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Why volatility is good for investing

Richard Hemming

Find out how Under the Radar made an average cash return of 170% on the way up and how we’re seeing value after the current sell off.

THE IMPORTANCE OF TAKING RISK OFF THE TABLE

In our Big Bumper Issue this week, we have a special case study on managing risk. We summarise our actions on some 21 stocks in our current universe that we have been taking profits on. This emphasises the value of cashing in when you are making profits.

We don’t always get it right (and yes, we’ve had some doozies). There are cases where we’ve made significant losses. But cashing in when you have been profiting is important in order to offset those losses and overall and over the long-term, we’ve been on top.

We detail how we have achieved an average cash return of 170%.

Some of the stocks in Under the Radar’s Small Cap Portfolio we had held for a long time, like Melbourne IT, now called ARQ Group (ARQ), Clover (CLV) and Nick Scali (NCK) and have delivered triple digit returns. These are great companies, but it only counts if you take profits off the table. We used the market strength of the bull run in the lead up to this year to bank some profits.

A graph showing the last 5 years of Freedom Foods (FNP)

 

VOLATILITY IS BACK AND HERE TO STAY

One minute investors are bullish over a US Federal Reserve Chair Jerome Powell signal that the fast pace of interest rate rises will slow; the next they realise that this means the economy is slowing and hit the sell button. One minute the market hails the great deal making prowess of US President Donald Trump in averting a trade war; the next they realise he’s all bluster and start selling.

The US market remains expensive, interest rates are on the up, and trade tensions are rising, which means that it doesn’t take much to swing the market either way. The easy gains are seemingly at an end and share market volatility is back again. Value investors like myself are breathing a sigh of relief. “Why is that?” you might ask

WHY IT’S GOOD FOR STOCK PICKERS

For one thing, we’re seeing a great deal more value. If a stock is priced at $1 one day and 80 cents two months later, but nothing has changed in relation to its profitability, its value proposition has improved! After climbing 65% since mid-2013 to early October 2018, the ASX Emerging Companies Index has fallen over 22%. The index has touched the same level it was in 2014.

Volatility is also good for stock pickers because it means that the dispersion between the best and worst stocks is high, or at least, higher than it was. When volatility is low, everything pretty much moves in the same direction, so there is little value stock pickers can add. Higher volatility is associated between a bigger divergence between the winners and losers.

WHAT’S HOT AND WHAT’S NOT AT THE BIG END OF TOWN

At the big end of town, the selling has included expensive growth stocks such as the travel companies Webjet (WEB) and Corporate Travel (CTD), while value names such as Rio Tinto (RIO) and Telstra (TLS) that have performed poorly are being sought after because their valuations are underpinned by relatively sustainable, albeit low growth, earnings. Amidst the negative news coverage of the Financial Services Royal Commission in the past couple of weeks, investors are actually buying the big banks, such as Comm Bank (CBA), which are trading at the their lowest discount relative to the All Industrials ex banks earnings multiple since the early 1990s.

Many stocks in our universe of Small Caps are not overvalued and there is less possibility of sustained general market weakness. Some of the heat has been taken out and we’re looking to take advantage. Where we labelled many of our favoured stocks speculative, in this post-correction world they appear less so.

Regardless of whether there is volatility or not, the big share market falls highlight the importance of taking some risk off the table when your stocks do well. Perfect market timing is almost impossible. Many investors cashed out as soon as Donald Trump became the US president just under two years ago. What a mistake that was. Having recently run through our own universe it has become clear how important it is to take profits when a stock is over valued and to buy back in when that same stock comes off. Also, here’s a tip: don’t reinvest dividends! Cashing in on corporate profits via dividends is a great way of crystallising value and reducing risk.

THE TIME TO BUILD YOUR PORTFOLIO IS WHEN THE MARKET IS WEAK

Two stocks we have previously taken profits on we now like at current levels. One is the allergen free food producer Freedom Foods (FNP) whose stock is down 25 per cent in the past three months. A conservative FY19 estimated EBITDA of $50m implies an enterprise value to EBITDA multiple of 20 times as a best case scenario. This is a high price, but this is a quality small cap that has grown into a mid-cap, where a founding family shareholder controls the long-term outcome.

A graph showing the last 5 years of Freedom Foods (FNP)

Online retailer Kogan (KGN) has been hit by a combination of a weak market, a negative reaction to share sales by founders and directors, and increased competition from offshore retailers not collecting GST. Its stock has almost halved in the past few months. Despite its GST disadvantage, the fundamentals of Kogan remain strong with active users increasing 38 per cent in the year to 31 October from the prior year, while FY18 revenues climbed 42 per cent to $412m. I’m not saying Kogan won’t be a volatile stock, but as Australia’s clear number one online retailer, now may be the time to grab it while it’s on a (relative) discount.

About the Author

Richard Hemming

Investment analyst and Editor of Under the Radar Report

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