Rudi’s View: August Preview – Curve Balls, Profits & Opportunities

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

In this week's Weekly Insights:

-The Non-Recession Recession
-August Preview: Curve Balls, Profits & Forecasts
-Conviction Calls
-Focus on Quality
-FNArena Talks

By Rudi Filapek-Vandyck, Editor

The Non-Recession Recession

When is a recession not a recession?

I'll leave the debate to the global community of economists, but needless to say the first two quarters of 2022 did not deliver the recession the US economy had to have, irrespective of the statistical outcomes for the period.

As to why US share markets simply shrugged and moved on, CIBC's Avery Shenfeld provided the answer:

"Rumours to the contrary, economists don’t define two consecutive negative quarters as a recession.

"There can be job-free recoveries for a while, but the very definition of a recession essentially rules out having one without job losses, let alone a recession with a hiring boom."

When share market commentators, including myself, talk about recession coming, we're referring to company earnings falling by -20%, or maybe by -10%. Could be zero growth, on average, or a tiny positive number.

We just don't know yet which scenario is most likely. We might find out between now and February next year.

This year's August reporting season is too early in the cycle to provide investors with all the answers needed.

August Preview: Curve Balls, Profits & Forecasts

If I were to put in my good-humoured attempt at an old fashioned Dad-joke, I'd start off with:

I am old enough to remember when corporate reporting season in Australia was all about profits, margins, dividends and forward-looking guidance.

It's not as if reporting seasons in the past have never been closely intertwined with macro-geopolitical, -financial or -economic concerns, but ever since the early days of the pandemic in 2020, corporate results season in Australia has never been simply about corporate health and profits.

If it wasn't about the virus, or societal lockdowns, the key drivers underneath share price trends have been the return of inflation followed by the normalisation in global bond yields.

The power of all four has proven extremely dominant throughout the past five results seasons and ahead of August, investor consensus is for a global recession on the horizon (domestic Australia not included).

We don't know yet about the exact timing or what will be the severity of the upcoming economic slump, but corporate results will definitely be assessed against the background of (much) tougher conditions ahead.

That is, unless central bankers declare the war on inflation is due for a pause and they stop their rigorous tightening, which adds yet another macro factor into the mix.

An end to the war in the Ukraine could be another macro catalyst, albeit an unlikely one.

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At face value, the Australian share market looks like a bargain hunter's paradise. The market's average Price-Earnings (PE) ratio starts with 13x while the average dividend yield has risen to 5% on the back of sharply weaker share prices for large segments of the ASX.

The long-term average PE in Australia is 14.9x including a few years of very high valuations. Prior to those years of elevated multiples, the average PE stood at 14.5x; still a long while off from today's multiple.

The problem with today's average is that commodity producers are enjoying exceptionally favourable conditions, to which investors have responded with low valuation multiples (as they traditionally tend to do when confronted with peak-of-the-cycle earnings and cash flows).

BHP Group ((BHP)) shares, for example, with circa 11% the largest index weight in Australia, are trading on 7x next year's forecast earnings per share. Shares in Rio Tinto ((RIO)) are on 7.3x. For Fortescue Metals ((FMG)) the comparable multiple is only 6.3x. The numbers look pretty similar for the large caps in the local energy sector.

Following the commodities resurgence post late-2020, mining and energy now represent the second largest group in the local index, after banks/financials.

Any experienced and astute investor knows such low PE multiples are not by default a signal of severe undervaluation; they are merely a sign that investors worry about the two years ahead. But having low PEs for such a large index constituent does depress the overall average, artificially creating the impression of a "cheaply" priced share market.

In the largest group, the banks are mostly trading on below-average multiples too; once again showing the market is concerned about RBA rate hikes, their impact on local housing and the subsequent impact on spending and the local economy in general.

Excluding the two largest index sectors, the average PE in Australia quickly rises above 20x, which, by contrast, still doesn't look that cheap at all.

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The biggest problem investors are facing today is figuring out what is the correct valuation for companies that mostly have no track record in dealing with an economic recession. For multiple reasons, the brief recession of 2020 is hardly a reliable reference point.

Not making things any easier, the impact of sharply higher bond yields, tighter liquidity and high inflation on economies and companies individually has been gradual, if not slow-paced thus far this year, while supply chain bottlenecks seem to be easing and lockdowns outside China are now a thing of the past, but the pandemic is not.

Combine all of the above and August seems too early to reveal the full impact for every company on the ASX.

With fast-moving share markets having de-rated large segments of the exchange, including retailers, small cap technology, building and construction materials, steel producers, gold miners, property trusts (REITs), mortgage brokers, et cetera one would be inclined to think the bias is leaning towards upside surprises this season.

The current pre-season has already provided a number of examples with explosive share price rallies in response. Think Audinate Group ((AD8)), Megaport ((MP1)), Nanosonics ((NAN)), and WiseTech Global ((WTC)), among numerous others.

However, the current set-up is by no means an invitation to go all-out on high risk positioning, with plenty of others generating steep losses, including Allegiance Coal ((AHQ)), Bega Cheese ((BGA)), Nitro Software ((NTO)) and just about every small and mid-cap gold producer out there.

At face value, corporate Australia looks positioned for an above-average performance this month. Profits for shareholders are projected to have grown by 20%-plus, while dividends are expected to come in near an all-time record high but recent caution by the board of Rio Tinto signals this year's numbers are best not taken for granted.

Similar caution is already reflected in today's consensus forecasts which, mostly, reflect the view commodity producers have at best one more year of 'exceptional' in front of them. Forecasts do differ as to how favourable exactly the coming twelve months might still turn out for BHP, Woodside & Co but FY24 has negative growth penciled in.

The dilemma as how best to position for the upcoming economic recession yes/no, this year/next year, mild/more severe is not limited to miners and oil and gas producers, but easily extends to local retailers, both bricks and mortar and 100% online.

Judging from recent market updates by JB Hi-Fi ((JBH)) and Accent Group ((AX1)) the day-to-day dynamics for these companies vary widely even without much of a noticeable correction in house prices as is now widely assumed to happen over the 18 months ahead.

Investors should also note: while dividend payouts are anticipated to remain strong, total payouts in Australia are highly concentrated with the big four banks and big three miners representing 60% of the total forecast FY22 dividend payout.

Current market estimates are for significantly lower EPS growth in FY23 and FY24, with the number for each year in single digit, and with more downgrades yet to follow.

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While just about everyone expects to see net downgrades to growth forecasts over the weeks ahead, there's plenty of disagreement on the magnitude of what should be expected, and priced in, in terms of slower growth in FY23.

Analysts at Citi, for example, expect economic recession in all of the major economic regions of the UK, Europe and the USA (with China to miss its own target), but they also expect corporate profits to prove relatively resilient, which should reduce further downside potential for equity markets worldwide.

Their peers at Macquarie, however, continue to see (a lot) more downside, but they also anticipate a stronger-for-longer environment for the cyclical commodities.

Not all answers will be provided through company performances this month. But one observation stands: research analysts have been showing their short-term scepticism throughout June and July in responses to corporate market updates that can probably be best summarised as:

Okay for now, but what does it look like in 6-12 months' time?

I suspect the same question will be on institutional investors' mind throughout the August season.

Which is why I suspect many share prices will not necessarily follow through on early positive responses to better-than-expected performances. Whereas the past suggests better-than-forecast corporate results can support share price outperformance for up to four months, this time around the dynamic might be fundamentally different.

The difference comes down to that key question: how resilient are these profits and margins under rough weather?

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The oft mentioned credo is that, ultimately, share markets take their guidance from, and follow in the footsteps of corporate profits.

This is only half true, at best.

In practice, share markets move in the direction of where forecasts of corporate profits are pointing towards. The two are not by default the same. This is why, on occasion, macro considerations overwhelm bottom-up reality.

By mid-2022, market forecasts have now started to fall in Europe, the US and locally in Australia too.

For the US specifically, media and commentators steadfastly mention percentages of "beats" and "misses" but the real statistic to pay attention to is how corporate results impact on analysts' forecasts post the event.

On Macquarie's observations, Q2's share of "misses" from US result releases is currently 4x higher than in Q2 last year and double the percentage in Q1, with downgrades to forecasts outnumbering upgrades by 2 to 1.

Plus more than half (56%) of S&P500 companies missed analyst expectations on free cash flow; the number of misses rises to 59% for operating cash flow.

Free cash flow, points out Macquarie, is an important, big "miss" given valuations in the US are more closely tied in with cash flows than they are in Australia.

Macquarie's notes might prove important later in the year as some of the more downbeat forecasters (Mike Wilson at Morgan Stanley, David Rosenberg, et al) consider the Q2 reporting season in the US as simply the first in a succession of disappointing quarterly seasons.

Macquarie also notes 47% of S&P500 results to date have revealed higher-than-expected inventories.

In Europe, businesses are on average beating forecasts for sales, but triggering downgrades because of margin pressure.

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As things stand at the beginning of August, analysts' forecasts are lowest for your typical retailer, with negative profit growth only followed by (on average) marginal growth in the two years ahead. Food and Staples companies are projected to fare much better.

Healthcare is expected to be its historically resilient self, but internally a wide diversion has opened up between, say, CSL ((CSL)), ResMed ((RMD)) and Pro Medicus ((PME)) on the positive side and Integral Diagnostics ((IDX)), Healius ((HLS)) and Sonic Healthcare ((SHL)) in (anticipated) struggle street.

In between sits perennial promise Ramsay Health Care ((RHC)), also constantly under private equity interest.

A big year is projected for insurers in FY23, whereas diversified financials, which includes local asset managers, carry very low expectations. Real estate looks similar to healthcare: resilient as a sector, with large divergence internally.

Technology, believe it or not, is expected to continue to generate robust growth numbers in August and the years ahead, but probably needless to make the point: this sector is beset with all kinds of variaties, ranging from very high but slowing (WiseTech Global) to reliably consistent (TechnologyOne ((TNE)), to long-term potential with risk and question marks (Megaport) and not-sure-what-to-believe-anymore (Damstra Holdings ((DTC)).

Somewhere in between sits the currently very popular Audinate Group.

As far as the banks are concerned, nothing spectacular is expected with the debate raging about how much benefit exactly will flow through to the bottom line from a higher cash rate and how much impact should be accounted for when property dynamics change for the worse, even if only for a limited time?

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Companies expected to surprise positively, on Citi's assessment, include Bapcor ((BAP)), Baby Bunting ((BBN)), Coles Group ((COL)), Goodman Group ((GMG)), Harvey Norman ((HVN)), Orora ((ORA)), and Woolworths ((WOW)).

Quant analysts at Morgan Stanley have selected Medibank Private ((MPL)), Whitehaven Coal ((WHC)), The Lottery Company ((TLC)), QBE Insurance ((QBE)), Ampol ((ALD)), Downer EDI ((DOW)), Worley ((WOR)), Challenger ((CGF)), ASX ((ASX)), Atlas Arteria ((ALX)), Bendigo and Adelaide Bank ((BEN)), Orora, Qube Holdings ((QUB)), Altium ((ALU)), and Computershare ((CPU)).

Morgan Stanley's quant selection for likely disappointment might contain a few surprises: Charter Hall Group ((CHC)), Evolution Mining ((EVN)), AGL Energy ((AGL)), Allkem ((AKE)), OZ Minerals ((OZL)), BHP Group, Reece ((REH)), Cochlear ((COH)), GPT Group ((GPT)), REA Group ((REA)), Iluka Resources ((ILU)), Mirvac Group ((MGR)), Origin Energy ((ORG)), Lendlease ((LLC)), and CommBank ((CBA)).

Also noteworthy: struggling Magellan Financial Group ((MFG)) still ranks as a likely disappointment among ASX small caps this month on Morgan Stanley's quant analysis, alongside Healius, Integral Diagnostics, Platinum Asset Management ((PTM)), and Sims ((SGM)).

On the broker's fundamental research desk, Magellan remains the least preferred in the local sector which, all il all, is not considered attractive or full of potential. A recent sector update by Morgan Stanley was titled "No Way Home" and lamented the lack of obvious catalysts for a local sector that is struggling with funds outflows.

Morgan Stanley likes Perpetual ((PPT)) the most, as well as, on a broader asset definition, Macquarie Group ((MQG)).

Following on from growing risks with inventories in the US, Macquarie has identified City Chic Collective ((CCX)) and Breville Group ((BRG)) as potentially carrying the highest inventory risk on the ASX.

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JP Morgan sees stabilising bond yields providing support for local REITs which are expected to report extremely strong growth this month (18% on average).

While the sector will be facing asset devaluations instead of revaluations going forward, JP Morgan continues to see great value in the sector.

The broker's top favourites are Mirvac Group, Charter Hall, Scentre Group ((SCG)), and Dexus ((DXS)), as well as smaller-caps National Storage ((NSR)), Centuria Industrial REIT ((CIP)), Centuria Capital Group ((CNI)), HomeCo Daily Needs REIT ((HDN)), Waypoint REIT ((WPR)), Home Consortium ((HMC)), and Hotel Property Investments ((HPI)).

Scentre Group, Charter Hall and National Storage in particular have been singled out for strong earnings deliverance this month.

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Similar to the retailers, Macquarie's forecast is most media companies will still report robust performances in August, but it'll only be a matter of time, predict the sector analysts, before a slow down in advertising will make its mark across the sector.

Macquarie's sector favourites are Carsales ((CAR)) and HT&E ((HT1)) while both Seven West Media ((SWM)) and Nine Entertainment ((NEC)) might surprise through capital management.

Macquarie forecasts the bottom for media companies' share prices is 6-12 months into the future.

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Recent research updates have become noticeably less optimistic on international travel and higher-for-longer oil prices.

Self-declared oil bears at Citi, for example, are now working off average Brent oil price forecasts of US$98.5/bbl and US$75.3/bbl for 2022 and 2023 and by 2025 the low is projected at US$51/bbl.

For more reading on the upcoming August results season:

–https://www.fnarena.com/index.php/2022/07/28/rudis-view-im-so-bearish-im-bullish/

–https://www.fnarena.com/index.php/2022/07/21/rudis-views-pre-august-observations/

–https://www.fnarena.com/index.php/2022/07/14/rudis-view-corporate-profits-the-next-challenge/

–https://www.fnarena.com/index.php/2022/07/07/rudis-view-minus-20/

Conviction Calls

Morgan Stanley has highlighted Baby Bunting ((BBN)) as one small cap retailer that is poised for outperformance this August reporting season.

Further supporting their confidence, the analysts state Baby Bunting has one of the strongest competitive positions of any Australian small cap retailer in terms of relative scale, brand, loyalty on top of a genuine omni-channel offering.

When it comes to small cap Software-as-a-Service (SaaS) companies, Morgan Stanley's Top Pick on the ASX is Bigtincan Holdings ((BTH)).

For previous pre-August nominations: see last week's Weekly Insights:

https://www.fnarena.com/index.php/2022/07/28/rudis-view-im-so-bearish-im-bullish/

Morgan Stanley also issued a special 3 Conviction Buy Ideas report which specifically highlighted CSL, Telstra ((TLS)) and Breville Group.

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This week's update on stockbroker Morgans' Best Ideas saw the inclusion of Jumbo Interactive ((JIN)), likely inspired by recent share price weakness, and the removal of Endeavour Group ((EDV)), Baby Bunting (yep, see the contrast with above), Domino's Pizza ((DMP)), and Whitehaven Coal ((WHC)).

No shortage in Best Buy ideas with Morgans' selection currently counting 33 ASX-listed companies, including Wesfarmers ((WES)), Macquarie Group, GQG Partners ((GQG)), Dalrymple Bay Infrastructure ((DBI)), Lovisa Holdings ((LOV)), Mach7 Technologies ((M7T)), Treasury Wine Estates ((TWE)), Incitec Pivot ((IPL)), Webjet ((WEB)), BHP Group, South32 ((S32)), Dexus Industria REIT ((DXI)), and HomeCo Daily Needs REIT ((HDN)).

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With A-REITs increasingly on investors' radar in recent weeks, sector research by Barrenjoey has reportedly highlighted above average risks from higher bond yields which lift the costs for carrying and servicing debt.

Those identified as most vulnerable include GPT ((GPT)), Centuria Industrial REIT ((CIP)), Charter Hall Long WALE REIT ((CLW)), Dexus ((DXS)), and Shopping Centres Australasia Property ((SCP)).

In addition, and assuming property prices are now staring at a -15%-20% decline in valuations over the next 18 months or so, the research also highlighted higher risks for Mirvac Group, Stockland ((SGP)) and Lendlease.

Focus On Quality

The debate is still raging whether Growth can make a sustainable come-back or whether Value remains the best strategy-tilt even when history shows recessions are not really kind to cyclical companies.

Enter a third option: sturdy, reliable businesses that power on, regardless of economic cycles and conditions. It's the Quality way and market strategists at Wilsons dedicated their latest report on why a focus on Quality makes a lot of sense today.

This quote that says it all:

"We expect global economic growth and earnings growth to slow significantly over the coming year. As a result, companies with high quality, resilient earnings streams should be increasingly sought after by the market."

Apart from taking a peak at FNArena's dedicated All-Weather Performers section (for paying subscribers only), how does one identify true Quality companies?

Wilsons offers a few key characteristics:

-High return on equity (ROE) or high return on invested capital (ROIC)

-Low variability in annual earnings

-Strong balance sheets with modest gearing

Plus investors can throw in an extra factor in the form of, for example, quality of management and/or industry leadership.

Additional quality attributes can include strong generation of free cash flow and high operating margins.

Wilsons does observe Quality has underperformed over the past two years as first high multiple stocks got exuberantly priced, then de-rated and earlier this year the energy sector outperformed strongly.

But with earnings slowing and more downgrades than upgrades on the agenda, the view is that resilient, high-quality companies look poised to grab market leadership once again.

All-Weather Performers: https://www.fnarena.com/index.php/analysis-data/all-weather-stocks/

FNArena Talks

FNArena Talks now includes the very first interview that does not involve myself.

Danielle Ecuyer interviewed climate scientist Matthew England and I think everyone who cares about the world tomorrow, and how it impacts on the economy and the share market, should watch it.

It's only 20 minutes long, but Matthew's knowledge and eloquence means the interview is packed with insights.

https://www.fnarena.com/index.php/fnarena-talks/2022/08/01/climate-scientist-matthew-england/

(This story was written on Monday 1st August, 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

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– 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)
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