The Wrap: Artificial Intelligence, Construction Industry, Rising Bond Yield Winners & Small Cap Ideas

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Weekly Broker Wrap: ASX-listed companies investing in AI; construction industry cost inflation; rising bond yield beneficiaries; and post reporting season small cap ideas.

-Which ASX-listed companies are investing in AI?
-Construction industry cost inflation 
-Rising bond yield beneficiaries 
-Post reporting season small cap ideas

By Mark Woodruff

Which ASX-listed companies are investing in AI?

In Australia companies are significantly increasing the amount of money they are spending on artificial intelligence (AI) in an effort to drive efficiency gains and derive better insights from their customers.

Firms that make the investment are more likely to disrupt their competitors, take market share and realise efficiency gains within their businesses. Deploying the technology often results in better predictions, recommendations or decisions. Additionally, there can be streamlined production processes, tailored product offerings, targeted online advertisements and price discrimination.

Unsurprisingly, UBS identifies the IT sector is leading the investment charge though the Financials and Consumer sectors are also prominent. Driven by access to data, companies within more 'traditional' industries like banking and bricks and mortar operations like supermarkets and other retailers are leveraging automation and gaining better insights.

Overseas experience indicates larger firms with higher sales mark-ups and cash reserves tend to invest more in AI. They then, in turn, experience faster growth in sales and employment, which translates into growth at the industry level. 

As a result, the positive effects are concentrated amongst the largest firms leading to a positive correlation between AI investments and industry concentration. Thus, investing in AI increases the scale of the most productive firms and contributes to the rise of 'superstar' firms.

This is where things become interesting as UBS asks: Which Buy or Neutral-rated Australian companies under its research coverage are both data driven and investing accordingly in data and technology?

Given they are more data-driven than other sectors, Shopping Centre mall owners Scentre Group ((SCG)) and Vicinity Centes ((VCX)) are prominent. Their usage is higher given the need to understand customer shopping behaviours to ensure an optimal leasing mix, explains the broker. Their expenditure is increasing on data/technology in order to offer incremental product and services, and merge the physical and digital worlds.

Within the Energy sector, Z Energy ((ZEL)) rates a mention by UBS for investing the most into data capabilities relative to peers. This has resulted in new ways of paying for fuel, more targeted advertising and the ability for retail consumers to hedge fuel price risk.

Downer EDI ((DOW)) also utilises data analytics to drive greater efficiency within its Transport and Infrastructure operations and maintenance business, according to the analyst. Meanwhile, within Resources, BHP Group ((BHP)) is leading the way by leveraging autonomous haulage and drilling, as well as real-time monitoring of iron ore operations.

Other highly-data driven companies covered by UBS that are investing heavily in AI include Seek ((SEK)), Qantas Airways ((QAN)), IDP Education ((IEL)), Megaport ((MP1)), Origin Energy ((ORG)) and Woolworths Group ((WOW)).

Construction industry cost inflation

Despite strong demand and volume growth in the construction industry, profit growth for builders is likely to be limited, due to severe cost inflation and a limited ability to pass on higher costs. Overall project costs are up around 5% over the past six months and are expected to rise again.

In league with the Australian Institute of Building, Jarden participated in an August 2021 survey which asked builders across Australia questions relating to profitability, order book, pricing and business performance.

Survey results appear to be in-line with the broker’s view that cost pressure in the construction sector is higher than previously expected and unlikely to abate in the coming six months. As the impact of HomeBuilder fades in the next 12 months, it’s expected new dwelling costs will become a key driver of inflation.

Survey respondents expect to see an around 10% steel product price increase in the coming six months, which is seen by Jarden as positive for BlueScope Steel ((BSL)), while cement costs are also likely to rise circa 5% (which is similar to the past six months). In keeping with this, separate industry feedback to the broker suggests input costs are up across the board (8% estimated since January 2020), with a 25% increase for structural timber (another 15% expected) and steel rising by 30%.

Over 60% of respondents noted the rise in project costs could not be passed on to customers. With building material and labour costs likely to rise further in the coming months, Jarden suggests the best contractors or project managers can do is to build in a higher "buffer" when bidding for new projects.

Boral ((BLD)) announced its intention to lift prices in October 2021, while Adbri ((ABC)) is yet to announce any change.

Another potential risk to watch out for is delays in construction completion due to tight shipping schedules.

Jarden's property research team has noted delays in getting imported goods (such as elevators, glass) from overseas have caused difficulties for developers in apartment completion.

On top of this, wage increases of 10-15% are becoming increasingly common. However, so far this has been limited largely to more skilled labour, with increases for unskilled/entry-level positions limited by industry awards, explains the analyst.

However, major developers, such as Mirvac Group ((MGR)) and Stockland ((SGP)) are more likely to be concerned about rising land costs than rising building material costs, with the ability to pass through costs to the end-buyer. It’s thought subcontractors are the most likely to be squeezed.

In a positive for Mirvac Group, according to the broker, 30% of respondents expect strong residential apartment construction activity after covid has passed. Meanwhile, Home Consortium ((HMC)), Goodman Group ((GMG)) and Centuria Industrial REIT ((CIP)) should benefit as Healthcare property, detached housing and industrial property demand is also expected to remain strong.

The residential outlook is more positive than the common view among listed construction and building material company executives, who appear to indicate that potential strong multi-residential construction activity depends on a return of immigration.

Anecdotal evidence from Jarden's property research team aligns with the survey results, in pointing to strong recent demand for residential apartments in Sydney, despite the lockdown.

The weakest outlook from the survey was across retail and tourism-related property.

Survey results also highlight to Jarden a significant opportunity to improve penetration of trade for the likes of Wesfarmers ((WES)), Reece ((REH)) and CSR ((CSR)).

Finally, Boral, CSR and Mitre10 ((MTS)) rated the lowest for service, while Beacon Lighting ((BLX)), James Hardie Industries ((JHX)) and Harvey Norman ((HVN)) rated the highest.

Rising bond yield beneficiaries

Share market strategists at Macquarie recommend a basket of ten (Outperform-rated) stocks positively correlated to bond yields. This comes as real yields are beginning to rise, after the US Federal Reserve has given advance warning of tapering at its September meeting.

There are two stark differences between now and 2013, when yields rose by more than 120bps in the seven months between the warning and the formal announcement.

Firstly, with a taper announcement possible in November or December this year, there is potentially only one or two months warning. Hence, there is a risk of a 2013-style taper tantrum, which saw ASX stocks fall around -9% in a month. During this period, Health was the best performing sector while Mining was the biggest underperformer, notes Macquarie.

The second difference is that the expected rise in bond yields is policy driven and counter-cyclical. The cycle is already slowing, the commodity cycle has likely peaked and tapering should support a stronger US dollar. Under normal circumstances in a slowing economy Defensives would be preferred, but rising yields may negatively weigh this time around.

So the hunt is on for two categories of stocks, under Macquarie’s coverage that benefit from higher US real yields and are Outperform rated:

–Stocks with a direct positive earnings link; this group includes Insurers Suncorp Group ((SUN)) and Insurance Australia Group ((IAG), as well as Computershare ((CPU)) and Link Administration ((LNK)).

–Stocks with an indirect earnings impact in an improving cycle; the broker likes Energy shares including Woodside Petroleum ((WPL)) and Origin Energy, as well as Worley Group ((WOR)), Downer EDI, Qantas and Incitec Pivot ((IPL)).

On the flipside, stocks with negative correlation to real yields include a range of Growth, Defensive, Infrastructure and Gold sector stocks. A group of ten that Macquarie would be wary of are as follows:

Underperform-rated stocks include Domino’s Pizza Enterprises ((DMP)), Commonwealth Bank ((CBA)) and Xero ((XRO)).

Neutral-rated stocks include JB Hi-Fi ((JBH)), Fisher & Paykel Healthcare ((FPH)), Ansell ((ANN)), Wesfarmers ((WES)), Carsales.com ((CAR)), Magellan Financial Group ((MFG)) and Sonic Healthcare ((SHL)).

All the above caters to the correlation between share prices and real yields. In a similar, but quite separate analysis, Macquarie looks at the correlation between forward Price Earnings (PEs) and bond yields.

On this basis, the broker concludes rising real yields could be a potential valuation headwind for 75% of the ASX100.

Again Macquarie filters through Outperform-rated stocks under coverage, that benefit from higher US real yields, where there is a direct earnings benefit. These include Computershare, Suncorp Group and Link Administration. Neutral-rated stocks include Challenger ((CGF)) and Virgin Money UK ((VUK)).

Underperform-rated names, for which PEs have a high negative correlation with real yields are Commonwealth Bank, Alumina ((AWC)), Altium ((ALU)) and Reece. Neutral-rated stocks are JB Hi-Fi, Magellan Financial Group, Wesfarmers and Woolworths Group.

In addition to the top ten Outperform-rated stocks, Macquarie outlines its overall strategy portfolio in terms of higher yield beneficiaries. Those upon which there is a direct earnings impact and have positive weights in the portfolio are:

QBE Insurance Group ((QBE)), IAG and Suncorp, while Banks are represented by ANZ Bank ((ANZ)) and Westpac ((WBC)). Janus Henderson ((JHG)) and Computershare are also included.

Also, for Energy sector exposure, the strategy portfolio is overweight Woodside Petroleum, Ampol ((ALD)) and BHP. It’s thought these stocks are well positioned given oil demand was negatively impacted by covid and should be supported by re-opening. The Energy sector also considered to have a low valuation on cyclically low earnings.

The broker believes defensive positions are necessary, given the slowdown and prefers Staples and Health though acknowledges these stocks could be negatively impacted by rising yields.

The Staples exposure is obtained via Coles Group ((COL)), Endeavour Group ((EDV)) and Woolworths, while Health includes Ramsay Healthcare ((RHC)), Healius ((HLS)), Cochlear ((COH)) and Resmed ((RMD)).

Reporting season winners

Small cap specialists at Jarden have weighed up the profit reporting season and have separated high-conviction ideas into three silos: 

–Online retail; long-term winners that have emerged from the pandemic with an enhanced business model and market position. These companies include Adore Beauty ((ABY)), Adairs ((ADH)), City Chic Collective ((CCX)) and Temple & Webster ((TPW)).

–Auto; with NSW approaching the vaccination rate needed for a reopening, the broker expects sentiment to swing in favour of the dealers. Ongoing supply constraints are conducive to margins per vehicle holding into 2022, with the preference in the sector being Peter Warren Automotive ((PWR)).

–Other key picks; include document management firm Class Ltd ((CL1)), helped along by the recent Topdocs software acquisition; charity donor-management company PushPay ((PPH)) after the Catholic segment in particular has gained traction more quickly than envisaged; and the covid-recovery play of IDP Education.

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