Daily Thematic: More than Just Banks and Resources: Opportunites in Aussie Tech and more

In this briefing:

1. More than Just Banks and Resources: Opportunites in Aussie Tech
2. Ursus Interruptus
3. Screening the Silk Road: Q1-2019 Small-Mid Cap GARP (Zulu Warrior Screening)
4. Japan: Moving Average Outliers – New Year Rally
5. Japan: What to Buy & Sell if the ¥ Rises to 90

1. More than Just Banks and Resources: Opportunites in Aussie Tech

• Australia’s IT sector generally flies under the radar, particularly with international investors who see Australia as mainly a Resources play on China and a Banking play on the domestic economy. China is coming to an end, as its demand for raw materials slows and the economy becomes more service and consumer orientated and this will surely slow longer-term earnings growth.  In the short-term, the domestic Banks are at the mercy of the Banking Royal Commission, falling house prices in Sydney and Melbourne a household sector with high debt.
• While it will be a very long time before the IT sector becomes a meaningful composition of the benchmark there are some exciting stocks showcasing Australian IT development capability. The entire sector of 12 stocks is less than 50% of the market cap of BHP, but it has generated impressive returns vs not only the benchmark but also the global IT sector. 
• Stock analysts tend to under-estimate earnings and this sets the sector up for relatively good performance vs the global benchmark. The sector has performed relatively well during the tech-led global equities correction and it has not seen the large number of downgrades seen in the global benchmark.  However, it now trades on a Price: Book discount and looks relatively attractive, in our view.
• If the rally in global equities can sustain momentum over the next few months, we think several stocks in the sector can provide investors with solid outperformance. We have written extensively on our view that the equity market downturn in H2 2018 was a correction and not the start of a deep end-cycle bear market. 
• We included WTC and TNE in our update to the model portfolio that was included in the 2019 Equity Market Outlook.TNE has generated solid cash flow performance and earnings growth from its domestic growth agenda, while WTC has also generated good cash flow performance from its acquisition-by-growth strategy.  CPU has delivered best in class improvement in earnings quality within the ASX 200 universe, closely followed by WTC.  LNK and APX have seen deteriorating earnings quality. 

2. Ursus Interruptus

A number of readers were surprised by our recent change of view (see A Rare “What’s The Credit Card Limit” Buy Signal). We had been adopting a cautious tone since August (see A Major Market Top Ahead).

The September–December decline had been highly ambiguous. I believed that unless I could pinpoint the reasoning behind the risk-off episode, it was impossible to call a market bottom. However, U.S. equity prices had already fallen about 20% on a peak-to-trough basis, and the historical evidence indicates that such a decline is already discounting a mild recession. How much worse can it get?

In addition, technical signals such as the Zweig Breadth Thrust, indicate that psychology is washed-out and turning around. The statistical odds favour high prices over a one-year timeframe.

We had mainly focused on the risk conditions in the past, while ignoring valuation. Today, the combination of favourable valuation and positive momentum has changed my outlook. Based on these conditions, we would expect stock prices to grind upward for the remainder of 2019, but in a volatile manner.

A balanced fund that was at target weight in its asset allocation would be underweight equities today. We suggest that accounts raise their equity risk profile by re-balancing back to target weight. Should the stock market weaken and re-test the old December lows, it would be a signal to take a risk-on position and overweight equities.

From a technical perspective, the breadth thrusts were signals of the initial bottom is in, but to expect further volatility in the next few months. Don’t be surprised if the stock prices were to weaken again to test or undercut the December lows in a double or multiple bottom. Looking out 6-12 months, history tells us that returns should be positive.

3. Screening the Silk Road: Q1-2019 Small-Mid Cap GARP (Zulu Warrior Screening)

• Value made a comeback, but growth remains core: In May 2018, we examined the divide between value and growth stocks, ( Notes from the Silk Road: Small-Mid Cap Screening for Zulu Warriors). As Q3 unfolded, this eventuated with a +7.5% reversal in favour of value stocks, only to see growth resume dominance in October and November.
• The optimal value/growth style dynamic: We feel exposure to growth at a reasonable price (GARP) coupled with a healthy FCF yield (via our amended Zulu Screen) should provide some healthy medium to long term returns for investors.
• The Screen’s Risk: The Zulu Screen relies on analyst estimates. When market sentiment is weak and forecasts are not amended in a timely manner, the screen is susceptible to mis-selection.
• Q2 2018 screening list succumbed to volatile markets: This was seen in our May screen with our list posting on average a 30% decline in share price, relative to the broader Asia-Pacific Ex-Japan declining 13.6% and the Asia Pacific index by 11.8%.
• Are there reasons for the underperformance? 10 of the 19 stocks in the May screen were from Hong Kong, which saw the Hang Seng Index (HIS) decline 16% over the same period. The decrease seems due to concern over trade wars and doubts about the China economy. Our key approach to stock selection is to take a medium-to-long-term view as well as focus on quality ranked stocks relative to their peers. This is highlighted via the average stock rank of the group declining only 15.8% from 89.6 to 75.5 points.
• Our Q1 2019 screen selected only 9 stocks. Of the 9 stocks identified, the average PEG Ratio was 0.4x, the price to FCF yield was 11% and ROCE was 25%. Stocks were selected from Australia, New Zealand, India, Korea, Japan, Hong Kong, Taiwan and Singapore. Cowell Fashion Company from Korea was the only remaining stock from our May screening.

4. Japan: Moving Average Outliers – New Year Rally

MARKET COMPOSITE

NEW YEAR RALLY – From the December 25th’s lows of 8% by number and 11% by value, the percentages of Japanese stocks above the weighted sum of moving averages have recovered to 14% by number and 20% by value – just on the ‘buying zone’ line. As we expected, the Total Market Value has rallied 8.7% and looks to have some further to run, especially if the Yen reverses some of its recent strength. The Bank of Japan provided a ‘helping hand’ on both 4th and 10th January, the only days this year so far on which the market declined. 

SECTORS

SECTOR BREAKDOWN – The top six sectors measured by the percentage above the weighted average of 5-240 Days remain, predictably, domestic and defensive – REITs, Information Technology, Media and Utilities continue from our previous review with Healthcare and Transportation replacing Food, Beverages and Tobacco and Internet Content & Services. Equally predictable is the bottom half-dozen. Banks, Autos, Metals, Electrical Equipment, and Chemicals remain from 23rd December Moving Average Outliers Insight, with Building Materials replacing Non-Bank Finance. Over the last trading five days, however, there has been a noticeable reversal with Autos, Electrical Equipment, and Machinery all over ’55’ while Other Consumer Products, Restaurants, Telecommunications and Food, Beverages & Tobacco are all below ’40’.

COMPANIES

COMPANY MOVING AVERAGE OUTLIERS – As with the market and sectors, our moving average outlier indicator uses a weighted sum of the share price relative to its 5-day, 20-day, 60-day, 120 day and 240-day moving averages. Extreme values are weighted sums greater than 100% and less than -100%. We would caution that this indicator is best used for timing shorter-term reversals and, in many cases, higher highs and lower lows will be seen. 

THE +/-100% CLUB – The number of extreme negative outliers reached a peak for 1,352 on December 25th and has since returned to ‘normal’ levels. We suggested in the previous Insight in this series that such an extreme number of extremes was a signal of a short-term bottom, which, so far, has proved to be correct.

5. Japan: What to Buy & Sell if the ¥ Rises to 90

Source: Japan Analytics

CURRENCY DRIVER – The ¥/US$ cross rate has strengthened by 5.3% since the recent US$ peak of ¥114.20 on November 12th 2018, which has led some FX and technical specialists (including Thomas Schroeder  here on Smartkarma) to call for a more sustained bout of US$ weakness. A period of Yen strength is far from a consensus forecast for most Japanese equity investors, and historically a stronger Yen has resulted in a weaker Japanese equity market. The three Yen ‘peaks’ highlighted by the vertical lines in the chart above all coincided with medium-term lows in TOPIX.  

¥ < 100 – If we isolate only the 1,484 days in the last forty years when the USDJPY cross has traded above ¥100, the average TOPIX index is 975, which would imply 36% downside for Japanese equities were the Yen to rise above ¥90. Nevertheless, the three Yen peaks we have isolated have proved to be excellent entry points with the subsequent trough-to-peak performance being 28% in 1995~1996, 108% in 2011~2015 and 48% in 2016~2018. Long-term Japan ‘bulls’ should welcome the coming US dollar bear market. 

EARNINGS DRIVER – The USDJPY cross remains an important driver of earnings and earnings momentum in Japan. As measured by our Results and Revision Scores, there is a good correlation between the trends in both scores and the year-on-year change in USDJPY lagged by six months, especially around significant turning points for the cross rate (marked by the vertical lines). The Results and Revision Scores have declined since January 2018 in line with the stronger Yen. A move up to above the ¥90 level would, without doubt, take both scores into negative territory again- the only question being, are we replaying 2009/10 or 2016/17? 

CURRENCY CORRELATIONS – In the DETAIL below, we list the larger capitalisation companies whose share price performance most closely correlated with the dollar-yen cross rate. As a preview, the most correlated larger capitalisation company that has been listed since 2006 is, unsurprisingly, Toyota Motor (7203 JP).

THE FOREIGN CURRENCY TRANSLATION ADJUSTMENT – We also go one step further and use the ‘Foreign Currency Translation Adjustment’ that forms part of Other Comprehensive Income (which has been disclosed in corporate balance sheets and income statements since 2001 and 2011, respectively) to measure the extent of each company’s global business and the embedded currency risk. The correlation of the aggregate FCTA for all non-financial companies is, as would be expected, reasonably tight after adding two-month lag for the reporting cycle. As these amounts are directly deducted from Net Assets for companies adopting JGAAP and from Shareholders’ Equity for those companies reporting under SEC or IFRS standards, the impact on valuations cannot be ignored.