Rudi’s Views: Pre-August Observations

This story features CSL LIMITED, and other companies. For more info SHARE ANALYSIS: CSL

In this week's Weekly Insights:

-Pre-August Observations
-Reporting Season: Early Signals
-ASX/S&P Index Rebalance Predictions
-Conviction Calls
-All-Weather Model Portfolio
-FNArena Talks

By Rudi Filapek-Vandyck, Editor FNArena

Pre-August Observations

To borrow a famous quote from Winston Churchill and make it my own:

You can depend upon the share market to do the right thing. But only after it has exhausted every other possibility.

And so it is with great delight that I have been witnessing the return of buyers to share prices in some of the highest quality and resilient business models listed on the ASX. Think CSL ((CSL)), Cochlear ((COH)) and ResMed ((RMD)), but also Amcor ((AMC)), TechnologyOne ((TNE)) and Woolworths ((WOW)).

Both analysts and investors might at times find it difficult to warm towards these High Quality stalwarts, usually because the valuation never looks as attractive as for lower quality, smaller cap and cyclical companies, but it is my observation when times really get tough and uncertainty dominates the broader picture, these are the Go-To companies that will stabilise and rise first amidst turbulent and volatile times.

Always difficult to pinpoint exactly when that moment arrives, but in 2022 it seems to have arrived in early June, just before share prices for the likes of BHP Group ((BHP)), Woodside Energy ((WDS)) and Fortescue Metals ((FMG)) started to break down. Take a look at share price graphs for the likes of CSL, Cochlear, Woolworths and TechnologyOne and admire how strong the rebound is that has occurred over the past six weeks.

I think we can now conclude the market is comfortable with valuations for these High Quality companies following this year's general de-rating as bond yields had to reset from exceptionally depressed yields. At the same time, with the risk of an economic recession looming, or at the very least a significant slowdown, the apparent rebound is equally the market's call on (much lower) earnings risk.

In simple terms: amidst a multitude of risks surrounding the upcoming August reporting season, as well as the eight months ahead of next year's February season, where do we all think the greatest risks lay for downgraded earnings and reduced dividends?

I think the market is showing us where the risks are the lowest.

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Traditionally, a recovery in share prices of CSL & Co marks Phase One in the equities market recovery, so which sectors might be up next?

With a rare exception of, maybe, coal prices, I continue to see large question marks obfuscating the outlook for iron ore, base metals, oil & gas, precious metals, EV battery materials, steel and most other cyclicals. Serious questions remain about what exactly is happening inside the Chinese construction industry; what will happen in Europe during the upcoming winter; or the duration of the strength and direction of the US dollar.

These unanswered enigmas all represent additional risks on top of the one key question in mid-2022: how recession-proof exactly are those businesses?

Note: even if there won't be a recession anytime soon, it is most likely that question will still be asked by nervous investors.

My focus thus naturally shifts towards technology and smaller cap growth companies, as well as to the local REITs. All three market segments have been trading under serious duress this year, as first excessive exuberance needed to be priced-out and then the natural de-rating kicked in from higher bond yields.

There is one caveat that needs to be highlighted: that optimism that has been creeping into share markets these past weeks is based upon a general belief that inflation will peak soon, as well as that bond yields will mostly trade sideways from here onwards, i.e. the peak in 10-year bond yields is well and truly past us; at least for the time being.

These are all-important requirements for those three sectors to experience a sustainable recovery from beaten-down share prices. Plus, of course, the next question that will be asked is: how recession-proof exactly are those businesses?

If ever anyone has the feeling that investing during a raging bull market is so much easier, well, that feeling is probably 100% correct.

One problem with local technology and smaller cap growth companies is most have a rather limited track record and, with exception of the exceptionally brief recession of 2020, there's no reference or framework for how these business models operate when confronted with economic stress tests.

Which is probably why, being a cautious investor, approaching the upcoming reporting season with a great deal of caution seems but the logical thing to do. And that's assuming August does not come too early in today's cycle, leaving key questions for the next eight months.

Either way, I am of the belief that, here too, the market is providing investors with valuable clues as to the various risk profiles of companies that are either technology or promising high growth small cap opportunities.

I am generalising now, but there should be very little surprise as to why shares in TechnologyOne have not nearly fallen as much as, say, Kogan ((KGN)), Nuix ((NXL)), Redbubble ((RBL)) or Zip Co ((ZIP)), and they have been quicker in staging a noticeable recovery.

Mr Market can be a highly unreliable weather vane, and the next tantrum might be but another economic update away, but my experience is that when it comes to separating the wheat from the chaff, i.e. identifying which companies are High Quality and which ones are certainly not, Mr Market's communication is often loud and clear, and correct.

Note, for example, how both Objective Corp ((OCL)) and WiseTech Global ((WTC)) issued a positive market update in July. Yes, of course, one can potentially make a higher return out of a share price that has fallen a lot further, but what is the real trade-off when adjusted for the risks involved, as well as when taking a longer-term view?

Lower quality fly-by-nighters tend not to perform well over a longer period of time. This is the confusing message the share market throws at bargain hunters: it does not account for the risks involved.

Having said all of that, certainly following the firm bounce in share prices since early June, there should now equally be a degree of caution when buying into the local High Quality names. If they're in the portfolio already, congratulate yourself. Your decision from the past has once again been vindicated.

But as also indicated by current valuations and price targets for those stocks, buying now runs the risk of low returns in the immediate, and there always remains the risk for disappointment in August, for higher bond yields, or for inflation to stick around for longer.

This is the share market, remember? Other opportunities will present themselves.

Some of the most obvious opportunities, it would seem, are among local REITs. Just about every sector analyst has conducted a general review of the sector over the past two months, and not one has drawn a different conclusion to most ASX-listed REITs seeming undervalued.

The one requirement for this sector to genuinely and sustainably close the gap between share prices and intrinsic valuations is for investors to become comfortable with the outlook for bond yields (thus: inflation and central bank policies), about which we can all make various forecasts, but this can take a while, still.

Since most REITs are, operationally, in good health, which also applies to balance sheets, investors can opt for the waiting game, while confidently cashing in relatively high distributions to shareholders.

Exactly how to play this sector is very much dependent on personal views and preferences. Sector heavyweight Goodman Group ((GMG)) is usually singled out as a lower-risk exposure, but it also pays out a rather low yield in distributions. See the earlier remarks about quality and risks, which also applies to REITs.

Potentially higher returns, including a higher yield in distributions, can be derived from owning Charter Hall ((CHC)) or Qualitas ((QAL)), while the likes of HomeCo Healthcare & Wellness REIT ((HCW)), HomeCo Daily Needs REIT ((HDN)) and Charter Hall Retail REIT ((CQR)) look well-undervalued.

Some in this sector, like Waypoint REIT ((WPR)), are now closing the gap with analysts' targets rather rapidly.

Investors should, however, not ignore that parts of the sector might still have vulnerable balance sheets combined with the potential for disappointing operational performances. Macquarie in a recent report highlighted Scentre Group ((SCG)), Charter Hall Long WALE REIT ((CLW)) and Dexus Industria REIT ((DXI)) within this context.

JP Morgan, on the other hand, has nominated GPT Group ((GPT)) as its least preferred A-REIT because of low interest rate hedging, significant vacancies inside the Office portfolio and a higher geared balance sheet, ahead of a likely devaluation in asset values.

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The FNArena-Vested Equities All-Weather Model Portfolio owns shares in Goodman Group, as well as in HomeCo Healthcare & Wellness REIT, alongside Super Retail Group ((SUL)) and Telstra ((TLS)) for their reliable and dependable dividends.

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The various selections available to paying subscribers via the All-Weather Stocks section on the website have seen a few changes in light of this year's changing share market context.

No longer represented under the label of Emerging New Business Models are Fineos Corp ((FCL)), Megaport ((MP1)) and Symbio Holdings ((SYM)). This is not to say these beaten-down share prices cannot become a profitable investment in the months or years ahead, but I believe their respective risk profiles no longer justify inclusion.

On the other hand, earlier this year I did add Steadfast Group ((SDF)) as a Potential All-Weather Performer, and I have since also added Endeavour Group ((EDV)) and Objective Corp ((OCL)) to the same selection.

WiseTech Global ((WTC)) has made a come-back under Emerging New Business Models. It was once removed due to bad governance practices which I hope are now well and truly in the past.

The selection I umm and ah the most about are local Dividend Champions, which is now officially under review.

Paying subscribers have 24/7 access to all lists, personally curated by myself, on the dedicated All-Weather Stocks section on the FNArena website with the explicit warning that none of it is investment advice.

Reporting Season: Early Signals

The local reporting season hasn't genuinely started just yet, but early signals mimic initial reports from the Q3 reporting season over in the USA: investors should prepare for heavy swings either way.

One of the disappointing market updates in Australia stems from Jumbo Interactive ((JIN)) as the online reseller of lotteries was believed to be poised for a strong performance in August. Instead the share price got dumped on Friday. Higher costs and lower margin sales seem to have been responsible for the miss in guidance.

But there's a twist in the Jumbo story. With just about every analyst maintaining the longer-term, structural growth story remains intact, investors holding large swathes of cash would be hoping there will be more Jumbo experiences over the weeks ahead with companies that have their longer-term interest.

In the same vein, analysts thought Rio Tinto's ((RIO)) quarterly production report was weak and that share price would probably have fallen more on the day if it hadn't already weakened that much over the month past. Rio Tinto's weak quarter follows a number of soft updates and operational disappointments from smaller cap producers over recent weeks.

Credit Suisse, in its update on Sandfire Resources ((SFR)), highlighted a different kind of risk that resides within the smaller cap resources sector with the FNArena Broker Call Report stating on Friday:

"The broker raised concerns around Sandfire Resources's cash generation, and ability to service debt in the next 6-12 months, and believes the company is likely to suffer funding challenges if commodity prices continue to decline."

To stay with the swings and roundabouts narrative, a number of companies surprised in a positive sense throughout the week past, including Data#3 ((DTL)), Eager's Automotive ((APE)), Viva Energy ((VEA)), and WiseTech Global. Given where share prices are, generally speaking, those share prices are likely to be rewarded.

And herein lays the key challenge for investors over the coming six weeks: there will likely be an oversized number of disappointments, but not every "miss" is a bad thing. Similar to earlier in the year ahead of the February reporting season, everyone who owns shares must accept that "misses" will occur, and they are simply not always predictable.

Add the CEO suddenly jumping ship at EML Payments ((EML)) and ANZ Bank ((ANZ)) buying the banking operations from Suncorp Group ((SUN)) and there might be enough surprise and excitement on offer this season to keep even the most stoic among us on their toes.

A healthy dose of cash reduces risk and offers opportunity, as does patience. Meanwhile, the public debate -globally- rages on about recession yes/no and central bankers continuing to tighten aggressively yes/no.

Nobody ever promised this was going to be a walk in the park.

ASX/S&P Index Rebalance Predictions

The next rebalancing of local share market indices is not due until September but this doesn't stop analysts at Wilsons already reflecting on and publishing predictions of which stocks might get booted out or included.

With some indices, like the ASX300. currently running below capacity there's anticipation September will see a noticeable catch-up with more inclusions than exclusions.

Wilsons is expecting 13 new members for the ASX300 in September, and given six vacancies this forecast only requires seven removals.

Most likely fresh inclusions, on Wilsons' assessment, are Boss Energy ((BOE)), Mincor Resources ((MCR)), Ebos Group ((EBO)), Neometals ((NMT)), Ventia Services Group ((VNT)), Grange Resources ((GRR)), Australian Clinical Labs ((ACL)), OFX Group ((OFX)), Maas Group ((MGH)), Macquarie Telecom ((MAQ)), Seven West Media ((SWM)), Arafura Resources ((ARU)), and Argosy Minerals ((AGY)).

Those believed will be booted out in September are: AVZ Minerals ((AVZ)), PPK Group ((PPK)), Nuix, AMA Group ((AMA)), BWX ((BWX)), Redbubble, and Dubber Corp ((DUB)).

The ASX200 will already see one change on Thursday this week when soon-to-be-acquired Uniti Group ((UWL)) is to be replaced with West African Resources ((WAF)).

Wilsons sees five more probable changes in September with all of Charter Hall Social Infrastructure REIT ((CQE)), Johns Lyng Group ((JLG)), Capricorn Metals ((CMM)), Genworth Mortgage Insurance Australia ((GMA)) and Sayona Mining ((SYA)) poised to replace AVZ Minerals, Zip Co, City Chic Collective ((CCX)), EML Payments and Life360 ((360)).

As far as the ASX100 goes, Wilsons is predicting one probable change with nib Holdings ((NHF)) as a replacement for Virgin Money UK ((VUK)).

It is also possible that Shopping Centres Australasia ((SCP)) replaces Tabcorp ((TAH)), while still an option, but at this stage labeled as "unlikely" are the inclusions of TechnologyOne and Charter Hall Long WALE REIT for which Star Group Entertainment ((SGR)) and ARB Corp ((ARB)) would have to lose their spot.

As per usual, there are likely no changes to be announced for the ASX50 or ASX20 with Wilsons ascribing an unlikely chance for replacement of respectively Lendlease ((LLC)) with Lynas Rare Earths ((LYC)) and of James Hardie ((JHX)) with South32 ((S32)).

Historically, any changes to the ASX200 have the largest impact as institutions often cannot own stocks that are outside of that index. Also, when a stock moves inside the top100 it officially becomes a large cap, meaning institutional small cap investors are forced to sell it in-line with their mandate.

Standard & Poor's is scheduled to announce the September changes on Friday the 2nd, to be implemented two weeks later, on Friday the 16th, after the close of the market.

Conviction Calls

Morningstar recently updated its Global Equity Best Ideas which saw the fresh inclusion of Berkshire Hathaway, but for the brevity of today's report, let's stick with the ASX-listed ideas.

Morningstar's methodology is heavily weighted to valuation, and on the assumption there is a price for everything, its collection of best opportunities can sometimes lead to some odd bedfellows (so to speak).

Hence, specifically for Australia and New Zealand, the following Best Ideas have been put forward:

Newcrest Mining ((NCM)), TPG Telecom ((TPG)), Kogan, InvoCare ((IVC)), G8 Education ((GEM)), a2 Milk ((A2M)), Woodside Energy, Magellan Financial Group ((MFG)), Westpac ((WBC)), Aurizon Holdings ((AZJ)), Brambles ((BXB)), Lendlease, WiseTech Global, AGL Energy ((AGL)), and Fineos Corp.

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Morgan Stanley's Australia Macro+ Focus List consists of the following 11 holdings: Amcor, Computershare ((CPU)), CSL, Goodman Group, Macquarie Group ((MQG)), Orica ((ORI)), Qantas Airways ((QAN)), QBE Insurance ((QBE)), Woodside Energy, and Telstra.

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Ord Minnett has highlighted the virtues of owning Telstra to its clientele, with Australia's number one telco sharply reducing debt on the back of asset sales and offering a rather steady-as-she-goes, non-discretionary growth profile at a time when many other businesses will be challenged.

Telstra shares have provided a total positive return of 6.9% over FY22 while the market overall ended with a negative return, points out the broker. Given Telstra's balance sheet is limited in franking credits, and more asset sales remain on the agenda, Ord Minnett is anticipating share buybacks will complement the juicy dividend over the coming years.

The combination of growing cashflows and buybacks might push up the annual dividend to 22c by FY25, reckons the broker. Ord Minnett estimates capital management at the telco could reach an additional $3bn over the next three years (FY25).

Telstra was included in the All-Weather Model Portfolio in early 2021 for exact those reasons, as the Portfolio always owns a number of reliable dividend payers.

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With smaller cap healthcare services providers facing their most difficult trading environment in years, according to Wilsons' research, the broker has identified two favourites in Silk Laser Clinics ((SLA)) and Capitol Health ((CAJ)).

In contrast, Wilsons predicts Pacific Smiles ((PSQ)) and Integral Diagnostics ((IDX)) may struggle to re-rate back to the good old times.

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The language is finding its way into stockbroker updates these days as witnessed by the following quote from a recent report by stockbroker Morgans:

"We call out key all-weather companies we think are most capable of resisting cost inflation".

Those 'All-Weather' companies, on Morgans' assessment, are Woolworths, Coles Group ((COL)), CSL, Amcor, REA Group ((REA)), AGL Energy, ALS Ltd ((ALQ)), Corporate Travel Management ((CTD)), Treasury Wine Estates ((TWE)), and PWR Holdings ((PWH)).

The broker's Best Ideas for commodities stocks are BHP Group, Santos ((STO)), South32, Whitehaven Coal ((WHC)), and New Hope Corp ((NHC)).

Companies identified for potential disappointment in August: APA Group ((APA)), Ansell ((ANN)), Star Entertainment, Bapcor ((BAP)), Ramsay Health Care ((RHC)), and Blackmores ((BKL)).

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Emerging companies analysts at JP Morgan have nominated GUD Holdings ((GUD)) as their Top Pick and Flight Centre ((FLT)) as Least Preferred.

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Analysts at stockbroker Morgans have nominated their favourites among ASX-listed retailers: Lovisa Holdings ((LOV)), Breville Group ((BRG)), and Universal Store Holdings ((UNI)).

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Investors looking for a positive thesis from here onwards, you don't have to look any further than JP Morgan strategist Marko Kolanovic:

"While growth risks are elevated, our base case looks for an acceleration in global growth in the second half of the year, led by China, and a moderation in inflationary forces that should allow central banks to pivot."

All-Weather Model Portfolio

Mid-year review & update for the All-Weather Model Portfolio – better than most, but still suffering a small loss over the twelve months past. Cash really was King over the months past.

https://www.fnarena.com/downloadfile.php?p=w&n=8D20B84A-B77F-4E15-E9990983A9D4BFE6

FNArena Talks

My presentation at the Australian Gold Conference (30 minutes):

https://www.youtube.com/watch?v=J7IzgE5eQ0k&t=4s

Podcast – Spark your F.I.R.E. (57 minutes) on this year's Bear Market and how to survive it:

https://podcasts.apple.com/au/podcast/chat-w-rudi-filapek-vandyck-fnarena/id1450103785?i=1000517106346

Peak Asset Management debate whether the bottom is in for this Bear Market (I am one of five participants, 63 minutes):

https://www.youtube.com/watch?v=aL4auOWWtUM

(This story was written on Monday 18th July, 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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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

Subscriptions cost $480 (incl GST) for twelve months or $265 for six and can be purchased here (a subscription to FNArena might be tax deductible):

https://www.fnarena.com/index.php/sign-up/

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