Rudi’s View: Balancing Between Opportunity & Risks

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In this week's Weekly Insights:

-Balancing Between Opportunity & Risks
-Conviction Calls
-FNArena Talks

By Rudi Filapek-Vandyck, Editor FNArena

Balancing Between Opportunity & Risks

If there is one strong universal agreement among investors of all kinds and colours it is that bear markets present opportunity for those who can look beyond short term volatility.

The flipside to this narrative is that when investors buy in too early, they can still suffer heavy capital losses and might then have to be patient for much longer to see their bravery rewarded, assuming they pick a company that will survive the economic downturn and the share price doesn't get obliterated in the meantime.

Probably the most famous anecdote regarding the latter concerns Isaac Newton who, despite his revered intelligence, lost a financial fortune during what is today known as the South Sea Bubble of 1720^(*).

But investors don't have to go back that far into history to establish that time does not heal all wounds suffered on the share market. Plenty of sorry tales stem from the Nasdaq meltdown in March 2000. Today many might have forgotten but the second tranche in the privatisation of Telstra ((TLS)) back in 1999 was sold for $7.40 a share to retail shareholders.

More than two decades later and the Telstra share price needs to double to get back to that level, and that's conveniently omitting the fact the shares surged a lot higher at that time. Luckily, the company does pay a hefty dividend, and it has done exactly that over the period since, but a pretty picture or a Grand Return it offers not.

What about the fact that three of the major banks in Australia never managed to return to share price levels achieved pre-2008? Shares in National Australia Bank ((NAB)) traded well above $40 back in 2007. They would have looked an ab-so-lute bargain at $30, but two decades later and $30 is double digits above where the shares are trading.

The message for investors could not be any clearer: don't assume a lower share price by definition means better value, a bargain, or excellent long term returns. This warning in particular applies during a time of major asset valuations resetting on the back of higher inflation, higher bond yields and central bankers winding down extreme policy support.

Some of this month's broker updates are indicating that with changing times comes a much lower valuation for companies that find themselves on the wrong side of the economic cycle.

Last week, UBS prepared for a much tougher outlook for consumer discretionary spending, not just in Australia, but worldwide. UBS's modeling now has a valuation/price target for shares in women's plus size fashion retailer City Chic Collective ((CCX)) of $2 – not that far above the $1.91 the shares are trading at on Monday.

Nine months ago City Chic shares nearly touched $7.

Admittedly, one single broker valuation or assessment is not necessarily the most accurate guide. Consider, for example, Ord Minnett has a valuation of $2.35 for Metcash ((MTS)) whose FY22 financials proved much better-than-expected on Monday. With other brokers carrying valuations between $4.20 and $5 it seems Ord Minnett is simply the odd one out, even more so now that Metcash has outperformed forecasts, fueling expectations its operations are solidly defensive and might continue growing.

Metcash is not the only ASX-listed company that has defied accumulating headwinds and investors' more sombre outlook with the likes of Growthpoint Properties Australia ((GOZ)) and Vicinity Centres ((VCX)) equally beating market scepsis with their trading updates, suggesting maybe, just maybe, investors have been wrong when fearing the depth of the economic downturn that is by now on everbody's mind?

I am afraid such assessment stands in frontal contrast with the trend in economic forecasts which increasingly sees a skew emerging towards much slower growth and possibly economic recessions (negative growth) for all of Europe, the UK and even the USA. Most companies cannot grow at a faster pace than the economy, and even those that can might not prove 100% immune.

True, not all forecasts will prove accurate, and certainly not everyone is on board with the new trend, but these economic shifts are slowly moving events. An operational update today might not necessarily be representative for what happens in six months' time. Meanwhile, the weakest dominoes have started to reveal their vulnerabilities.

Small cap Pro-Pac Packaging ((PPG)) just issued its second profit warning in six weeks. The CFO left seven weeks ago. Always hopeful skin care retailer BWX ((BWX)) announced a sudden capital raising at a heavily dilutive price of 60c (last share price $1.17).

Link Administration ((LNK)) suitor Dye & Durham now wants to pay $4.30 per share instead of the previously indicated $5.50 (last share price $3.85).

It's not like mining companies have been all about good news either. Shares in WA gold producer Dacian Gold ((DCN)) are today lingering around 8c, down from 32c in April (52c in early 2021) as the company's previous guidance for FY22 was shot to pieces because of staffing problems and sharply rising costs. Gold producers are subjected to prices for diesel and gas like so many others.

Shares in St Barbara ((SBM)) equally experienced another dive lower following yet another disappointing market update, as proved the case for Ramelius Resources ((RMS)). Even industry heavy-weight Glencore disappointed with management citing higher input costs from diesel, explosives, logistics and electricity.

One of the big debates that is colouring and dividing the outlook for economies and corporate sectors this year is how much of an impact does the accelerating tightening by central banks have on housing markets, and how much will impact on consumer spending?

Is it too obvious to state that history may not be the most accurate guide this time around?

Maths & Multiples

Stepping aside from the macro-economic enigma, for now, there is one reason why most investors tend to under-appreciate just how damaging this year's re-adjustment process can still turn out to be for risk assets such as listed equities. In simple terms: it's the power of mathematics.

A company generating $11 in earnings per share trading on a multiple of 21x would have been valued at $231 and possibly trading at a premium pre-November.

What happens this year if EPS drops to $10 and the multiple contracts to 15x? All of a sudden that valuation shrinks to $150 – a loss of -35%.

This still assumes the market remains comfortable with the outlook for next year and the year thereafter, as well as with inflation returning inside the targeted 2-3% range.

If the latter proves not to be the case, as is the forecast of a number of renowned economists (Blanchard, Ferguson), then the market's multiple will shrink further, as has always happened during periods of higher inflation. During the 1970s, as some market observers keep pointing out, the average Price Earnings (PE) multiple for share markets in developed economies shrank to single digits.

Former Merrill Lynch alumni David Rosenberg (Rosenberg Research) keeps telling his clientele: for your own sanity, you don't want to put such a low multiple on this year's profits, even without taking into account those profits most likely will be lower next year.

Morgan Stanley strategist Mike Wilson points out the Equity Risk Premium (ERP) -the premium paid for owning shares rather than US Treasuries- is still well-below its pre-covid average. It's not easy to understand why this is the case, or whether today's equity premium will revert back to its old average, or exactly when, but such a move can easily translate into another double-digit correction for the share market in general – simply to bring today's ERP back to what it used to be.

All in all, it doesn't require too much of sticky inflation and falling corporate profits to pull down the S&P500 to 3400 or even 3000, which at today's level translates into further losses of roughly -10-20%.

These are broad market averages and the outcome for individual shares would vary wildly, in both directions.

Long-term: Positive Stats

Of course, things always look darker before dawn and this year's challenging set of circumstances does not necessarily end with worse case scenarios. Recent data analysis by Ord Minnett very much emphasises the positive returns that await investors following a negative year for the Australian share market.

Historically, two negative outcomes for subsequent financial years are quite rare with the research going back to 1990. This only happened in 2000-2001 and in 2008-2009.

Plus the average return post a negative period (as this year's financial year will be) has much better odds of generating positive returns when investors hold shares for a longer period. As per Ord Minnett research, the first twelve months post a negative financial year can still have wildly different outcomes, varying between +35% and -22% (with six years positive and only two negative).

But extending the holding period, significantly shifts the odds in investors' favour. Over three years, the worst outcome was an annualised loss of -0.2% with the best three-year return 27.8%. There have been no historical losses for holding periods of five years post a negative period for the ASX.

Note: these calculations are for indices. As illustrated earlier above, the outcome for individual shares does not necessarily mimic those outcomes.

What's An Investor To Do?

Taking all of the above into account, what's the best approach for investors this year?

First up, accept that if you own more than a couple of shares you almost by definition will suffer some disappointment and set-backs. There's only so much one can predict and anticipate in advance. This year's conditions are extremely tricky. Next year's might get trickier.

My advice is to keep your focus on the global slowdown and the potential for recession. Make sure you are confident in the companies you own. Still, keep in mind there will be disappointment – you just don't know yet exactly when and where.

Appreciate the value of cash. Investing in the share market does not mean you need to be fully invested all the time. Cash doesn't swing around by -30% and offers optionality. It also helps you sleep at night when volatility picks up once again.

Don't just look at the potential upside. Things can still get a lot uglier from here. But maybe they won't. There are no guarantees in this endeavour. Try to find a balance between the potential for opposing outcomes.

One consideration might be to add some gold exposure to the portfolio – for when inflation proves nastier and trickier than we all assume today. A little bit of insurance is never a bad idea.

In the right here, right now I'd be inclined to reduce risk and emphasise quality and defensiveness, but that doesn't mean you cannot own small caps or high conviction calls. Be aware: a bull market rewards risk-taking, a bear market might not.

The flipside is that bear market rallies can be quick, wild and significant. Then again, there's always the potential lurking for that next leg downwards.

If you're happy to buy more, move in small steps. Be patient. Prepare for a drawn-out process.

Accept that we are all human. Mistakes are part of the process. Avoid regrets.

According to some analysts, equity markets usually don't bottom until central banks stop hiking rates. We are nowhere near that point.

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^(*) Regarding Isaac Newton and the South Sea Bubble: https://royalsocietypublishing.org/doi/10.1098/rsnr.2018.0018

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More Reading:

-Not the Bottom, Not The End https://www.fnarena.com/index.php/2022/06/23/rudis-view-not-the-bottom-not-the-end/

-Double Your Protection: https://www.fnarena.com/index.php/2022/03/17/rudis-view-double-your-protection/

-Quo Vadis, Corporate Profits? https://www.fnarena.com/index.php/2022/06/02/rudis-view-quo-vadis-corporate-profits/

-Don't Fight The Fed: https://www.fnarena.com/index.php/2022/05/26/rudis-view-dont-fight-the-fed/

-Trend Is Turning For Corporate Profits: https://www.fnarena.com/index.php/2022/05/12/trend-is-turning-for-corporate-profits/

-A Bear Market Anomaly That Confuses: https://www.fnarena.com/index.php/2022/05/05/rudis-view-a-bear-market-anomaly-that-confuses/

-Peter's Portfolio Reviewed: https://www.fnarena.com/index.php/2022/04/13/rudis-view-peters-portfolio-reviewed/

-2022, The Big Adjustment: https://www.fnarena.com/index.php/2022/02/17/rudis-view-2022-the-big-adjustment/

Conviction Calls

One of the eye-catching share market observations recently was published by Model Portfolio guardians at stockbroker Morgans sharing feedback from institutional clients who have deep concerns about what corporate profits might look like for FY23.

In response to such concerns, reports Morgans, institutions are limiting their preferences to larger cap companies with plenty of liquidity. This means high quality companies in the smaller cap space are currently being ignored, opening up opportunities for other investors.

A word of caution: Morgans' Growth Model Portfolio is by no means heading all-in, but still anticipates a "tricky" market to navigate successfully and thus prefers a staged approach whereby smaller parcels are being bought in selected small and mid-cap companies that share those highly sought-after characteristics of being of high quality with good long term growth prospects.

Morgans specifically mentions Aristocrat Leisure ((ALL)) -a local Top20 stock, mind you- as well as Reliance Worldwide ((RWC)), IDP Education ((IEL)), Lovisa Holdings ((LOV)), Eagers Automotive ((APE)), and Domino's Pizza ((DMP)) among many more unnamed nominees listed on the ASX.

Morgans being a stockbroker, rather than a trustworthy journalist who acknowledges the value of precision and details, one smaller cap opportunity mentioned is PWR, but it's not clear whether this refers to PWR Holdings ((PWH)) or to Peter Warren Automotive ((PWR)).

I am inclined to think it's PWR Holdings, but would not be surprised if it applies to both companies.

Morgans, clearly, likes the re-born Woodside Energy ((WDS)) with both its Core Model Portfolio and Growth Model Portfolio buying additional exposure in May.

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Morgan Stanley's Australia Macro+ Focus List consists of the following ten constituents:

Amcor ((AMC)), Computershare ((CPU)), CSL ((CSL)), Goodman Group ((GMG)), Macquarie Group ((MQG)), Orica ((ORI)), Qantas Airways ((QAN)), QBE Insurance ((QBE)), Woodside Energy, and Telstra ((TLS)).

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The Model Portfolio over at Canaccord Genuity has adopted a more "cautious" view on the way forward for economies and share markets and this has translated into less exposure to the banks (now moderately underweight), the removal of cyclicals Mirvac Group ((MGR)) and Seek ((SEK)) and the inclusion of Endeavour Group ((EDV)) and recent Tabcorp-spinoff Lottery Corp ((LTC)).

The Portfolio has also moved to a moderately Overweight exposure to large cap iron ore mining with Rio Tinto ((RIO)) replacing Lynas Rare Earths ((LYC)).

Other stocks included are Woodside Energy, BHP Group ((BHP)), OZ Minerals ((OZL)), Amcor, Qantas Airways, Transurban ((TCL)), Woolworths ((WOW)), Ramsay Health Care ((RHC)), CSL, CommBank ((CBA)), National Australia Bank ((NAB)), Westpac ((WBC)), Macquarie Group, Medibank Private ((MPL)), Suncorp Group ((SUN)), Computershare, and Lendlease ((LLC)).

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"Citi economists see the risk of a global recession approaching 50%. The analyst consensus for 11% global EPS growth in 2022 and 8% in 2023 looks too bullish. Top-down, we expect 0-5% growth each year, but even that forecast will be too high if recession hits. Big profit downgrades would be a further drag on market performance, with cyclical stocks most vulnerable."

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"Macquarie’s Macro Strategy Team now expects most of the developed world (US, UK, Europe) to be in recession by 2023 as persistently high inflation forces interest rates into restrictive territory, ultimately resulting in slower growth and higher unemployment."

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Wilsons' Focus List has now removed Silk Laser Australia ((SLA)), while reducing exposure to Pinnacle Investment Management Group ((PNI)) and Judo Bank ((JDO)).

The strategist at the firm believes inflation is poised to fade over the next six months and thus warns investors against turning too bearish at this junction in the cycle.

Meanwhile, Wilsons' (freshly discovered) most preferred 'value' exposure is now Cleanaway Waste Management ((CWY)); the stock has been added to the Focus List. Weightings for CSL and Telstra have both been increased.

Wilsons new motto: "we think balancing the risk and return in portfolios is imperative to protect capital."

Other ASX300 members that, on Wilsons' analysis, look great value in June include Lendlease, Qantas Airways, Macquarie Group, Dexus ((DXS)), Goodman Group, GPT Group ((GPT)), National Storage REIT ((NSR)), IGO ((IGO)), Lynas Rare Earths, ALS Ltd ((ALQ)), and Domino's Pizza.

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From the latest strategy update by T Rowe Price:

"While equity valuations are more reasonable after recent declines, we remain cautious on the earnings growth outlook and inflationary impacts on margins supporting our modest underweight. Within fixed income, we remain underweight bonds and overweight cash."

"…growth could be due for a spurt higher as many of the tailwinds for value—higher energy prices and rates—may be peaking."

FNArena Talks

I will be participating in a Global Markets Webinar on Wednesday June 29th, 7pm, organised by Peak Asset Management, around the central theme of: Is This The Bottom?

Other participants are David McNamee, Director Altor Capital, Steve Torso, MD Wholesale Investor, Ron Shamgar, head of Australian equities at Tamim Asset Management, as well as Niv Dagan, executive director Peak Asset Management.

Should be interesting. To register: https://us02web.zoom.us/webinar/register/1016553643062/WN_vnto5a75SZeX8XHc_2IaxA

(This story was written on Monday 27th June, 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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