Diary of a Private Investor

Bull Market or Bubble?

Since the start of the year I have been pondering this question, are we in a sustainable bull market phase or are we seeing a market bubble that is about to burst?

Several investors I follow on Twitter have been talking of moving funds into cash or shorting US shares and indices. Paul Scott, via his daily Small Cap Value Report (SCVR) on Stockopedia, has been speaking of it being a “mad bull market”. Perhaps! Personally, I am not seeing a mad bull market but then, I am not invested in highly rated growth stocks such as BooHoo, Gear 4 Music, Purplebricks etc. (and fair play to those investors who have made big returns on such investments, they are just too risky for me) and so perhaps I am not seeing as much froth as others. Certainly, the main indices on both sides of the pond are at or near all-time highs.

Against this, there was an excellent article this week by The Naked Fund Manager via Research Tree which looked at the effect of the falling value of sterling on potential M&A activity. The perspective being that UK companies are cheaper to foreign (especially US) buyers and therefore, increased M&A activity should lead to a closing of the gap between current market valuation and the true value of the enterprise. In other words, when seen through the lens of a potential buyer, high quality companies that offer high return on capital (ROCE) and high return on equity (ROE) coupled perhaps with strong free cash flow (FCF) and growing revenue/profitability, are not actually that expensive right now when adjusted for recent forex movements. This makes a great deal of sense to me, especially as I have constructed my portfolio almost exclusively around such companies – so naturally, the article also provides me with confirmation bias, which is not necessarily a good thing of course.

In the final quarter of 2016 one of my holdings, Avesco (AVS), was acquired for over 100% premium. Then there was the acquisition of ARM holdings by Softbank shortly after the Brexit Referendum, the aborted takeover of Unilever by Kraft Heinz last week, the recent takeover battle for Lavendon and this week’s proposed takeover of gaming company 32 Red to name but a few more (that I haven’t owned at time of the takeover). As I wrote in my new year Six of the Best … article, virtually every UK company is vulnerable if sterling remains weak. Unfortunately for Market UK, it is our better quality companies that are most vulnerable and if this increase in M&A activity comes to pass, then a year or so from now it will mean there are less high quality UK companies left to invest in. But right now, it does suggest there is still decent potential upside.

My own strategy is largely unchanged. I am investing in high ROE/ROCE companies with revenue and profits growth, strong FCF and paying a dividend. I continue to have a bias for companies with non-sterling earnings, especially US dollar earnings. I have very little exposure to inward facing UK companies and am generally avoiding retailers and other net importers. I haven’t crunched this week’s numbers yet but year-to-date my portfolio is up 5-6% which if it continues on that trend would mirror the 30% growth I achieved in 2016. While I am very pleased with this rate of return, it doesn’t feel like bubble territory to me. Sure, there will be a market correction at some point but a full blown, global market crash seems less likely. I hope that my focus on quality (and to a less rigorous extent, momentum) will see my portfolio recover relatively quickly from any wider market sell-off.

In the meantime, earnings season has just begun and I believe I am holding companies that will deliver strong results, most of which have trailed this via recent trading updates. Let’s see how the market reacts but for now, I am struggling to see this bull run as a full blown bubble, especially for companies that are delivering solid results that in many cases are exceeding market expectations (via broker forecasts). Sentiment though, is a funny old thing, is it not?

Happy investing folks!
Simon

 

Disclosure – At the time of writing I do not own shares in any of the companies mentioned in this article

 

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