Solving The Share Market Enigma

At times, it seems financial markets move in mysterious ways, confounding most observers and commentators on the sidelines.

This is one of those times.

If corporate profits are poised to fall by an estimated -30%, with the effect of such falls to be further enlarged through emergency capital raisings and mass dividend cuts and postponements, not to mention the commensurate layoffs and reductions in capital spending, should the Australian share market not be down more than it is?

When we stop looking at the market as one broad, general, homogenous complex and start paying attention to the many divergences and subtleties in play, it turns out there is a lot more intelligence behind the apparent madness that is confounding many an expert, both here and overseas. Underneath the surface of it all, we discover the share price of a2 Milk (A2M) is up year-to-date, in excess of 30%, which seems sheer madness, until we take note of the company's recent market update which, yet again, forced analysts to increase forecasts and their valuations.

a2 Milk shares are still trading below FNArena's consensus price target for the stock, with two stockbrokers -Macquarie and Citi- suggesting the shares might well have double-digit percentage in further upside.

This is but one of many aberrations in today's share market that is lost on those who analyse and draw conclusions from a broad, generalised angle.

Not every company is about to suffer a -30% retreat in profits. Instead, it can be argued a2 Milk shares are still not overly "expensive"; not if management continues to execute well and keeps releasing operational updates that are better than market expectations.

Herein lies the challenge for today's share market investor: the best returns are not achieved from picking low valuations or beaten down share prices; superior returns stem from items that cannot be seen in financial data or excel spreadsheet calculations, like operational consistency, the ability to add value through investment, a dependable moat, and an uninterrupted long-term growth trajectory.

A Profession In Deep Pain

Most professional investors have struggled with the change in share market dynamics that is not only characterising the share market throughout this year's Bear Market to date; on my analysis this change started revealing itself in 2013.

As is typical for the share market, momentum swings from the winners to the laggards and the beaten down, and then back to the former winners, so finding any straight consistencies requires a lot of interpretation and analysis and, above all, a longer-term horizon.

Most professional fund managers have found it near impossible to simply beat their key benchmark (usually the country's index) over the past seven years. This Bear Market has not reversed that trend.

With the ASX200 index down -23.1% over the March quarter, data gathering by Mercer shows the median long-only fund in Australia went down by -24.5% over the period. So much for warning investors the true value of putting your money with an active manager would reveal itself during the darker times.

Best performing throughout the quarter was Hyperion Australian Growth, which fell only -12.5% in the first three months of 2020 and is still up 5.8% (before fees) from a year earlier.

The "secret" behind Hyperion's success is not exceptional stock picking. The secret is that Hyperion avoids cheap looking, beaten down "value" stocks. When interviewed by the Australian Financial Review recently, Hyperion's fund managers summed up their favourite stocks as CSL (CSL), Cochlear (COH), ResMed (RMD), Macquarie Group (MQG), Xero (XRO), TechnologyOne (TNE), and WiseTech Global (WTC).

In other words: Hyperion is a "Growth" investor. Viewed from yet another angle: Hyperion's investment style is very much in sync with the share market dynamics as identified since 2013.

Alongside the widening gap between "Winners" and "Losers", irrespective of your typical share market swings, Hyperion sat mostly on the winning side, including so far this year.

Another outperforming fund is Loftus Peak Global Disruption. Loftus Peak was founded seven years ago by Alex Pollak, formerly media analyst for Macquarie Research. The fund's performance over the period makes many jealous (or hide behind their desk, depending on one's angle).

Loftus Peak fell by the Grand Total of -2.63% in March while total performance for the March quarter is a positive 2.11%. Over one year the performance reads 16.40%. The average over three years is 19.65% per annum.

Pollak's fund invests internationally, so there is the extra advantage of a weaker Aussie dollar, which has also helped Hamish Douglass's flagship performance at Magellan Financial ((MFG)).

In all three examples, including Magellan, the solid outperformance stems from sticking with the "winners" under post-2013 conditions instead of trying to find value among beaten down laggards and corporate "losers" from societal and economic changes.

Let's really stick the boot in with a few extra quotes from the managers at the helm of Hyperion: the Australian benchmark is full of "old world businesses" and "low quality".

Elsewhere in the AFR interview the explicit point is made that many of the so-called strong value propositions in today's share market, the favourite hunting ground for many an investor, are companies losing market share and operating with margins under pressure.

These companies are heavily reliant on favourable economic conditions to perform well, but in a low growth environment, or when the economy is not growing at all, owning shares in such companies essentially translates into extra fundamental risk.

What this translates into is that your traditional value-type investor is essentially moving up the risk curve, and not investing in lower-risk opportunities as has been their mantra over many decades.

Mind The Gap

The current share market set-up creates all kinds of dilemmas for investors, professional and retail. Should one stick with or further add to "winners" like a2 Milk, Fortescue Metals ((FMG)) and Xero ((XRO)) or should the main focus now change to the laggards, many of whom are trading on prices well below valuations and target prices put forward by stockbroking analysts?

Recent analysis by Goldman Sachs suggests the gap between winners and losers, High PE stocks and the rest of the share market, has now blown out to never-before seen proportions; wider than during the infamous late 1990s-early 2000 run up in new technology, telcos and media companies.

This suggests a market rotation is due, maybe even overdue.

It's not like we haven't seen such rotations taking place already. The previous one happened after the short Bear Market during the final four months of 2018.

It lasted less than six months, which means it started with gusto and oomph in January of that year but by the time investors started preparing for the August results season, market momentum swung back in favour of CSL and the like.

The reason for this became clear during the reporting season of August which on many accounts proved the worst in Australia post-GFC. Investors will also remember the many dividend cuts taking place, with Australia one of few countries that saw dividends going backwards, including from the banks.

Investors should also note stocks like CSL equally performed well during the ASX200's 20% rally during the late 2018-aftermath; it's just that laggards and cyclicals, including miners, energy companies, mining services providers and financials temporarily performed better during that period.

The rotation prior to last year's would be of more concern to fund managers at Hyperion and Loftus Peak, as the one that took place in the second half of 2016 was equally short -no more than five months or so- but that one was extremely violent.

Stocks like CSL and many mid-cap tech stocks fell by -20% or more during the period, while BHP, CBA and the like rallied by 20%, creating an extremely rapid market re-adjustment.

Which type of rotation should investors expect this time around?

The enormously wide gap between winners and losers in today's share market suggests the 2016 type looks most preferred, but for that to occur a widespread agreement needs to descend upon global investors that strong recovery and economic growth are on the horizon.

Summarising all of the above, I think we can draw yet another conclusion that equally flies in the face of everyone who thinks share markets are already reflecting rather rosy scenarios for the future.

I think the opposite is rather true and that wide gap as identified by Goldman Sachs is yet more evidence markets are not reflecting a quick V-shaped recovery and resumption of societies after current lockdowns have eased around the globe.

This is why that gap between the less risky stocks (High PEs) and the more risky stocks (low PEs) is so wide.

Markets haven't lost their heads, and they are not out of touch with economic reality at all. Quite the opposite holds true: an historically wide gap between the winners and beneficiaries in the share market, and all the rest reveals investors are quite sceptical about what possibly lays ahead.

In popular economists' lingo, today's share market is weighing up between economic recoveries in the shape of a drawn-out U, the excruciatingly slow moving L, and the frustrating W, but not so much the quick V-shape.

Only the latter version of recovery could trigger that same type of violent rotation that characterised late 2016, or the coming out of the 2007-2009 Grand Bear Market post March 2009.

Even then, I still haven't seen anything to suggest otherwise than once the world has recovered from this year's global pandemic and economic recession, the bigger picture remains a repeat from the years past, characterised by low inflation, low bond yields, low interest rates, low economic growth, and high debt levels.

Are alternative scenarios possible? Definitely. With governments now increasingly involved, nobody knows how quickly the context can shift to radical policies such as Modern Monetary Theory, or MMT.

But it remains too early to start speculating about that just yet.

Expect existing trends to persist, with interruptions, as has been the pattern over the past seven years.