Rudi’s View: February Results; Macro, Traps And Opportunities

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In this week's Weekly Insights:

-February Results: Macro, Traps And Opportunities
-Conviction Calls
-Index Changes

By Rudi Filapek-Vandyck, Editor FNArena

February Results: Macro, Traps And Opportunities

Contrary to popular belief, bear market periods are actually quite common in global markets.

Pre-GFC we all liked to think there would not be a repeat anytime soon of the Nasdaq meltdown post March-2000, but, depending on the chosen definition, it's not too difficult to identify late 2007-March 2009, 2011-mid-2012, May 2015-February 2016, late 2018 and the first quarter of 2020 as bear market periods with similar base characteristics.

Common observations for all these periods involve heavy volatility (at times into never-before-witnessed-extremities), indiscriminate and forced selling (not always possible to distinguish the two), with an underlying tendency to end up at a lower price point, irrespective of multiple big rallies to the upside, triggered by short-covering or otherwise.

Overall sentiment usually turns very dark as investors worry about a total collapse or the-end-of-the-world-as-we-know-it. Very scary price charts make their appearance and comparisons with the 1930s or 1987 are drawn.

This time around the worry is that central bankers have left it too long to adjust their ultra-accommodative policies and that inflation, in combination with slowing growth in fragile economies, might wreck global equities and domestic properties.

It is my observation these periods of great market uncertainty are a process that needs to run its course. And, contrary to what some forecasters might pretend, the end outcome is never this early set in stone already. History also suggests worst case scenarios have a habit of, ultimately, not materialising, or only on very rare occasions, like 1929, 1987, 2000 and 2007.

None of this means investors should not take heed of the fact that risks are present; these risks are tangible and they can, potentially, cause great distress and severe portfolio damage. My own biggest concern for a while has been that central bankers lose their confidence and start tightening too firmly and at too rapid a pace while most economies around the world are decelerating into a mid-cycle slow-down.

We can but speculate what such a scenario would do to markets, but it most likely won't be pretty. Bond markets are pricing in a firm acceleration in countries like the US and now also the eurozone, but it still remains to be seen whether central bankers will walk that path as it has been laid out.

It is well possible that, from a data release and news driven angle, markets are currently caught in the midst of peak-inflation-fear, and there's likely a lot more in portfolio re-alignments that still needs to happen. Also, even if the general view that consumer price inflation should peak this quarter and start deflating throughout the rest of the calendar year proves correct, an oil price approaching US$100/bbl and the threat of an energy crisis in Europe are not helping with calming investors' nerves.

In terms of market price action, it doesn't appear markets have as yet seen the point of widespread capitulation. This in itself is a worry too.

Put it all together, and I think investors should prepare for a number of weeks of the same underlying market dynamics, at least. Maybe if the Fed delivers that very first rate hike. Maybe if the oil price corrects to the downside. Maybe if inflation data releases start showing  lower numbers. Maybe at some point the bond market has reached its ceiling in terms of pricing in future rate hikes.

Maybe Russia and NATO can come to an agreement.

The good news is history shows bear markets tend to be much shorter than bull markets. The not so good news is we might still be only at the front end of the current process.

Buckle in and don't get impatient!

February 2022 – Reporting Season

Regardless of the many global uncertainties, operational dynamics for corporate Australia presently seem too fragile and too unpredictable to instill a lot of confidence about the future strength and trajectory of profits and cashflows.

Early reports delivered by the likes of Amcor ((AMC)), Credit Corp ((CCP)), Janus Henderson ((JHG)), Nick Scali ((NCK)), Pinnacle Investment Management ((PNI)), REA Group ((REA)), ResMed ((RMD)), and two of the major banks have already delivered plenty of food for thought for local investors.

Equally telling: Westpac ((WBC)) shares are the only one mentioned that booked a gain upon market update and managed to hold on to those gains!

So what have we learned from early results releases so far?

Companies are struggling. If it's not the inability to source supply or to hire new staff, the omnipresent virus and its many impacts and limitations are weighing down on operations and margins. And investors are in no mood to ignore, forgive or forget.

Under different circumstances, a better-than-forecast quarterly result by Australia's leading property portal, REA Group, might have put a small rocket under the share price, in particular since the share price had already come off by circa -17% since November, but  this time the weakness has continued post release.

Within this context, it is probably worth pointing out this year's February result season has been preceded by a number of profit warnings, as well as a noticeable number of disappointing quarterly production updates from miners and energy companies. In most cases, rising costs were the main cause for disappointment.

On the other hand, Westpac's quarterly update was far from fantastic, with margin pressure alive and kicking and stringent cost control the absolute necessity. But market expectations had been assuming worse, and thus the Westpac share price has rediscovered upward momentum. ANZ Bank ((ANZ)) didn't quite have the same experience.

There might be a strong signal in here for investors. Quality performers that perform well won't necessarily be rewarded this season, but maybe the underperformers that avoid worst case scenarios will?

I note AGL Energy ((AGL)) has been among the best performers on the ASX over December and January, as well as Virgin Money UK ((VUK)), Crown Resorts ((CWN)), and Origin Energy ((ORG)). The latter's share price is supported by a general expectation that an extra payout to shareholders will be announced with the release of interim financials following the sale of equity in the APLNG project.

Taking guidance from the Telstra ((TLS)) experience over the year past, investors are likely to retain their enthusiasm for companies ready to announce asset sales and pass on part of the proceeds to shareholders. News Corp ((NWS)) might be next with rumoured intentions to soon list Foxtel.

Investors should also note how firm the share price in Nufarm ((NUF)) is holding up now management has communicated its five-year growth plans.

Themes that will continue to dominate the landscape throughout February include M&A and dividends, with potential upside surprises from miners and maybe large cap financials too, and the all-important cost control. Some analysts believe companies will remain reluctant to quantify their outlook if they don't feel costs can be contained.

Interestingly, technology analysts at RBC Capital have remodeled their sector valuations with higher bond yields as key input, alongside several of the now widespread challenges facing corporate Australia. As a general rule of thumb, report the analysts, this has reduced valuations across the sector by some -15%.

All in all, earnings forecasts in Australia have held up in the second half of 2021, but predominantly because of higher-for-longer commodity prices. This year market forecasts are falling. If history can be relied upon, forecasts will be lower again once the February reporting season has run its course, though market strategists at stockbroker Morgans disagree.

Morgans' positive view is partially based on the assessment that analysts have largely positioned forecasts cautiously, hence there should be more room for upside surprises a la Westpac.

All shall be revealed over the weeks ahead.

Corporate Margins – How Much Should We Worry?

Market strategists at UBS believe the bias is to the downside, but they also observe that if today's expected earnings growth of circa 13% for FY22 declines to, say, 9% this would still represent a pace "noticeably above trend".

UBS also points out that inflation on goods should be plateauing from here, making it easier for companies battling rising input costs through goods to pass it onto customers and consumers. On the other hand, services inflation has likely further to run, and is probably more difficult to pass on.

UBS research does nevertheless suggest most sectors on the ASX are operating on profit margins not far off from historical averages, suggesting any concerns about unsustainable profits seem misplaced. The sole exception is the healthcare sector where operational margins have substantially increased in recent years.

At the company level, UBS analysts have discovered the trend is for companies in higher margin businesses to expand margins most over recent years.

One sector that is facing more margin pressure in Australia are building materials companies. UBS doesn't see pressures from supply chains, energy and labour to ease anytime soon and this, up to a degree, offsets the favourable outlook for companies in Australia and the US. UBS's favourites in the sector are James Hardie ((JHX)) and Reliance Worldwide ((RWC)).

James Hardie was equally on other analysts' lists and the company -sometimes referred to as possibly Australia's highest quality cyclical- once again delivered on Monday, including upgraded guidance.

Another trend, UBS suggests, is for Australian businesses to start playing catch-up with capex spending trends elsewhere in order to make business models better protected against change and labour market tightness. Most sectors of the ASX seem to have decelerated their relative capex spending over recent years, according to the broker's analysis.

UBS thinks investors will welcome the shift.

According to Morgans, companies that fare better than most in combating cost inflation and protecting their margins include Aristocrat Leisure ((ALL)), Amcor, Brambles ((BXB)), NextDC ((NXT)), REA Group, Sonic Healthcare ((SHL)) and PWR Holdings ((PWH)).

Meanwhile, equity strategists at JP Morgan point out corporate earnings in the US have thus far performed better than expected, yet again. They think analyst forecasts over there are too conservative and estimates for Q4 will have to rise.

Bond Yields Not Always Most Important

Infrastructure analysts at Morgan Stanley acknowledge rising bond yields by default pose a headwind for infrastructure stocks, which might make it easier for the likes of Qube Holdings ((QUB)) and Aurizon Holdings ((AZJ)) to outperform their peers this year.

But Morgan Stanley also thinks the theme of traffic recoveries as economies re-open will prove a mightier influence and thus toll road operators and airport stocks carry the broker's favour.

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Put it all together, and it's probably not unreasonable to conclude risks are a-plenty and less easy to avoid this season. So what's the best strategy?

The FNArena/Vested Equities All-Weather Model Portfolio raised its cash level substantially in December and January, mostly through generally reducing existing positions.

As I have oft explained previously, I regard these tough and volatile periods in the share market as the ideal trigger to clean up the portfolio. Contrary to general practice, I never am looking to take or secure profits. Instead I consider such times as an opportunity to return to basics and question my confidence and conviction.

As such, a decision was made to sell all shares in Ansell ((ANN)), a decision that was subsequently vindicated as management was forced to issue a profit warning. However, post the subsequent sell-off in the stock, Ansell was quickly returned into the Model Portfolio on the belief that on a 1-2 year horizon, the shares offer excellent opportunity/value.

The expectation is the February results season will offer plenty more opportunities, though we shall need to remain nimble and selective, while also keeping a close eye on what happens at the macro-level.

Winners & Losers – The Forecasts

Companies likely to surprise in a positive manner, according to analysts at Goldman Sachs, include Nine Entertainment ((NEC)), Sims Metal Management ((SGM)), Iluka Resources ((ILU)), Tassal Group ((TGR)), HealthCo Healthcare and Wellness REIT ((HCW)), Jumbo Interactive ((JIN)), GUD Holdings ((GUD)), Sonic Healthcare, and Domino's Pizza ((DMP)).

Companies identified for likely negative surprises this February reporting season include CommBank ((CBA)), Monadelphous ((MND)), Mineral Resources ((MIN)), and Temple & Webster ((TPW)).

Analysts at UBS have identified their own candidates for likely surprises in either direction.

For a positive surprise, UBS has selected Imdex ((IMD)), Suncorp Group ((SUN)), IDP Education ((IEL)), Computershare ((CPU)), ASX Ltd ((ASX)), Origin Energy, Challenger ((CGF)), Domain Holdings Australia ((DHG)), QBE Insurance ((QBE)), Reliance Worldwide, Steadfast Group ((SDF)), and Perpetual ((PPT)).

For a negative surprise, UBS's focus is on AMP Ltd ((AMP)), Insurance Australia Group ((IAG)), Wesfarmers ((WES)), Magellan Financial Group ((MFG)), Coles Group ((COL)), Domino's Pizza, Platinum Asset Management ((PTM)), Southern Cross Media ((SXL)), and Adbri ((ABC)).

Insurance and diversified financials analysts at UBS are anticipating good results from QBE Insurance, Suncorp Group, Computershare, ASX, Pexa Group, Challenger, Steadfast Group, and Perpetual. Suspected disappointments are to come from Insurance Australia Group, AMP, Magellan Financial Group and from Platinum Asset Management.

Colleagues at Credit Suisse equally believe the bias is for more negative surprise from Platinum Asset Management, while seeing potential surprise coming from ASX, Link Group ((LNK)), Janus Henderson ((JHG)), and Perpetual.

Credit Suisse also sees upside risks for QBE Insurance, Steadfast Group, Medibank Private ((MPL)), and Insurance Australia Group while downside risks are reserved for Suncorp Group and nib Holdings ((NHF)).

The aforementioned technology analysts at RBC Capital see downside risks for Altium ((ALU)) and Appen ((APX)) this season while Pro Medicus ((PME)) and Fineos Corp ((FCL)) should be among the best protected in the sector due to long-term contracts and minimal churn.

At stockbroker Morgans, market strategists have identified a number of key tactical trades into results, including HealthCo Healthcare and Wellness REIT ((HCW)), Hub24 ((HUB)), Lovisa Holdings ((LOV)), Megaport, People Infrastructure, nowadays trading as Peoplein ((PPE)), Seek, and Sonic Healthcare.

Morgans had also identified Ansell, but that idea went flat because of a profit warning ahead of the interim results release, as well as Credit Corp ((CCP)), which delivered but its share price not so much.

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As per always, FNArena keeps track of the local reporting season via: https://www.fnarena.com/index.php/reporting_season/

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See also:

February Looks Tricky: https://www.fnarena.com/index.php/2022/02/03/rudis-view-february-looks-tricky/

Risks To Consider: https://www.fnarena.com/index.php/2022/01/27/rudis-view-risks-to-consider/

Conviction Calls

Discretionary retail analysts at Goldman Sachs suspect investors will be best off by seeking out investment ideas with strong valuation support this season.

Their three Buy-rated ideas are Adairs ((ADH)), Super Retail ((SUL)), and Harvey Norman ((HVN)).

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Market strategists at Banyantree have selected a2 Milk ((A2M)), Beach Energy ((BPT)), Cleanaway Waste Management ((CWY)), IDP Education, NextDC, Nitro Software ((NTO)), REA Group, and Tabcorp Holdings ((TAH)) as their Top Picks for 2022.

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RBC Capital's technology sector favourites are Pro Medicus, Fineos, EML Payments ((EML)), and Megaport ((MP1)).

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Stockbroker Morgans has added 10 additional names to its (already extensive) list of Best Ideas in Australia for the year ahead.

Those 10 newcomers are Atomos ((AMS)), Beacon Lighting ((BLX)), Maas Group ((MGH)), Newcrest Mining ((NCM)), Pro Medicus, Red 5 ((RED)), Seek, South32 ((S32)), Webjet ((WEB)), and Wesfarmers.

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Morgans also identified four companies it believes offer "compelling value": Acrow Formwork and Construction Services ((ACF)), People Infrastructure, now Peoplein, Superloop ((SLC)), and Generation Development ((GDG)).

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Software analysts at Shaw and Partners believe they have found a new gem in the sector; Keypath Education International ((KED)) with the shares trading some -60% below the price target set by Macquarie on February 1.

Sector Top Picks, according to the team, remain Mach7 Technologies ((M7T)), Whispir ((WSP)) and Gentrack Group ((GTK)).

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Small cap specialists at JP Morgan continue to nominate Tyro Payments ((TYR)) as their Top Pick, while Flight Centre ((FLT)) remains least preferred ("Bottom Pick").

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Wilsons' Top Picks for 2022 consists of 19 names; ARB Corp ((ARB)), Aroa Biosurgery ((ARX)), City Chic Collective ((CCX)), Collins Foods ((CFK)), CSL ((CSL)), EML Payments, GUD Holdings, Immutep ((IMM)), ImpediMed ((IPD)), NextDC, Nick Scali, Plenti ((PLT)), ReadyTech ((RDY)), Ridley Corp ((RIC)), Silk Laser ((SLA)), Telix Pharmaceuticals ((TLX)), Tyro Payments, Whispir, and Xero ((XRO)).

Index Changes

Index composer Standard & Poor's will announce the next set of changes to Australian indices on Friday March 4th, to become effective after the close of trading on March 18th.

Analysts at Wilsons predict a slew of changes is awaiting the ASX300, while each of the smaller indices could see one or two changes announced.

Starting with the ASX20, Wilsons thinks Brambles ((BXB)) and Block ((SQ2)) seem ready to be replaced with James Hardie ((JHX)) and Santos ((STO)) respectively.

For the ASX50, M&A has created an extra gap and thus only one stock might have to disappear -potentially Aurizon Holdings ((AZJ))- to welcome Seek ((SEK)) and BlueScope Steel ((BSL)).

A similar scenario awaits the ASX100 where Orora ((ORA)), potentially, might be booted out  in order to welcome up to three newcomers, identified as Iluka Resources ((ILU)), ARB Corp ((ARB)), and Seven Group Holdings ((SVW)).

The ASX200 could see up to five removals and seven replacements. Might be enjoying their final weeks of membership; Mesoblast ((MSB)), Spark New Zealand ((SPK)), Unibail-Rodamco-Westfield ((URW)), SkyCity Entertainment ((SKC)), and St Barbara ((SBM)).

Candidates likely to join the index are Arena REIT ((ARF)), Telix Pharmaceuticals ((TLX)), Siteminder ((SDR)), City Chic Collective ((CCX)), De Grey Mining ((DEG)), AVZ Minerals ((AVZ)), and Home Consortium ((HMC)).

Things could end up a lot more interesting for the ASX300 where, if everything goes to plan, up to six empty spots will have been created through M&A. Wilsons has in addition identified 10 candidates that seem ready to be replaced, plus five additional candidates that might be replaced.

Those deemed "probable" to lose their spot are Marley Spoon ((MMM)), Mount Gibson Iron ((MGX)), Cedar Woods Properties ((CDW)), Opthea ((OPT)), Emeco Holdings ((EHL)), Paradigm Biopharmaceuticals ((PAR)), Sezzle ((SZL)), Electro Optic Systems ((EOS)), Piedmont Lithium ((PLL)), and Resolute Mining ((RSG)).

Have been identified as "possible" candidates awaiting their replacement: Mayne Pharma ((MYX)), Strike Energy ((STX)), Cooper Energy ((COE)), Carnarvon Energy ((CVN)), and AMA Holdings ((AMA)).

The list of companies that most likely will fill up the gaps include Siteminder, AVZ Minerals, Judo Capital Holdings ((JDO)), Pexa Group ((PXA)), APM Human Services International ((APM)), Lake Resources ((LKE)), Core Lithium ((CXO)), Sayona Mining ((SYA)), Aussie Broadband ((ABB)), Firefinch ((FFX)), Jervois Global ((JRV)), MA Financial Group ((MAF)), 29Metals ((29M)), Calix ((CXL)), Ardent Leisure ((ALG)), and PWR Holdings ((PWH)).

Seen as possible candidates to join the ASX300 are Syrah Resources ((SYR)), Boss Energy ((BOE)), Vulcan Steel ((VSL)), Praemium ((PPS)), and Bigtincan Holdings ((BTH)).

If past experiences are anything to go by, changes for the ASX200 tend to have the largest impact. Changes for the ASX100 might impact through the fact that small cap investors can no longer own the stock.

(This story was written on Monday 7th February, 2022. 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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