A VIEW FROM THE TOP END

Markets:

In our last update we mentioned the Citibank bear checklist that was flashing warning signs for markets in the US. Subsequently, Tech has continued to sell off with inflation prints worrying growth investors, and stocks labelled as value in America also pulled back from their recent highs. What we are seeing in markets is a reaction to the inflation numbers caused by an enormous pent-up demand from Covid lockdowns, an assessment that the Covid winners may not repeat or maintain their strong growth numbers as well as speculation that recent price increases are transitory or “baked-in” inflation of the price of goods.

Current Strategy – Inflation-Growth Pullback and Reflation:

At TFM we run three strategies, a low volatility strategy, a midterm strategy, and a growth strategy. Each “bucket” is designed to meet financial metrics around capital appreciation, income, and risk. Overlaying those metrics is our framework where we target capital light and tax like companies, as well as fourteen sectors that we feel have tailwinds over the next decade. At different points in the economic cycle certain portions of the fourteen sectors are more in favour than others.

From the end of the Covid crash, which ended Mar 23rd with the simultaneous firing of Central Bank stimulus bazookas, we have been playing a barbell strategy of assets with a high correlation to their respective markets in real estate infrastructure, commodity, and tech sectors. In June 2020 we began to add some reflation plays as a vaccine announcement was becoming more and more likely.

With the rally in growth stocks reaching its peak on Feb 16th, 2021, the prospect of an increase in real interest rates and inflation lurking, we have reached a point where our strategy adapts. This means we will rotate to sectors that will work well in the new financial landscape - a landscape that increasingly looks like dealing with an economic cycle that could be a quarter to half the length of a traditional 7 to 10 year cycle.

The biggest change to our holdings will be in long term portfolios, as the low volatility and midterm accounts hold many of the assets that work well at this point in the cycle. Around the time of our last update, our longer-term portfolios moved to a cash position around 17%. Since that time, some cash has been reallocated to additional “reflation” holdings to good effect. The balance of cash has been retained as we see weakness continuing to hit parts of the market as the challenges of a proposed higher US corporate tax rate, supply chain disruptions and subsequent price spikes weigh on investors’ minds.

Beaten up sectors often mean beaten up share prices of some quite good companies. With the shift in markets, like during the Covid crash and subsequent rally, we reduced our exposure to high growth tech whose valuations were based on longer term cash flows - this was a positive move. Where we felt we had to retain some exposure was concentrated in technology companies that show near term earnings and niche capabilities in data utilisation and cyber security. The selloff in technology stocks in general has continued and while at the moment retaining these names impacts short term performance, they have cash on their balance sheet / low or no debt, genuine earnings, positive cashflow and a runway to grow, as well as operating in areas that will require old and new world companies to buy their services even as interest rates rise.

Some specific companies that have been beaten up the last few months are Tesserent (cyber security), Bubs (infant formula), Appen (data annotation and utilisation) and Nuix (a specialist legal and cyber security system provider). All four companies are part of our framework representing, protein, cyber security, and artificial intelligence plays, respectively.

Bubs has recently seen their Chinese infant formula business affected by the loss of the Chinese student driven daigou channel, where special shoppers here in Australia would clean out grocery shelves of the product to send home at a profit. The company is much more than a China play and has established a strong growth presence in Australia and SE. They have made a key COO hire with experience in the region, and they have 22 months of operating cash on their balance sheet. The recent troubles at A2 Milk have hit the sector hurting the share performance at Bubs. We view Bubs as a reopening play and that benefit from the reestablishment of the foreign student flow to Australian universities.

Appen is a data annotation company that will be assisted by the ever-increasing amount of data that moves to the digital environment with the World’s largest companies being end users of their data annotation capabilities. The company is profitable, and a major market player within the sector with strong cash balances.

Tesserent is an Australian Cybersecurity business that is growing strongly by both acquisitions and with organic contract wins in the Australian middle market business sector and with the Five Eyes governments selling cyber security solutions. With recent attacks on Channel 9 in Australia and oil pipeline owners in the US by hackers, this remains an area that requires an allocation in portfolios as the incidence and scale of cyber-attacks is likely to increase rather than decrease.

Finally, Nuix is a legal tech company that helps with the discovery process of cases. Their product is one of the best in the sector and is growing in users. Like Appen, Nuix is a profitable business now, with positive cash flows and over a years’ worth of cash on the balance sheet. Nuix is new on the ASX exchange, as it was recently floated. Nuix has decided to convert their product to a subscription as a service (“SaaS”) model, from the current licencing. When a software business makes this move, they create sticky and steady customers, but their cashflow suffers in the short term. These short-term worries over user growth and cashflow during the transition to SaaS at a tumultuous time for growth shares has caused a tumble in the shares of Nuix. Timing is everything.

Updating our checklist:

• Valuation: The ASX200 P/Efwd is 19.22x and the S&P P/Efwd is 22.65x. The recent sell off in the US combined with earnings expectation upgrades has brought valuations back down from when we last reported. With a reopening economy the UK looks significantly cheaper than the US at the moment.


• Global PMIs: Continuing the push for commodities is China’s expanding money supply and PMIs. The Caxin purchasing managers index came in ahead of expectations again, accompanying a large burst in export figures. While iron ore and copper cannot rise forever, there is depth to the demand for both commodities that is being extended.


• Downgrades on guidance: Earnings season is ending, and we are starting to look to year end for Australia and Q2 overseas. Confession season has begun. Announcements of rejigged guidance will begin to roll in over the next 4weeks as companies look to update the market.


• Infection rates to slow globally: Flare ups in India are starting to see progress as public health measures and vaccination begin to gain traction. The US and the UK have seen demand for the vaccine fall and are embarking on efforts to get vaccination to the 70% herd immunity threshold. If you get your jab in Ohio, you have a chance to win one of five $1m prizes. Other jurisdictions are offering free drinks or pizza to get people out. With the vaccination rate falling in the US, Canada is starting to roll and has taken the lead in vaccination. The Canucks are now immunizing their population at 3x the rate of us here in Australia. We had a run of bad luck with the vaccines we backed here and now we are waiting for supply to free up. You can follow Australia’s vaccination journey with our live vaccine tracker at the link below:
  
  TFM Vaccine Tracker




• Monetary and Fiscal stimulus announcements globally: The Australian Federal budget came out this past week. The Federal Treasurer, Josh Frydenberg, delivered the details of a budget that splashes significant amounts of capital for everyday Australians. Infrastructure, the middle class and first home buyers are amongst the beneficiaries. Australia will deficit spend to make this budget happen, but iron ore at over $200 per tonne against a Federal Budget estimate of $55 helps a lot. One of the keys of the budget is the government’s targeting of the unemployment rate below 5%. This mark would see wage growth of over 2%. It is an election year style budget from the Liberal government, next up is to see if we go to the polls soon.
  

The broader economy continues to improve both at home and abroad. Markets are a leading indicator, and as we saw during Covid, do not necessarily reflect what is going on in the real economy now. Inflation is a fear again, with commodity prices rising, real estate on a run and wages set to grow with a falling unemployment rate. Markets will adjust, and then certain sectors will become the best place to hide if inflation does become a problem. As mentioned above we do review our strategy frequently, and our advisors are trained to use our products to meet your longer-term financial goals. If you do not feel like going it alone or find yourself with some extra capital, we recommend you get in touch with one of our advisors to discuss putting that capital to work. Take care and we will be in touch again in two weeks.

Regards,