Bank holiday Double issue: Macro and Investment Ideas

A deeper dive into energy markets, why readers are cautiously bullish especially on EM equities, Citywire’s new elite fund manager tool and first impressions of small fintech outfit TruFin

Poll results: a slight bullish skew

Last week I asked readers to vote on their investment views – over 300 of you took part and the results are below.

Overall, I’d say there is no clear message, though the tone is cautiously bullish.

Slightly more of you - 35% - are more bullish since the start of the year but 31% of you are less bullish. No great signal there.

As for the equity geographies, the only clear winner was emerging markets – everything else was a bit muted.

Lastly as for cash (more/less), the biggest vote was for no change with decreasing cash being the next best choice.

So, if we can sum it up in sentiment terms. I’d say we are very cautiously bullish on equities, and probably most bullish on Emerging Market equities. I wouldn’t be that far away from that position myself.

Markets in April: sideways shuffle

So, the numbers are in for April. In the key US benchmark, the S&P 500, we’ve experienced a sideways market, which has edged a bit higher off the back of decent earnings numbers. Here is a very useful summary from analysts at S&P Dow Jones:

• For April, the S&P 500 posted a 1.46% gain, after March’s 3.51% gain and February’s 2.61% decline. Year-to-date, the index was up 8.59% (after 2022's 19.44% decline, 2021's 26.89% gain and 2020's 16.26% gain).

• Breadth for the month ticked up, as 266 issues were up (263 last month), with 22 (32) issues up at least 10% and 1 (7) up at least 20%, while 235 (240) declined, with 28 (53) declining at least 10% and 4 (14) down at least 20%. Year-to-date, breadth increased, with 291 issues up (47 up at least 20%) and 212 down (19 down at least 20%).

• The market moved higher as earnings beat the lowered estimates, with an expected small gain (1.3%) over Q4 2022, but they were weaker than previously expected, with forward guidance cautious. Inflation continued to decline, but slowly, as the Fed May 2-3 meeting was expected (85% based on futures) to end with another 0.25% increase, as the market was betting it would be the last for now (with 23% expecting another 0.25% increase in June).

• Volatility significantly decreased for April, as the market posted a 1.46% gain on positive breadth, as the YTD was up 7.71%.

• The average daily high/low spread declined to 0.92% from last month’s 1.51%.

• 3 of the 19 days had an intraday high/low spread of at least 1%, compared to 11 last month.

• Trading declined 24% for the month.

As for investor positioning overall, analysts at Deutsche Bank confirm that sideways, cautious optimism positioning – they see “Flat overall positioning” as equities “go sideways through the first two weeks of the Q1 earnings season despite a big spike up in beats and earnings tracking the first sequential rebound in this cycle”. In sum, nothing much to write home about!

One good bit of news is that US corporate earnings are looking very solid. Deutsche reports that we are now nearly two-thirds of the way through the season (265 companies in the S&P 500, 64% of market cap have reported), and “every measure of beats has spiked this quarter to well above historical averages. The magnitude of the jump across several measures is something that has been seen only when coming out of large downturns such as the GFC and the pandemic shock….Earnings growth in yoy terms is on track to rise slightly (-3% to -2%) from Q4 to Q1, but to remain negative. On a sequential basis, however, adjusted for seasonality, earnings are on track to rise a very strong 5.1% qoq from Q4 to Q1.”

What is very noticeable though is the breadth issue, or should we say lack of breadth! Although it’s true that most S&P 500 were marked up in April, the great majority of the gains came from a handful of tech stocks.

According to analysts at SocGen, the top 10 stocks are responsible for 86% of the overall index return. In the chart below they compare the concentration of returns this year to quarterly returns going back to Q4 2021. The current situation is the most extreme example they’ve found in the recent past. As they remark, a “Pictures worth a thousand words...”

Energy: Bumper profits and more to come

I’m interested to see how the corporate greedflation story (corporates using the inflationary situation to boost operating margins) is feeding through into popular discourse. The Times last week ran a story based on research by Jefferies analyst Martin Deboo which showed those margins were ticking up.

Deboo pointed to “the price increases pushed through by Unilever last year were 31 per cent greater than the increase in its cost of goods… Deboo’s analysis also shows that price rises by Reckitt, the powerhouse behind Dettol cleaning products and Durex condoms, were more than double the increase in its cost of goods last year — albeit he conceded that the way in which Reckitt reports meant that figure was overstated to a degree”.

As an aside, as regards the UK context, its worth noting that although the overall UK corporate profit margin has edged up noticeably, it’s still only a tad above the medium-term average. The US is very different.

Most of the greedflation anger though is being directed at the energy sector. BP’s first-quarter numbers are just out, and they showed a big increase from $49.3bn to $56.2bn but underlying replacement cost profit, BP’s headline measure of profit from operations, was down 19.4% to $5.0bn.

Over in the US by contrast, it’s a very different story. The US energy majors are rolling in cash!

The WSJ reports that

“Exxon’s quarterly net income of $11.4 billion and Chevron’s $6.6 billion more than double their quarterly averages for the past 10 years, a Wall Street Journal analysis showed. The results amounted to a first-quarter record for Exxon. Even so, both companies’ earnings were off more than 40% of the record quarterly profits they reached last year. Despite falling prices, both companies cited climbing oil-and-gas production as critical to their returns, while adding that their efforts to boost low-carbon energy supplies are growing quickly. Exxon said its oil-and-gas production rose by almost 300,000 barrels a day compared with the same year-ago period”.

Another key number to watch out for is the growing cash mountains. Exxon had almost $33 billion in cash at the end of the quarter, a larger war chest than it has had since mid-2008, FactSet data show. And what might they do with that cash? The message seems to be they’ll conserve the cash in case energy prices fall and they need a fallback position to fund new capex projects.

Now, the standard narrative at this point is to switch back to those energy futures markets and ask what might happen to oil prices i.e that energy stocks have a tight correlation with spot prices (which they largely do). Here the key moving parts are of course OPEC Plus which is trying to keep prices higher by cutting output, the likely impending slowdown/recession/the strength of the Chinese rebound, and the abnormally mild weather of the last winter.

Over the last week or so, the recession fear has won out and oil prices have slipped below the $80 level but it’s worth noting that oil is still up from a 15-month low reached in mid-March. I think Bloomberg has it spot on when it says that “ the lack of enthusiasm to take it [oil prices] higher suggests big reservations about the ability of supply restrictions to have much effect. It also tends to confirm the evidence from the bond market that sentiment is swinging back toward a belief in an economic slowdown with lower rates in its oily wake. “

But there are some confounding factors worth watching out for if you are an investor. Bloomberg’s excellent Javier Blas has been visiting the crucial Permian Basin hotspot of Midland, Texas, where the found an “interesting consensus: Output will likely reach its peak in a few years and remain flat. That leaves the question of what a post-peak planet will look like — and right now it looks like shareholders are going to be the big winners of the shale slowdown.” The moral of the story - those unconventionals with valuable existing reserves will get snapped up quickly.

“The once famously fragmented shale industry is ripe for M&A, and it’s going to mean big money for massive conglomerates like Exxon Mobil (which, Javier writes, is in the enviable position of having lots and lots of cash) and ConocoPhillips that have deep pockets to prioritize efficiency over growth” according to Bloomberg.

That augurs badly for the continued dominance of the US as a marginal supplier to rival the Saudis.

All of this brings me nicely to a recent market overview from energy investors at Guinness Asset Management. They look at oil markets from the Saudi point of view and reckon that the middle eastern petrosuperstate has a sweet spot price of around $80 to $100/bl which is “an affordable price range for the world economy, generates fiscal surplus, and avoids excessive supply growth from the non-OPEC world. It is this range that Saudi and its allies will continue to work towards as the year progresses."

I’d agree with that view. We might see breaks below $80, down to $70 as well as some breaks above $100 to $110 once the markets anticipate an economic rebound later this year.  But $80 seems about right for the medium-term equilibrium price. Guinness again:

“Based on a Brent oil price of around $80/bl in 2023, we calculate that the world would spend around 3.1% of GDP on oil, in line with the 30-year average of around 3%. We believe that oil would need to increase to over $120/bl, reflecting 5%+ of world GDP in 2023, if it were to have a noticeable negative impact on the global economy. Saudi know this, and we believe it is not part of their ambition to drive prices as high as $120/bl+.”

So, I think it’s sensible to factor in something like $75 or $80 a barrel for oil prices all things being equal with lots and lots of variation around that average. The Guinness fund managers then use that likely price to look at their own portfolio of major oil stocks – with the current valuation implying that the ROCE on their stocks will stay about 6%.

" If ROCE remains at 10-11% (which we forecast in a $75/bl world) and the market were to pay for it sustainably, it would imply an increase in the equity valuation of around 30-35%. To put this another way, we are often asked what oil price is implied in the portfolio, as a barometer of the expectation priced into the equities. At the end of March, we estimate that the valuation of our portfolio of energy equities reflected a long-term Brent/WTI oil price of around $61/bl combined with a normalisation of global refining margins. If the market were to price in a long-term oil price of $70/bl, it would imply around 25-30% upside while there would be around 55-60% upside at a long-term oil price of $80/bl Brent”.

Chart : ROCE vs P/B multiple for Guinness global energy portfolio

Source: Guinness Global Investors estimates to 31.03.2023

I’d add the following very large table below. This looks at the energy businesses in the S&P 500 and breaks them down into two groups – the integrated majors and oil and gas developers alongside the service companies and refiners. I then focus on two sets of metrics: performance stats and share price fundamentals.

The key numbers are at the top of the graphic: The average operating margin for direct energy businesses (drilling stuff out of the ground and then selling it) is now running at 42% with a current price-to-earnings ratio of 7.55, rising to a forecast PE of 11 in the coming year. Return on capital employed is at just under 32% and price to free cash flow is a very reasonable 10% with a forecast dividend yield of just under 3%.

I would make one simple comment – if the Saudis succeed in keeping oil prices above $80 on average over the coming year or two (quite likely if the economy picks up and inflation stays high), then these US oil and gas plays will be rolling in cash.

Commercial Real Estate rumbling

I’ve already mentioned a few times that I think the next thing to watch out for is the impending CRE crash ! Here’s Charlie Munger in the FT on the same subject

“It’s not nearly as bad as it was in 2008,” the Berkshire Hathaway vice-chair told the Financial Times in an interview. “But trouble happens to banking just like trouble happens everywhere else. In the good times you get into bad habits . . . When bad times come they lose too much.” Munger was speaking on the veranda of his home in Greater Wilshire, a leafy neighbourhood of Los Angeles, where he has lived for 60 years since he designed the property himself. Dressed in a plaid shirt, Munger held court from his wheelchair as the travails of ailing California-based bank First Republic were playing out in real time on a television screen airing CNBC in the background.

“Berkshire has made some bank investments that worked out very well for us,” said Munger. “We’ve had some disappointment in banks, too. It’s not that damned easy to run a bank intelligently, there are a lot of temptations to do the wrong thing.” Their reticence stems in part from lurking risks in banks’ vast portfolios of commercial property loans. “A lot of real estate isn’t so good any more,” Munger said. “We have a lot of troubled office buildings, a lot of troubled shopping centres, a lot of troubled other properties. There’s a lot of agony out there.” He noted that banks were already pulling back from lending to commercial developers. “Every bank in the country is way tighter on real estate loans today than they were six months ago,” he said. “They all seem [to be] too much trouble.”

Analysts at JPMorgan have also been echoing this concern, linking CRE to the regional banks’ squeeze.

“They note the office sector faces its own set of challenges, but do not believe that potential losses within the office sector are likely to destabilize regional banks.  However, they believe the small bank lending channel more generally does represent a macro risk, as tighter lending standards and profitability challenges in the banking sector could reduce available financing and raise the cost for small and medium sized businesses.”

Investment Ideas: Citywire’s new tool and TruFin

Fix the Future: Citywire’s new tool

I thoroughly recommend looking at Citywire’s new Fix the Future tool and accompanying commentary. The idea is actually very simple: track the best-performing fund managers and then aggregate what they invest in at the single stock level.

Or as Citywire describes it: “Applying an actuarially approved methodology, our search starts with the companies backed by the top-performing 5% of the 10,000 equity fund managers we track.” It’s a smart idea and I’ve started tinkering around inside the engine room to see what results it produces.

The key selling point of this tool is that it lets you very quickly piggyback off the intensive stock-specific research done by active fund managers. The results are then grouped together in broad themes ranging from virtual society to space technology. Crucially the tool lets you export the results by geography, and size (small/mid cap or large cap). You then get an aggregated conviction rating (anything above 90 seems be OK) and you can also specify how many managers in total have the said stocks in their portfolio – preferably double digits in my view (more than 10).

It’s important to add two academic caveats. The first is the obvious one – the past is not necessarily a useful guide to future performance. So, it’s great identifying the individual stocks in active fund managers’ portfolios, but that doesn’t mean the said stocks will do well in the future. I’d also caution that even successful, highly-rated active fund managers find it hard to beat most benchmarks consistently over time.

One other caution is prompted not by academic research but by the tool. Because the tool aggregates stocks from fund managers’ baskets which are then broken into themes, you are reliant on those themes being properly constructed and tested. You are also, by default, probably going to end up with a growth-oriented bucket of top stocks – not so great if you are a value investor fishing in boring legacy sectors.

All this said and done, what I find enormously helpful about this tool is that it is a great way of narrowing down a basket that will consist of growth stocks fitting key themes. Over the next few months, I’ll embark on a few ‘fishing trips’ using the database and identify a basket of stocks that would interest readers who are growth investors.

My own focus is on the following:

-          Focus on small caps. I’m wary of stock-picking skills amongst large cap investors. I’m not convinced that active stockpickers can build a consistent advantage amongst heavily researched well-known names in say the S&P 500. That’s why I’m by default looking to small and mid-caps where there is much more information asymmetry i.e there is evidence that in small and mid-caps very active stockpicking can produce real gems

-          Focus on a handful of key themes. My own view is that some themes are so broad as to be useless. My own hunch is that more tightly defined thematics where you can understand the drivers should be the real focus for most stock-picking investors

-          Focus on US stocks. Put bluntly, if you want to research small/mid-cap growth stocks, probably with a tech bias, you are best off fishing in the deepest, broadest market which is the USA.

On this basis, I’ll kick off with a theme for this week: digital infrastructure.

I shouldn’t need to explain too much why I think is so important – I’ve constantly championed the digital infrastructure sector and I also see a remorseless demand for more data-intensive applications and networks.

Using the Citywire tool I’ve selected for the following screens:

-          Max twelve stocks

-          Only those with a 90% plus aggregated conviction by elite fund managers

-          Only businesses with at least 10 managers owning the stock

-          Only those with a AAA rating

Feeding this into the Citywire engine I end up with the following shortlist below.

I’ve then fed those eleven stocks and their tickers into the Sharepad system to give us a snapshot of their key growth fundamentals – in the second graphic below.

For now, I make no comment on the individual companies other than to observe that if you are a growth investor looking to invest in one of the most compelling growth tech sectors (digital technology), in businesses with bags of room to grow (they are still small) that are in turn trusted by elite managers, then this is a great research jumping off point.

What to make of TruFin: first impressions

If like me you are enthused by the potential for Fintech to transform the financial services market, you’ll probably also be slightly disappointed to discover that nearly all the key players in this space that boast stockmarket listings are based in the US.

With a few exceptions such as Funding Circle (FC) and LendInvest – both of which I have talked about in some detail – the UK has a fairly limited range of fintech choices for investors, although there’s a great upswelling of late-stage private fintech businesses sitting in the portfolio of VCs such as Augmentum and Chrysalis Investments. I’d especially highlight what I think is by far and away the best neo bank on the market, Starling, as one example of a possible fintech giant.

Most attention has focused on consumer-oriented fintech plays although both FC and LendInvest remind us that there’s much more to fintech than just well-known neobanks.

Some of the best opportunities lie in the B2B arena i.e serving SME businesses or providing technology to existing financial services firms. Funding Circle for instance started out as a peer-to-peer lender taking in money from investors but switched focus early on and now only works with institutional investors (as does Lendinvest) looking to use its platform to lend to SMEs. This focus on providing an internet platform for larger investors to make loans to businesses (or landlords in Lendinvest’s case) is a smart move.

All of this brings us to TruFin, a UK-listed fintech play that seems to be below the radar for most fintech types. I first bumped into this business a few years ago after it was spun out of the hedge fund Arrowgrass. At the time, I knew it largely because it held a big stake in the peer-to-peer platform Zopa. Flash forward a good few years and TruFin has changed massively. The Zopa stake has gone as has Arrowgrass and TruFin now seems to be a relatively focused play on fintech as a software, with a focus on selling into the business space.

In particular, the business seems to have jumped on board the idea that finance and banking can be delivered as a software service also known as Baas (banking as a software service) with a sub-variant called lending as a software service (Laas). This is a prime niche and many VCs reckon it’s a huge growth opportunity. Another area of focus is what’s called embedded finance – embedding say point of sale financing options (Buy now pay later for instance) on third-party websites.

It’s important to say that TruFin is small – sub £70m market cap – and isn’t profitable at the group level. It’s also something of a strange hybrid in that it comprises four businesses, one of which (called Playstack) operates in an entirely different market altogether, namely games – about which I know next to nothing. It’s also a strange creature in that the two businesses that currently generate the most revenue – PlayStack and Oxygen – are probably the less interesting businesses long term whereas the potential jewel in the crown is involved in lending as a software service (Laas) called Satago. So with that caution out of the way, here are some basics on TruFin:

-          Ticker TRU

-          Share price 65p

-          Market cap £65m

-          Four main businesses: PlayStack, Satago, Vertus and Oxygen

-          Trufin is loss-making and will probably stay loss-making until FY 2023. For FY22, gross revenues were £16.1m (versus “no less than £16.0m” as per the trading statement), an increase of 23% yoy, and Adjusted Loss Before Tax was £8.0m (“no more than £8.1m”). The year-end group cash balance was £10.3m.

-          Business #1: Satago is a loss loss-making Baas and Laas (lending as a software service) platform aka a Working Capital Solutions Platform. The business has deals in place with Sage and Lloyds Bank (lending as a software service, single invoice finance product) to plug in its technology to their customers (digitized end-to-end tech stack). The core focus is on simplifying the invoice funding gap i.e. let SMEs get paid early. Single invoice finance allows the SME to fund invoices as and when it wants, on an ad hoc basis. Lloyds Bank now has a 20% equity stake in the business and the product is due to launch in the next 12 months.

-          Business #2: Oxygen. This business has built an internet platform that is widely used by local authorities to facilitate the early payment of supplier invoices. Amongst local authorities, it has a 24% market share in early payment services. Currently generates just under 50% of all group revenues and comprises around a quarter of group equity value.

-          Business #3: Vertus is a niche lender to the IFA consolidation market and works closely with IntegraFin. Consist of a £20m loan book. Specifically focussed on smaller IFAs looking to acquire like-minded IFAs when the owner retires with loans of £0.25m to £3m

-          Business #4: PlayStack, a games publisher that develops its own largely console-based games alongside third-party deals. Produces just under 40% of group revenues and comprises 45% of group equity value currently. The business made its first significant revenues of more than £8m, in 2020 on the back of the launch of Mortal Shell, its most successful game to date. In all currently boasts 30 games in its catalogue.

Trying to get a handle on the potential of these four business units is quite tricky.

For FinTech types like me there are some big positives here:

-          Most of the revenue growth will be in big, scalable markets with distribution partners (Lloyds and Sage)

-          The focus on business funding and especially invoice funding is a big plus – it’s a huge market opportunity

-          The main revenue streams are now based on recurring fee income from providing a technology service with high gross margins

The challenge is that the group is a bit of a hotchpotch of businesses.

As I said I know nothing about games –I  don’t even play them as I leave that to the younger members of the Stevenson household – and thus I can’t really offer any insight into the PlayStack business. As for Vertus, I understand the specialist lending space and the IFA market fairly well but can’t get myself too excited about the prospect of a specialized lender in this niche although I recognize it could be a lucrative niche. Fingers crossed, Vertus could hit a loan book of £100m at some stage in the next few years. But as for valuing it, your guess is as good as mine but it surely can’t be worth more than single-digit millions at most.

The two businesses with the most potential are Oxygen and especially Satago. These firms operate in compelling markets and if – and it’s a big if – Satago can make a go of its scale-up via partners such as Lloyds Bank and Sage, then I think the sky is the limit.

Putting valuations on a still fast-growing business like Satago is a complete guessing game, especially if the platform can be exported to the European continent. But a rough back of the fag packet exercise can easily get Satago to sales in 2025 of say £15m. The multiples on Baas and Laas businesses are notoriously generous (not to say sometimes quite insane) and thus we could easily pin a 5 times sales multiple even if the business is still loss-making. That takes us to a possible £75m price tag on the Satago business alone within a few years – TruFin has a 70% stake in that business, so that is potentially over £50m of future value.

Oxygen is a little more difficult to value but let’s for argument’s sake say it gets to £2m EBITDA in 2024 – we could apply a 12 times EBITDA multiple to that number which would get is £24m (TruFin owns 88% of that business). On a side note Oxygen was approached last year by a PE buyer with a valuation of £25m.

These two businesses alone (£75m) could/might justify TruFin’s existing market cap with PlayStack and Vertus thrown in for free. But, as I have already said, I believe the real potential jewel in the crown here is the Satago business though it’s worth remembering that it operates in a very competitive marketplace with businesses such as Trade Ledger also very active in the market.

But if Satago can make a go of its distribution through Sage and Lloyds Bank, then a valuation of north of £100m in the next 2 to 4 years is not impossible. That said, there’s still a long way to go before this sunny forecast materializes – and plenty could go wrong.

So, what’s the bottom line on TruFin? It is, in my view, a bit of a mixed bag with some very contrasting businesses in the mix alongside some less exciting opportunities. I’d be happier if Vertus and PlayStack were sold on and the group focussed solely on invoice finance and the Laas/Baas products. Over the next few months, I’ll dig a bit deeper and see what emerges.