Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 456

Is this the real life or is this just fantasy?

From time-to-time equity markets are enveloped by short-term irrationality and aspirational future cash flows. While some investors embrace this fantasy world, others choose to keep their feet on the ground.

I’ve likened this situation to The Matrix, the film in which people were offered the choice between taking a blue pill or a red pill.

The blue pill effectively plugged them into this sort of fantasy machine-led world. The red pill would reveal the truth and what’s occurring in the real world.

Today we have blue pill investors and red pill investors. The question is which investor do you want managing your money?

Blue pill investors

These investors at the forefront of market irrationality have been driven by various forces, including:

  • Historically low rates – you can’t get yield on bonds; you can’t get yield on cash in the bank.
  • A belief that central banks will remain all powerful and they’d keep buying bonds forever and keep interest rates incredibly low.
  • The rise of passive machine-led investing, which sees capital blindly flow into the biggest stocks in an index, regardless of fundamentals and valuations.

In this context, market disruption, trends and stories become even more of a drawcard. Growth stocks are all the rage. Especially small and microcaps. Afterall, there are few other options.

In this environment, the market went, what I call upside-down – it inverted. With rates being extraordinarily low, blue pill investors chased hyperbolic returns.

Case in point - the graph below. It summarises the ASX small and microcap universe of stocks between $50 million and $3 billion in market cap. It shows what would've happened if you bought a portfolio equally weighted of stocks that had negative operating cash flow from September of 2019.

Source: Bloomberg, as at 28th February 2022. Australian listed stocks between $50m and $3bn market cap divided into positive op cash flow and negative op cash flow as at 1/1/2019. Average returns measured across basket of stocks.

You can see that perversely, negative operating cash flow companies (blue line) materially outperformed positive operating cashflow companies on average over that period of time.

This is the blue pill fantasy world that we’ve experienced in recent years.

But as history tells us, it won’t last forever. The stock market can be irrational short term, but in the long run, we have found that the laws of economics, a little like gravity are hard to escape. We think the market is actually very rational in allocating capital over time.

Red pill investors

Also in the above chart, you can see the curve does come down towards the end of the period. We are starting to see negative cash flow operating companies pulling back as rates tick up and people wake up to the fact that inflation is likely here to stay.

A rising interest rate environment also sees the cost of capital rise and a “risk off” environment emerge. This is what happens in the real world.

While blue pill investors have dominated markets in recent years, red pill investors realised that for a long period of time, capital has been very cheap and the way capital has been allocated (by both companies themselves and investors) has perhaps been a little loose. They stuck to fundamentals and never forgot that valuations matter. All the while, as blue pill investors dominated markets, red pill investors were presented with an abundance of opportunity.

Now a critical juncture is emerging. Rising interest rates have a flow on effect that means cash burning companies are actually becoming more costly to hold. With interest rates on the rise this does tend to lead people back to the notion that cash is actually worth more today than tomorrow.

Disciplined red pill investors always focus on sustainable free cashflow and look at numbers through the cycle.

Long term investors would have seen all types of stocks go through cycles. We like the idea of trying to smooth out aggressively over-earning companies and not punishing companies that are temporarily under-performing on a short-term basis. This is the reason we look at ‘through the cycle’ cash flows and earnings.

Furthermore, we like to buy stocks that have low debt levels. Why? With rates rising, the cost of debt is increasing, and this puts pressure on the earnings of these companies with massive amounts of debt on the balance sheet. Additionally, we are trying to buy stocks at a discounted valuation. We try to value the stock on a mid-cycle basis and pick these stocks up at a decent discount.

And the final point is that we do keep an open mind for inflection points and changes in a company’s strategy or management teams.

A red pill stock idea

Michael Hill (ASX:MHJ) is one of our key portfolio holdings and one we think is a great illustration of long-term red-pill thinking.

It is a specialty jewelry retailer with operations in Australia, New Zealand and Canada, with a 40-year-plus track record. It is also a company that has been completely ignored in recent years by blue pill thinkers who favoured hot tech companies and concept stocks.

However, the graph below demonstrates some of the reason why we think it is a compelling opportunity for red pill investors.

Source: Morningstar, IRESS, Spheria

By looking at cash flow conversion (left graph) you can see how much of the earnings reported on an accounting basis that transfers into cashflow.

Additionally, we look at return on capital metrics (right graph). If earnings are growing on a fixed cost base and fixed capital base, there’s little doubt that earnings and returns will improve over time.

Current CEO, Daniel Bracken was hired several years ago. Since joining Michael Hill, Daniel has invested in technology, changed the pricing strategy, introduced a loyalty program and driven increased online sales. These changes have diversified the revenue stream and have led to dramatically improved results.

So much so that even the first half numbers just reported showed strong returns and earnings growth, despite approximately 20% of trading days being lost due to COVID lockdowns in Australia.

Investing for the long term

We believe that a focus on fundamentals and valuations will lead to long term outperformance for investors who are patient. For those caught up in irrational exuberance, they could very well find themselves caught in a capital landslide.

Ultimately, we live in the real world. And investors can’t continue to escape reality.

 

Marcus Burns is Co-founder and Portfolio Manager at Spheria Asset Management, an affiliate manager of Pinnacle Investment Management. Pinnacle is a sponsor of Firstlinks. This article is for general information purposes only and does not consider any person’s objectives, financial situation or needs, and because of that, reliance should not be placed on this information as the basis for making an investment, financial or other decision.

For more articles and papers from Pinnacle Investment Management and affiliate managers, click here.

 

RELATED ARTICLES

Reporting season – expect early signs of downgrading

February reporting season is the calm before the storm

Reporting season shows companies meeting challenges

banner

Most viewed in recent weeks

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

Supercharging the ‘4% rule’ to ensure a richer retirement

The creator of the 4% rule for retirement withdrawals, Bill Bengen, has written a new book outlining fresh strategies to outlive your money, including holding fewer stocks in early retirement before increasing allocations.

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are franking credits worth pursuing?

Are franking credits factored into share prices? The data suggests they're probably not, and there are certain types of stocks that offer higher franking credits as well as the prospect for higher returns.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Latest Updates

A nation of landlords and fund managers

Super and housing dwarf every other asset class in Australia, and they’ve both become too big to fail. Can they continue to grow at current rates, and if so, what are the implications for the economy, work and markets?

Economy

The hidden property empire of Australia’s politicians

With rising home prices and falling affordability, political leaders preach reform. But asset disclosures show many are heavily invested in property - raising doubts about whose interests housing policy really protects.

Retirement

Retiring debt-free may not be the best strategy

Retiring with debt may have advantages. Maintaining a mortgage on the family home can provide a line of credit in retirement for flexibility, extra income, and a DIY reverse mortgage strategy.

Shares

Why the ASX is losing Its best companies

The ASX is shrinking not by accident, but by design. A governance model that rewards detachment over ownership is driving capital into private hands and weakening public markets.

Investment strategies

3 reasons the party in big tech stocks may be over

The AI boom has sparked investor euphoria, but under the surface, US big tech is showing cracks - slowing growth, surging capex, and fading dominance signal it's time to question conventional tech optimism.

Investment strategies

Resilience is the new alpha

Trade is now a strategic weapon, reshaping the investment landscape. In this environment, resilient companies - those capable of absorbing shocks and defending margins - are best positioned to outperform.

Shares

The DNA of long-term compounding machines

The next generation of wealth creation is likely to emerge from founder influenced firms that combine scalable models with long-term alignment. Four signs can alert investors to these companies before the crowds.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.