Saturday, 12 July 2014

Technical Analysis of the Stock Market

And The Sage Group PLC

Astrologer casting a horoscope, Robert Fludd (1617), courtesy Wikipedia
Astrology fascinated some of the most brilliant minds of the past. They included Galileo and Kepler. Today some lesser lights devote much effort and time to technical analysis of the Stock Market. In both cases, people are fascinated by the challenge of discovering meanings hidden in numerical sequences as observed in the sky or charts of the stock market. And they are lured by the promise of wealth and public recognition.
It must have come as something of a shock to readers of the Traders Column in the Investors Chronicle, that the trader, in his farewell article this week, should write, "I have come to believe that much of what passes for Technical Analysis is nothing more than faith-based nonsense. It would be laughable, but for the real money that it helps to lose. I include in this several of the dark arts in which I myself have dabbled in the past, including Fibonacci, the Elliott Wave Principle, and much of Gann Theory."
It is rather as if Benedict XVI had announced that he was retiring from the Papacy because he no longer believed in God.
As readers of this blog might recall, one method of judging where we are in the stock market cycle is to review a list of down to earth indicators, such as those used by Howard Marks of Oaktree Capital Management. See
But I cannot resist presenting a chart prepared by (Doug Short) that I came across recently (click to enlarge):

The chart tracks the flow of funds from individual investors in the New York Stock Exchange (NYSE). It is hardly a surprise that the S&P 500 rises on the back of inflows and recedes on the back of outflows. What is interesting is the magnitude of investor buying on margin since 1998 and the rapidity with which investors liquidated their positions in 2001 and 2008. American investors have become much more active with the result that markets are more volatile now than they were between 1945 and 1998.
Doug Short recognises that, as data for credit balances is available only six weeks after the event, it lacks any predictive power. But he comments ". . . the magnitude of the latest negative credit level is comparable to the maximum debt reached four months before the 2007 market peak. I see this as yet another caution light for investor expectations."
As the FTSE All Share Index closely follows the S&P 500, this observation is relevant for UK investors.

The Sage Group PLC

Clay accounting tokens from Susa, Mesopotamia 3500 BC, courtesy Wikipedia
Successful long-term investors like to invest in companies with steady businesses that require little capital investment and are leaders in their chosen markets. Warren Buffett is said to look for specific qualities in a company. They are discussed at
The Sage Group PLC (Sage) is one such company that fits the bill. It specialises in providing accounting and related software packages for Small and Medium Enterprises (SMEs). Consider:
The market
Ø  Sage has built up a customer base of 6 million SMEs and recurring revenue is 71% of the business. 83% of subscribers renew their subscription annually. Both the proportion of recurring revenues and renewal rates are on the rise.
Ø  The company is heavily dependent on the mature markets in Europe (56% of revenues) and North America (28%). A move into Brazil and its large presence in South Africa coincide with weak fundamentals in both economies.
Ø  It claims to be market leader in six of its seven largest markets - the UK, France, Spain, South Africa, Canada and Brazil. And it claims to be the second largest supplier to mid-market SMEs in the USA.
Ø  The company has a good record of developing its products and adapting them to new technologies.
Ø  By offering a wide range of products for its three main market segments - companies with 1 to 20, 10 to 200 and 100-500 employees - Sage offers its clients products that fill their needs as they grow in size.
Sage has a myriad of competitors, ranging from large software companies such as SAP, Oracle and Microsoft, to new software companies that are offering cloud-hosted products. Its global market share has declined from 9% in 2008 to 6% in 2013. Its two biggest competitors, SAP and Oracle, have 25% and 13% respectively of the global market for Enterprise Resource Planning (ERP) software.
But recent reviews of its new cloud-hosted products suggest that the company has succeeded in developing good cloud-hosted products that can be integrated with its desktop software.
Further, Sage has embarked on a programme of selling off non-core assets to concentrate on what it does best. This is coupled with the objective of increasing 'organic revenue' by 6% a year. In the latest interim results for 2014, the company approached this objective by increasing 'organic revenue' by 5%.
Ø  Revenues, on average, have grown by 2% compared to a global industry average of 12% these past three years. In part, this is due to its concentration on developed markets, and in part to loss of market share. Earnings have also stagnated in 2011-13.
Ø  Cash generation is strong. In the last 5 years, Sage has generated net operating cash flow of 1.36 billion pounds that amply covers the 0.55 billion pounds normal dividend payout. The company uses little capital and pre-tax margins average over 20%.
Ø  Return on equity is now 26%, which has been elevated by some adroit financial management. Sage returned 1 billion pounds to shareholders last year by way of a special dividend and share buyback. It financed part of this with borrowings equivalent to one year's EBITA. In the process, the company reduced its average cost of debt from 4.6% to 3.8%.
Ø  The company has no significant exposure to defined benefit pension schemes. However, its balance sheet is top heavy with goodwill. Sage is a serial acquirer of businesses and, as its recent 188 million pound loss on disposal of businesses shows, these are often overvalued.
Sage's share price (in blue), until recently, has closely tracked the NASDAQ index (in green):

Graph courtesy Yahoo, click to enlarge
The drop off in Sage's share price in 2013 and 2014 reflects:
1.       The large special dividend payment, coinciding with a small inverted triangle in the chart.
2.       The market reaction to the September 2013 launch of a new cloud-hosted competitor in the UK called Xero. Xero is a New Zealand-based software company. With sales of 35 million pounds and a pre-tax loss of 18 million pounds, Xero has a market value of 1.6 billion pounds.
3.       The May 2014 announcement that Sage's CEO would be leaving the company.
At the current share price of 370p, Sage trades on a PE ratio of 16 and yields 3.1%. My valuation model values Sage at around 330p a share.
This valuation assumes that the present rate of organic revenue growth, which is 5% per annum, translates into a similar increase in earnings per share and net operating cash flow for the period 2014 to 2018.
The cautious investor will note:
v  Sage is vulnerable to new competitors, particularly in cloud-based products where the start-up costs are fairly small. The company states in its 2013 Annual Report that larger companies want desktop software and trained staff whom they can contact. This might well be true right now, but it does not follow that this will always be the case.
v  The loss of Sage's highly regarded CEO after only 4 years in office is a concern. He led the new strategy to concentrate on core products and generate 6% organic growth a year. Will a new CEO follow his lead, and if so, will the new CEO implement it successfully?
v  The shares have traded as low as 312p in the last 12 months and technology stocks in general are now out of favour.
Disclosure: I have a long position in Sage but will not trade these shares within the next 5 days.