Rudi’s View: Collins Foods, Rio Tinto and Aurizon

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In this week's Weekly Insights:

-June Index Rebalancing
-Inflation Is The 2021 Grand Debate
-Conviction Calls
-Research To Download

By Rudi Filapek-Vandyck, Editor FNArena

June Index Rebalancing

Since March 2007, reports Morgan Stanley, stocks that have been picked as the next fresh inclusion in the ASX200 have generated relative outperformance of no less than 7.5% from the period starting 20 days prior to the announcement, up to implementation.

Throw index exclusions into the mix and the relative outperformance becomes 13.7% at a success rate of 81%.

No wonder stockbrokers pay attention to potential index changes. The numbers speak for themselves.

Looking forward to the next announcements to be made by index guardians at Standard & Poor's, Morgan Stanley suggests Appen ((APX)) could potentially become the first of the WAAAX stocks to be dropped from the ASX100.

The plausibility of such a move is not considered very high, but it remains a possibility and Morgan Stanley suggests if Appen were to be dropped, Harvey Norman ((HVN)) appears best placed for replacement.

More important are potential changes to the ASX200 (see numbers mentioned earlier).

Morgan Stanley thinks there is a reasonable chance lithium producer Orocobre ((ORE)) will become part of the ASX200. The stock is considered a lower risk inclusion than its proposed merger partner Galaxy Resources ((GXY)). The merger between the two is expected to be finalised by August.

Other potential fresh index inclusions, according to Morgan Stanley, are Chalice Mining ((CHN)) and Uniti Group ((UWL)), and maybe (at a lower probability) Centuria Capital Group ((CNI)) too.

Stocks to potentially get booted out at the next revision include Resolute Mining ((RSG)), Austal ((ASB)) and Perenti Global ((PRN)) with added candidates at a lower risk being G8 Education ((GEM)) and Westgold Resources ((WGX)).

Morgan Stanley is equally toying with the possibility that TPG Telecom ((TPG)) might be replaced by Metcash ((MTS)) in the ASX100 while Orica ((ORI)) doesn't appear safe inside the ASX50.

Orica's potential replacement would be Northern Star Resources ((NST)), while if Ampol ((ALD)) might be replaced, that would potentially trigger the inclusion of Seek ((SEK)).

Changes in the ASX200 tend to be of more importance as they often include institutions selling out of or climbing on board the corporate register to recalibrate portfolios in line with the new index composition.

Inflation Is The 2021 Grand Debate

Financial markets have proven too much of an enigma for many an investor and share market commentator in 2021. Is it all about elevated valuations, an abundance in liquidity and the come-back of Value vis a vis Growth?

Or is there a lot more to digest in order to explain the often extreme and seemingly illogical day-to-day volatility, while share market indices are near all-time record highs, and holding up?

Probably the most apposite assessment of financial markets this year is via the Grand Debate that is raging across the five continents: are we at an early stage of a new inflationary period, or are markets jumping at shadows and will we all look back next year and wonder what all the fuss was about, really?

The answers to that all-important question are formulated with fierce conviction, amidst utter division. The conviction on both sides of the argument seems so high, neither side seems to be able to understand why the others cannot see what they see.

If ever there was a Mexican standoff in global finance, this year's Grand Debate would be it.

In one corner we have the inflationists who see a major break with the past decade as the economic V-shaped recovery intertwines with generous government spending and overly accommodative central bankers.

Closed borders, interrupted supply chains, geopolitical tensions, climate change and water shortages, major infrastructure spending and cashed up consumers; it all points in one direction: inflation is about to go through the roof. History won't be kind on today's policy makers.

In the opposite corner we have the deflationists who only see inflation spiking -temporarily- because last year's reference numbers are so low, while closed borders and interrupted supply chains will be resolved, albeit not immediately.

The real damage done to economies is not reflected in standard data and surveys, so goes the counter-argument, while megatrends such as technology driven-disruptions and ageing populations continue to keep a lid on inflation, on top of zombie companies, the global search for income, a massive mountain of global debt, and economic momentum that is already showing signs of decelerating.

The return of inflation favours higher bond yields and lower valuations for risk assets. Hence, investors in the first corner are buying financials, as they benefit from steeper bond yield curves, and producers of commodities like oil and gas, iron ore, copper, lithium and cobalt because the economic recovery is pushing up prices and inflation will exert itself on the back of higher input prices, which hurts those businesses that need to purchase commodities to manufacture their products.

Downward pressure on asset valuations also means you sell last year's covid-winners, as well as those companies that have benefited from the low growth/low yield/maximum stimulus environment that has characterised the post-2015 period. Add the economic recovery and it is not difficult to figure out why cheaply priced cyclicals and low quality companies have been the true beneficiaries in equities since November last year.

Most inflationists are also big fans of owning gold, and possibly silver too, but here the experience thus far has not been equally as positive.

This is, as I never tire to explain, because gold is actually a rather flawed instrument to seek protection against inflation. It only works under certain circumstances inside a certain context, like volatile growth and geopolitical tensions throughout the seventies combined with run-away inflation. It does not work with only a little bit of inflation that subsequently translates into higher yields on US Treasuries.

Like the Romans would say: quod erat demonstrandum. (In case nobody taught you Latin at school: the past year has delivered plenty of evidence).

But investors in the opposite corner refuse to budge, calling falling share prices in quality growth and technology companies the true opportunities in today's share market. You really think those Australian banks are now better companies with more and sustainable growth ahead in the years to come? You better think again!

It goes without saying, the opposite corner doesn't think there is another Commodities Super Cycle building either.

On Friday, FNArena published the views of Janus Henderson and T.Rowe Price on the current spike in US inflation: https://www.fnarena.com/index.php/2021/05/14/are-shock-us-inflation-numbers-a-concern/

The added observation here is that most inflationists have been ringing the alarm bell for many years, and they have been proven wrong time and again, except for the occasional brief period such as the second half of 2016. However, this does not by default imply they cannot be right this time and market momentum since November -six months ago- has been unequivocally on their side.

In the same breath, market momentum and the current spike in inflation can be explained through a multitude of different factors. Six months does not automatically create a new era. Market momentum will spin on a dime if growth data turn sour and inflation numbers start deflating again.

Making matters slightly more complicated, these two opposing corners are not the only divergence that explains this year's volatility in financial assets. There is no agreement on how central banks will respond to higher inflation either.

By now, you know how this game works.

In the one corner we have those who find solace in the steadfast resoluteness of central banks' messaging that inflation is not a genuine problem. It can run above 2% for a while and central banks can reign it in through less bond-buying and higher cash rates from the moment both economies and inflation seem on solid footing.

Central banks remain convinced this year's spike in inflation will deflate later on, making any policy adjustment at this stage premature.

The opposite corner tends to be a little more verbose. Here investors think central bankers are -again- deluding themselves and already making serious policy error by not responding to the early upward surprise in US inflation. History shows, these investors warn, that once inflation takes hold, it can only be reigned in through drastic measures that will put the economy into recesssion, and the global financial system at peril.

Central banks may not wish to act anytime soon, but they will be forced to according to the credo among critics.

Those critics of today's central bankers will buy gold because when the system ends up on the verge of collapsing, yet again, the world will be looking for safe havens that do not follow most other assets down into the abyss.

An important narrative as to why investors have been investing in crypto-assets in recent years relates to the eventual collapse of fiat currencies and the system; this narrative will be truly tested when uncertainty and volatility start dominating the landscape again, as it will at some stage (exact timing unknown).

The opposite view is that cryptos are but evidence of global excess liquidity looking for anything but a term deposit.

Take your pick. The years ahead will be interesting, to put it mildly.

So how do we respond as a sensible investor who doesn't like to lose his proverbial pants and shirt if/when the Grand Debate of 2021 results in a different outcome than what we expected, and what we have prepared for?

I think the obvious answer points in the direction of portfolio diversification. All or nothing seems like a high risk strategy that would not suit most Australians who manage their own portfolio ahead of or during retirement. The differences in outcomes for each of the aforementioned views and prognostications are so wide that, without diversification, the risk to portfolios seems a lot higher than is usually the case.

Depending on the direction of the Grand Debate over the remainder of 2021 and in 2022, beaten down share prices in defensives and Growth and technology stocks today represent either a fertile hunting ground for investors willing to look beyond the short term, while stomaching hefty volatility that is to remain with us, or they represent nothing but a value trap in a downward oriented trend that will pull share prices much, much lower still.

Equally, the outcome of today's Grand Debate will determine whether financials and resources stocks have already peaked, or will peak in the not-too-distant future, which given the nature of these leveraged plays on higher bond yields, economic growth and inflation can have a devastating impact on where share prices might ultimately end up.

I don't think it is likely this Grand Debate will end either way anytime soon and it won't be long before investors locally start concentrating on what exactly the August reporting season might bring.

I anticipate strong operational momentum for many companies that are on my radar. The likes of Aristocrat Leisure ((ALL)), Bapcor ((BAP)), Carsales ((CAR)), Hub24 ((HUB)), REA Group ((REA)), and many others have guided analysts and investors towards better-than-previously-forecast profits, but August, I think, will be mostly about what can investors expect to hear in terms of outlook and guidance.

Can we expect much clarity from these businesses when the rollout of vaccines is still not at pace and borders might remain closed for another year or so?

At this point, the FNArena Corporate Results Monitor post-February is unequivocally positive (see https://www.fnarena.com/index.php/reporting_season/) and many a resources company seems due a profit upgrade on the back of higher-than-expected commodity prices, which should provide support for share prices.

Smart investors will be thinking about and looking into alternative scenarios whereby the current status/market momentum will be challenged, even though there is no clear indication as yet this will happen.

Conviction Calls

Strategists at Morgan Stanley have been among the bulls in the local share market, but they too have become a bit more cautious.

Reason number one is because the ASX200 has already rallied to Morgan Stanley's target for the index, which was meant for December: 7100.

Reason number two is the slower-than-anticipated execution of Australia's vaccine roll-out is forcing GDP growth forecasts down for next year, which equally weighs upon what can be expected in terms of profit growth for Australian companies.

Reason number three is the share market is not cheap on historical precedents, even taking into account the low level of bond yields.

Morgan Stanley thinks there is probably room for a further 6% upgrade to corporate profits for FY23. Placing an average Price-Earnings (PE) multiple of 17x on those projections still leaves the local share market near the top end of historical valuation ranges. But it does lift the broker's target for the ASX200 to 7200.

The positive news is thus there is still further upside, even though it's not quite spectacular. Forecast average dividend yield is 4%.

A few weeks ago, JPMorgan lifted its index target for year-end to 7500, but that forecast is based on a stronger recovery for the second half, one that doesn't feature as much on Morgan Stanley's radar.

As far as Morgan Stanley's Model Portfolio goes, overall performance continues to be superior to the local index thanks to a barbell with major exposures to banks and resources. However, this time around, the Model Portfolio is adding more weight towards Quality stocks on the ASX through increased exposures to Ansell ((ANN)) and CSL ((CSL)).

Also, the Portfolio has switched out of Stockland ((SGP)) and into Mirvac Group ((MGR)). Profits were taken on Aristocrat Leisure ((ALL)), Spark New Zealand ((SPK)), Cleanaway Waste Management ((CWY)) and Sandfire Resources ((SFR)).

Instead, the Portfolio exposure to Newcrest Mining ((NCM)) has been enlarged while Worley ((WOR)) accounts for leverage to the capex theme.

Viewed from a macro-positioning, Morgan Stanley strategists are of the view the easy gains have been booked as far as the recovery and re-opening themes are concerned. The global bull market in risky assets is now seen transforming into a second phase during which a pause, at a minimum, seems but apposite.

The strategists are keeping an eagle eye on potential risks for corporate earnings.

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Resources analysts at JPMorgan have used their pre-mid-year update to reiterate their ongoing preference for Rio Tinto ((RIO)) as the sector's Top Pick while Alumina Ltd ((AWC)) is the least preferred in the sector locally.

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Martin Crabb, chief investment officer at Shaw and Partners, has its own approach to value the local share market and project future potential return. Crabb puts together a model based on consensus forecasts, which are rising, and thereupon calculates a fair value level with standard deviations to the upside and the downside.

The ASX200 has stalled in May, but because forecast earnings keep rising, Crabb's modeling now suggests at a smidgen above the 7000 index level, total return for the year ahead is now back into the double digits again. The projected 10.64% in total return is comprised of 3.90% in dividends and 6.74% in capital growth.

This means Crabb's outlook for the local share market is not that different from Morgan Stanley's, see earlier above.

On Shaw and Partners' numbers, S&P500 companies in the US are presently experiencing their biggest profit upgrade cycle ever.

In Australia, reports the broker, earnings per share for the ASX200 are now in an uptrend for 177 days, which makes the current period similar to the upgrade cycle post GFC and post the Trump tax cuts, alongside synchronised global growth. But the present one, predicts Crabb, will still go on for much longer and stronger.

Ord Minnett strategist Sze Chuah has a range for the ASX200 this year of 6700-7300.

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Portfolio managers at stockbroker Morgans do a lot of talking, but a lot less in concrete action, and that's not necessarily a complaint or criticism. The broker's latest update on its Balanced Model Portfolio signals multiple discussions have taken place, but ultimately no changes have been made to the portfolio because the managers are happy with how things are.

Morgans remains confident in further gains ahead for the local banks, and the Balanced Model Portfolio reflects this confidence. Large weight holdings include BHP Group ((BHP)), CSL, Macquarie Group ((MQG)), Rio Tinto, Amcor ((AMC)), Wesfarmers ((WES)) and Brickworks ((BKW)).

The one frustrating holding (in Morgans' own words) is still Aurizon Holdings ((AZJ)). We can but sympathise with the overall disappointment. Despite the Aurizon share price trading no less than -30% below consensus price target, and consensus estimates implying a dividend yield of 8% on FY22 forecasts, Aurizon shares are still unable to find any friends or upward momentum.

On balance, the share price is back to the lowest point during last year's pandemic panic-driven sell-down. That almost sounds like an achievement in its own right! A staunch bunch of portfolio managers at Morgans remains undeterred and states: "The yield is part compensation for the patience required here."

A few more actions have been put in place for the broker's Growth Model Portfolio which has now sold out of Breville Group ((BRG)), not because that growth story has ended, but because the managers see better momentum elsewhere. a2 Milk, following yet another profit warning, is also no longer included in the Portfolio.

The Growth Model Portfolio has added Reliance Worldwide ((RWC)) instead.

The four largest holdings in the Growth Model Portfolio are, in order of magnitude, BHP Group, Macquarie Group, CSL and CommBank ((CBA)).

Some of the smaller cap exposures are ALS Ltd ((ALQ)), Lovisa Holdings ((LOV)), Corporate Travel Management ((CTD)), Collins Foods ((CFK)), AP Eagers ((APE)), Megaport ((MP1)) and Hub24 ((HUB)).

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Wilsons has removed ResMed ((RMD)) from its Conviction list as the company's pace of growth remains affected by the global pandemic. The aforementioned Morgans Growth Model Portfolio has kept exposure to the global market leader in obstructive sleep apnoea (OSA) devices.

Wilsons' list of conviction buys now only consists of seven inclusions; ARB Corp ((ARB)), Collins Foods, Telix Pharmaceuticals ((TLX)), Pacific Smiles ((PSQ)), Whispir ((WSP)), ReadyTech ((RDY)), and Plenti ((PLT)).

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Analysts at Jarden recently initiated coverage on contractors and services providers to miners and energy companies and their view is this sector is only just at the early stages of what should prove an uptrend for the next 2-3 years. At this stage, Jarden prefers pure play exposure rather than equipment hire and contract mining.

For your typical cycle leveraged companies, the broker's preference lays with testing capabilities rather than maintenance.

Jarden's initiation of coverage involves five companies with ALS Ltd, Emeco Holdings ((EHL)) and MacMahon Holdings ((MAH)) all rated as a Buy with price targets of respectively $11.90, $1.55 and $0.35.

Monadelphous ((MND)) and NRW Holdings ((NWH)) both start off with an Overweight rating (which sits below Buy) with price targets of $13.55 and $3.40 respectively.

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Retail analysts at Bell Potter recently repeated their sector preferences ("Key Picks") for City Chick Collective ((CCX)), Domino's Pizza ((DMP)) and Accent Group ((AX1)).

Research To Download

Independent Investment Research's monthly Pharma & Biotech update:

https://www.fnarena.com/downloadfile.php?p=w&n=B7F89E73-F7FD-83D4-6DE553C8A0E478E0

(This story was written on Monday 17th May, 2021. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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