In almost 30 years of writing about equities I cannot recall a market as strange as this one. Sure, there have been bouts of irrationality over the years: the dot.com boom made no sense and the mining boom got out of hand. But some unusual dichotomies are at play today.
Our share market hit a record high this week, despite the yield on the benchmark 10-year Australian Government bond hitting a record low. Optimists say equities look attractive relative to bonds; pessimists say falling bond yields are signalling a deteriorating economy.
Several European countries now have a negative bond yield and there is a chance Australia could join them or get close within two years. Some economists believe the terminal rate (low point) for the Reserve Bank official cash rate is 50 basis points, implying another two rate cuts.
So we have negative bond yields overseas suggesting economy distress and local bond yields predicting a slowing economy, which is bad for corporate earnings and share prices. More on that will be known when ASX-listed companies report full-year earnings in August.
At the same time, the US-dollar gold price is up 23% from its low this year. Investors normally buy gold as a safe haven or when they expect further falls in interest rates, like now. The upshot is US-dollar gold at a five-year high and equities markets at record highs. And investors buying safe-haven and growth assets at the same time. Something has to give.
The dichotomy in small-cap equities is just as perplexing. Some small and mid-cap stocks are soaring and at irrational valuations. Think of the WAAAX stocks (Wisetech Global, Appen, Altium, Afterpay and Xero), which are best avoided. Or Nearmap or Pro Medicus.
But many long-established small and micro-cap stocks are trading at GFC-like valuation multiples. Driven by quantitative momentum-trading strategies, money is pouring into high-growth stocks and deserting the rest. That creates pricing inefficiency.
Here is another dichotomy: the market is booming yet there are hardly any initial public offerings (IPOs). I follow the IPO pipeline and in 2007 – the previous market peak – there were 200. This year – the new market peak – we will be flat out doing 50.
Bull markets normally encourage companies to raise equity capital through an IPO and list on stock exchanges. Rising commodity prices, in particular, flush out junior explorers, some of which have little more than a PowerPoint presentation and a patch of dirt to promote.
Not this time. Resource floats have trickled to a standstill in the past few years. Perhaps the IPO market will heat up after the profit-reporting season and a rush of floats will emerge in the traditionally busy fourth quarter, when promoters rush to close offers before Christmas. I can’t see it.
Experience tells me that when dichotomies such as this emerge, extreme caution in the share market is warranted. When most asset classes are rising, trades become crowded and the party usually ends abruptly and violently. Better to head for the exits too early than too late.
That has been my strategy this year: cautiously reducing equities exposure and adding more cash, fixed interest and infrastructure (assuming rates fall further). Investors should make portfolios more defensive and focus on the first rule of investing: capital preservation.
Case for small caps
It might seem odd to suggest value investors consider micro/small/mid-cap stocks in a market that looks overvalued and dangerous. Typically, small-caps rally at the later stages of bull markets and too often become portfolio landmines as investor greed sets in.
This small-cap market is unlike any I have seen. A narrow group of small and mid-caps, mostly technology companies, have soared. Many have languished. It is a market of two halves: small-caps bid up to crazy heights and small-caps forgotten about.
In search of opportunity I ran a screen through Morningstar’s database to identify small-caps with a trailing yield of at least 6%.
Database screens should be viewed as a starting point for further analysis, not a list of stocks to buy. And future earnings, of course, matter most. Still, I have found over the years that screens for small-cap yield, provided the dividend is sustainable, are a handy tool.
Most stocks that came up in the screen are best avoided: they are in structurally challenged sectors, have had nasty profit downgrades or are poorly managed.
Three stocks caught my attention. I emphasise that each suits experienced investors comfortable with small-cap investing and higher risk.
1. Aventus Group (AVN)
I first wrote about this owner of bulky-goods “superstore” properties for The Switzer Report in 2016 when it was $2.23. Aventus rallied to $2.50 within a year, then tumbled to $2 late last year as retail paranoia set in. It now trades at $2.43.
My thesis for Aventus is unchanged: the Real Estate Investment Trust (REIT) has an interesting position in a property niche that is poorly represented by other REITs. “Big box” retailing has good prospects and should be less affected by growth in online retailing.
Interest rates cuts and tax refunds should be a modest tailwind for bulky-goods retailers in the next 12 months. No doubt the tax cuts will pay for a lot of TVs.
At $2.42 Aventus is yielding 6.7% and should be able to maintain its distribution in a tough retailing environment, and slowly grow it over time. More will be known when Aventus reports its full-year result later this month.
Chart 1: Aventus
2. APN Convenience Retail REIT (AQR)
Like Aventus, APN has an interesting market niche: the REIT owns a portfolio of 70 service stations and convenience retail assets across Australia. Most of the assets are leased to well-known tenants, such as Woolworths and 7-Eleven, on long leases.
APN Funds Management, a well-performed property investor, launched APN Convenience REIT via an IPO on ASX in July 2017 at $3 per unit. The REIT now trades at $3.33 after rallying in the past month.
I like the long-term outlook for convenience retail. Population growth inevitably means more cars, traffic congestion and longer commute times. The number of service station locations around Australia has been relatively static despite this growth. Service station properties good locations in the larger cities, will become increasingly valuable.
Service stations tend to have long leases and quality clients. Also, the retail offering at service stations is expanding as 7-Eleven and others become mini-cafes and retailers. My local service station is standing room only after school as kids rush to the 7-Eleven for a Slurpee.
At $3.33 APN is yielding 5.5%. The yield has edged lower as the price has risen, but looks attractive given the quality of the APN Convenience Retail portfolio.
Chart 2: APN Convenience Retail REIT
Source: ASX
3.Kathmandu Holdings (KMD)
I am normally wary of investing in discretionary retailers for yield. The industry faces immense structural challenges and earnings can be volatile, hurting dividend stability.
Kathmandu has fallen from a 52-week high of $3 in October 2018 to $2.07 amid the retail malaise. The outdoorwear retailer has had a tough 12 months after a cybersecurity attack, the terrorist attack in New Zealand, and a milder and drier winter than usual.
At $2.07 Kathmandu is yielding 6.7% fully franked and plenty of bad news is factored into its share price, judging by its trailing PE of 12.7 times.
I believe Kathmandu has two key advantages. First, it is a perceived as a high-price, high-quality brand. Consumers race to its discount sales to buy a $500 jacket for $300. Kathmandu has scope to maintain higher margins because it is starting from the premium end. The risk is that Kathmandu overdoes the discounting and damages brand perceptions.
The second asset is Summit Club, one of Australia’s largest fashion retail databases. Having around two million customers to target online through the customer loyalty program is a valuable asset and one that Kathmandu can do a lot more with.
Chart 3: Kathmandu Holdings
Source: ASX
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 31 July 2019.
