operating margins and returns on capital currently both around 30%, though after really taking off last year – previously had both been in the mid-teens before that. The business is very cash generative with free clash flow consistently well in excess of profits. One downside is that only about one third of the group’s revenue is recurring, from support and maintenance, though this is growing and it does get quite a bit of repeat business from existing customers.
• Track record: the track record is decent. Cerillion is a fairly young business originating from a management buyout spin-off from Logica in 1999. It did fairly well as a private business before listing in 2016 and since then has seen rapid growth in revenues and profits, really taking off in the last couple of years.
• Competitive advantage: Cerillion has quite a few competitors, including some vertically-integrated telcos, CRM providers and specialists. Cerillion’s USP seems to that it offers an integrated product suite that can be implemented quickly and with little difficulty, in contrast to using multiple bottom-up bespoke products that may be more flexibly but need more work to integrate. This seems to be borne out in the online reviews I have seen, which generally seem very favourable to Cerillion. This is the sort of critical software service that customers are often reluctant to switch away from without good reason and Cerillion’s customer base seems to be fairly ‘sticky’. However, it is a little concentrated so the loss of one of the larger customers could have a significant impact.
• Growth prospects: these generally seem promising. As mentioned above, the communications sector as attractive in that it looks set to experience secular growth for years to come. This should indirectly benefit Cerillion, which refers extensively to the favourable current demand tailwinds from the 5G rollout and increasing usage of data. More specifically, Cerillion seems to have hit an inflection point in its adoption curve as it has started to win larger contracts. The hope is that this raises Cerillion’s profile and credibility and acts as a springboard for further success, especially given a lot of its growth comes from increasing repeat business from existing customers. There may be some scope for Cerillion to enter related markets, though I wouldn’t hold out too much hope as Cerillion is currently quite specialised and there is plenty of competition in other verticals. This means that my one reservation is around the size of Cerillion’s addressable market and to what extent this limits the scope of future growth. This doesn’t seem to be an immediate concern given Cerillion’s small size.

Price

Momentum is very good, with Cerillion recently issuing very positive results and a bullish outlook. The price did look to be on the point of breaking out to new highs when I bought but has since fallen back a bit in the wider market turmoil. Despite the big jump in share price this year, making me wish this had come onto my radar a bit earlier, the valuation still seems fairly reasonable given the growth prospects.