Navigating Markets: War, Inflation, and Interest Rates
Scandinavian tech is remarkably cheap!
Contained war?
It is hard to contend that a breakout of hostilities in the Middle East is a black swan given the simmering tensions in the region..Recent events, while unsettling, seem to be contained within Israel and the Gaza Strip, as indicated by the relatively modest increase in oil prices. If the situation does not deteriorate further, there is a likelihood that oil prices may stabilize and revert to previous levels. It is essential to recognize that the long-term trajectory of oil prices is influenced by global economic growth and supply conditions determined by OPEC.
Prior to the Hamas attack, oil markets were influenced by the delicate balance between anticipated supply constraints and concerns about sluggish economic growth. This delicate equilibrium is likely to persist, resulting in a trading range for oil prices, until there are clear signals indicating either a further decline in the global economy or an escalation of the Hamas-Israel conflict. While the outlook may not appear overly grim from my perspective, it is imperative to monitor the situation.
It is worth noting that oil prices play a crucial role in inflation calculations, and heightened global tensions have the potential to adversely impact stock markets. Therefore, a cautious approach is warranted, considering the interplay of these factors in the broader economic landscape.
Tech price divergence
There are many similarities between American and Scandinavian economies when it comes to financial conditions. According to Aswwath Domodoran, an equity risk premium of 5% is similar across all of these markets. The 10-year government bond yield varies some between the countries, where the US clocks in at 4,8%, Norway at 4,1%, and Sweden and Denmark around 3%. Despite lower rates, Swedish companies must be analyzed with more or less the same discount rate as Americans in my point of view, since the currency is so volatile. In regards to Norway, one has to factor in currency weakness and risks attached to a punitive tax regime in order to achieve realistic capital costs.
Remarkably, while the financial landscapes of the US and Scandinavia exhibit minimal divergence, an intriguing dichotomy manifests in the realm of technology stocks. Presently, Nordic tech equities stand notably cheaper than their American equivalents, an observation that warrants scrutiny. Despite the recent rise in interest rates, many American tech stocks have held up fairly well. In fact, it has been the “magnificent seven” who have been under the most pressure, presumably, as a reaction to the outperformance we saw earlier in 2023. American tech stocks paid their dues last year when many of them got re-rated to align better with higher interest rates. When I look over the American tech landscape today, I don’t find many companies that might be deemed grossly overvalued. Instead, I find that most of them trade at fair to slightly undervalued prices.
Conversely, the trajectory of Scandinavian tech stocks diverges significantly from their American counterparts. While these stocks did experience a downturn last year, the descent was notably subdued compared to their American counterparts. However, it appears that many Scandinavian companies are slated to face challenges in the latter half of 2023. Indeed, a number of these entities have witnessed precipitous declines since the summer's conclusion, indicating a paradigm shift in the market dynamics. This nuanced analysis underscores the intricate interplay of factors shaping the valuation of technology stocks in both the American and Scandinavian arenas.
Diverging IT-consultancies
In the current landscape of IT consultancy firms, a noticeable divergence is evident, as depicted in the chart below. Specifically, Cognizant (US) has significantly deviated from its Scandinavian counterparts this year. Notably, Bouvet (NO) and Net Company (DK) are reflecting a substantial anticipated slowdown in their future trajectories, while KnowIt (SE) appears to have priced in not just a slowdown, but a potential depression on the horizon.
The prevailing trend indicates a deceleration in enterprise spending on IT services over the upcoming quarters for these consultancies. However, it is important to note that this does not imply a halt in the digitalization efforts within the Scandinavian economy. I am inclined to believe that the market for consultancy services might be more resilient than currently perceived by market participants. A modest reduction in growth over the next four quarters would translate to only a marginal decrease, typically a few percentage points, in long-term returns when considering a decade or more of free cash flows.
Taking Bouvet as a case in point from the aforementioned group, the current market prices offer investors an opportunity to acquire a high-quality company at an attractive valuation. With a free cash flow yield well above 5%, Bouvet stands as a compelling investment, especially given its impressive average top-line growth of 13% over the last three years. However, there exists a risk associated with deeply undervalued quality companies, as they become attractive targets for leveraged buyouts. In such scenarios, a Private Equity (PE) group can construct a financial model where substantial returns, ranging from 3x to 5x in a five-year perspective, are feasible based on the strategic use of leverage and the company's robust free cash flow to equity (FCFE) position.
Traditionally, buyouts tend to be advantageous for retail investors due to the premiums offered. However, there is a caveat: the price at which the buyout occurs can be undervalued. Recent trends on the Oslo Stock Exchange, particularly concerning Kahoot, indicate a pattern where PE groups attempt to acquire assets at below-market prices. Consequently, it is my perspective that Bouvet's investors would be better positioned in the long term if the company pursued an independent path or explored strategic mergers, such as with entities like TwoDay, rather than succumbing to a buyout by a PE group driven solely by financial gains. This strategic approach ensures the sustained growth and stability of the company, safeguarding the interests of its shareholders over the long run.
Extremely cheap
In my previous communications with readers, I have emphasized the undervaluation of Evolution AB. While I maintain my assessment of Evolution AB's undervaluation, I refrain from categorizing it as 'extremely cheap'. However, the term 'extremely cheap' aptly applies to a company like Norbit AS.
Norbit stands out as a compelling investment option: it boasts positive net income, has consistently achieved over 30% year-over-year (YoY) top-line growth, and also provides dividends to its investors. Despite these strong fundamentals, the stock has experienced a drastic 20% decline in the past month. Notably, Norbit is a micro-cap growth stock, implying a certain level of expected volatility. However, the magnitude of this recent fall appears disproportionate and can be attributed, in part, to an exaggerated reaction to an uptick in capital costs. Moreover, short-term profit-taking activities might have contributed to the abrupt decline.
In essence, the current market presents an opportunity to identify undervalued Scandinavian tech companies, among which Norbit stands as a prime example. Despite the short-term fluctuations, the underlying strength of such companies, especially in the context of consistent revenue growth and dividend payouts, makes them attractive prospects for discerning investors. This situation highlights the potential for astute investors to identify valuable investment opportunities in the Scandinavian tech sector, where several noteworthy companies are currently undervalued.
The Godot recession
The yield curve inverted a considerable time ago, prompting widespread preparations for an economic downturn throughout 2022. Contrary to these expectations, the year commenced with a decline in inflation, leading some members of the investor community to discuss the possibility of a soft landing, with certain pundits even entertaining the idea of no landing at all. However, the sentiment in the market shifted in August and September, with indicators pointing towards the possibility of a recession looming on the horizon once again.
It is evident that a recession, inevitable in the economic cycle, will occur sooner or later. Presently, the labor market appears robust, suggesting that an immediate recession might be unlikely. It's crucial to note that no single indicator can decisively determine the onset of a recession. Rather, if we view recessions as processes rather than isolated events, we would expect to witness credit spreads widening. Surprisingly, the trend in 2023 indicates the opposite. The gap between corporate bonds and treasuries has, in fact, narrowed, and even the stability of junk bonds further contributes to the complexity of the current economic scenario.
Climbing the wall of worry
In the present economic landscape, several concerning factors, such as the conflicts in Ukraine and Israel leading to substantial increases in commodity prices, persistently high inflation contributing to prolonged elevated interest rates, and looming concerns about the impending Godot recession, have created a climate of uncertainty and apprehension. Concurrently, the market finds itself in an oversold condition. If certain unforeseen positive developments emerge in the trends mentioned above, there exists a significant potential for an upward market rally. Additionally, for investors inclined towards contrarian strategies, the current market offers ample opportunities to acquire undervalued stocks. Historically, stock markets have demonstrated resilience by surmounting challenges, often referred to as "climbing the wall of worry."
Taking a comprehensive view, despite the prevailing concerns, I believe the market is positioned favorably. The ability to navigate these challenges with caution and optimism, coupled with strategic investment decisions, enables investors to find opportunities even in uncertain times, highlighting the underlying strength and adaptability of the financial markets.
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