Rudi’s View: Which Stocks To Buy?

This story features LARK DISTILLING CO. LIMITED, and other companies. For more info SHARE ANALYSIS: LRK

In this week's Weekly Insights:

-Forecasts Under Pressure
-Which Stocks To Buy?

By Rudi Filapek-Vandyck, Editor

Forecasts Under Pressure

And when all is said and done, the dust has settled, and the verdict is in, we shall all observe it has been a fairly standard central bank tightening process, but one with a greater time lag between tightening and real impact on economic activity.

Financial markets can be prescient and smart, sometimes, but one thing they do not possess is patience. Plus, of course, not everybody is in the market to be reasonable, sensible, and knowledgeable with a longer-term focus.

Ultimately, the share market will do the right thing, but not before it has first tried out all other options available. It's my favourite summary of what a public forum for listed stocks is all about, time and again.

Three attempts to rally this year have ultimately resulted in very little progress made for the ASX, at the index level at least. Meanwhile, companies are issuing profit warnings and cautious/disappointing outlooks, while the trend in analysts' forecasts is negative.

It does beg the question: how many more options are there before local traders and investors take it on the chin and start incorporating this more subdued and challenging outlook in local share prices?

I don't know the answer. Another collective fall-of-the-cliff experience is by no means the only logical outcome, but the elevated risks are there for everyone to see, although thus far share price punishments in response to disappointing market updates remain largely reserved for smaller cap companies.

On Monday it's the turn for one of Tasmania's proud distillers and distributors of whiskey and gin, Lark Distilling ((LRK)), to emphasise increasing challenges and see shareholders' value sink by -16%-plus on the day.

Metcash's ((MTS)) FY23 performance released on the same day proved a slight beat on market forecasts, but management's cautious comments about changing consumer behaviour in the face of multiple pressures is unlikely to trigger significant upgrades for the year ahead.

Metcash is seen as a fairly steady and defensive business, even as hardware sales have an obvious connection with the housing cycle, but market consensus already has penciled in a slight retreat in profits and dividends in FY24. This is probably also why the share price weakened in the lead up to Monday's result, allowing for a positive response on the day.

Market updates by Lark Distilling and Metcash are both indicative of what is trending beneath the surface of the local share market; earnings forecasts are falling, and quite noticeably so. The average EPS forecast for FY24 recently turned negative.

The real reason for caution is this process of general realignment has arguably only just started. Analysts at Morgan Stanley did some data-digging recently and found about half of all ASX300 constituents have not received an update on forecasts for more than 50 days; some 45 companies have not seen an update for up to 90 days.

In line with our own observations here at FNArena, the latter group of companies most likely consists of small and micro cap companies that only receive irregular coverage from stockbrokers, but this only heightens the risks for severe mismatch either before or during the August reporting season for this cohort.

The first rally from last year's bond market quagmire occurred in October. Back then, explains Morgan Stanley, average EPS forecast in Australia was for 9% growth in FY23. By now this has been wound back to 3.6%, with this average falling week after week. One wonders how much will be left by late August?

Equally important, on Morgan Stanley's assessment, the consensus EPS forecast for FY24 is now a negative -2.9%. For good measure, analysts at Macquarie are still working off slightly more positive numbers with EPS forecasts of 4.2% and 1.5% respectively for FY23 and FY24. Those differences can mainly be attributed to Macquarie remaining more positive on the local resources sector.

But the underlying trend remains the same: the few companies enjoying positive revisions to forecasts, such as Adbri ((ABC)), AGL Energy ((AGL)), IGO ((IGO)), Origin Energy ((ORG)) and Webjet ((WEB)), are sharply outnumbered by the many whose forecasts are receiving downgrades, either on more challenging macro dynamics or following a disappointing market update.

Whatever one's view on the ASX's prospects for the months ahead, corporate health and profits should remain top of the list of risks to watch.

FNArena publishes its own weekly update on trends regarding broker ratings, targets and forecasts each Monday morning. This week's update:

https://www.fnarena.com/index.php/2023/06/26/weekly-ratings-targets-forecast-changes-23-06-23/

Which Stocks To Buy?

There is an argument to be made that while markets like to rally on a positive interpretation of macro developments, such as a pause in central bank tightening, the main anchor for equities in 2023 have been corporate profits – more so in Australia than in the USA, where additional liquidity from the Federal Reserve has been a positive factor too.

But, as also proven by the likes of Metcash and AGL Energy, not every ASX-listed company is trading cum earnings downgrade, and there's always room for a positive surprise.

Equally important: not every temporary set-back spells disaster; in many cases a weaker share price is actually a blessing for those investors looking to get on board at a lower price level. The recent market pullback has been quite indiscriminate with share prices generally trading at lower levels.

Time to put some of that cash on the sideline to work? If so, what stocks should we be looking to allocate to?

If your profile looks anything line mine; cautious, focused on Quality and sustainable growers, with a longer term horizon in mind, then my curated All-Weathers and related lists could be a great starting point. Hence, this might be as good as any other time to share some insights on some of the companies that carry my personal interest.

One of the better performers on my lists has been data centres operator NextDC ((NXT)) whose inclusion along other Emerging New Business Models is closely related to the modern day megatrend in data usage and generation, which in my view always meant supply would find it hard to keep up with explosive growth in demand. A prophecy that has been proven correct over the past eight years or so.

However, in the share market nothing ever moves in a straight line, and with bond yields, currencies, inflation, government policies, competition, charts and market sentiment all playing a role, there's always room for doubt, criticism, worries and shorters congregating around the theme of the day.

Eight months after last October's post-pandemic low of circa $8.50, NextDC shares have left most shorters licking their wounds on less stress from rising bond yields and ongoing confirmation both the business and its supporting megatrend remain in good health. Management is now expanding internationally, which raises the overall risk profile, but the advent of artificial intelligence, shortcut AI, is about to add an extra kicker for growth.

NextDC is included in the local Technology Index, but let's be clear: this is an infrastructure play, a la Transurban, whose outlook shall remain closely tied in with financing and building more data centres and signing contracts with telcos and big, international users to fill up capacity.

As can easily be established from the numbers released by NextDC over the years past; the business is fast-growing; into the double digits annually. If industry indications and projections are anything to go by, rapid growth can potentially continue for many more years to come.

One of such indications came from recent presentations by the much larger, Nasdaq-listed Equinix. With a market cap of circa US$70bn, 248 data centres in 27 countries, including in Australia, and 12,000 employees globally, Equinix is many times larger than the local market leader (market cap $6.3bn), but still growing each year at a targeted pace of 7-9%.

Management at Equinix recently explained to Wall Street analysts AI will likely become a major growth driver in the quarter century ahead. For the coming five years or so, Equinix believes the combination of AI and higher inflation (which is passed on as per contracts with clients) suggests the business can probably grow at 8-10% per annum instead.

Adding 1% growth might not seem like a big deal, but when accumulated, in aggregate over many years, it generates a boost to the valuation and thus the future share price. NextDC is much smaller, and predominantly Australia-based, but this likely also means a relatively larger impact on growth overall.

FNArena's All-Weather Model Portfolio was fortunate enough to double its exposure late last year and has been handsomely rewarded since with the share price today no less than 44% higher. But this is a long-term growth story, as also suggested by the much larger Nasdaq competitor, plus only one broker covering NextDC in Australia has a valuation below today's share price.

One smaller-sized AI beneficiary on the ASX should be Macquarie Technology Group ((MAQ)), formerly known as Macquarie Telecom. As data centres are only one of the company's features, any future benefits should be smaller too. The same principle applies for large cap Telstra ((TLS)), which also operates data centres, among much, much more.

Telstra is still considering asset sales, originally the key motivation to add the shares to the All-Weather Model Portfolio back in early 2021, but industry dynamics overall have turned for the better, and analysts are now projecting those attractive Telstra dividends will continue growing in the years ahead. With all the troubles on the horizon locally, ranging from mortgage cliff to spikes in bad loans coming, Telstra's profile comes with a golden frame in 2023.

The only companies I can think of with an even better dividend profile on the ASX right now are the insurers whose operational momentum is currently so strong that even the forced reimbursement of overpaying customers does not dent their share prices. Insurers have put the banks firmly in their shadow as preferred dividend payers this year.

Investors should note: history shows insurance moves through cycles and the impact from changing weather and climate is never too far off.

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As also shown in the above example of NextDC, financial market participants taking short positions (i.e. they position for a much weaker share price) are not by default the smartest mind in the room. On my observation, they end up many times over on the wrong side of history, ultimately, scrambling to unwind positions and limit losses.

In recent years, a number of companies of my personal interest have been targeted by shorters. Without one single exception, in all cases share prices have ultimately recovered, and then some, including for Amcor, Seek, TechnologyOne, and WiseTech Global, though this does by no means imply the shorters can never be correct.

Also, in some cases, think TechnologyOne and WiseTech Global, an attack by shorters can cause the share price to remain weak for a prolonged period, further accompanied by negative news flow (shorters also know how to play the media).

The reason why I mention this is because another megatrend company, IDP Education ((IEL)), recently suffered from a decision by the Canadian government to dilute the company's monopoly with more competition, and the share market has taken quite a negative view on the company's outlook in response.

The latter includes a growing interest from shorters. According to the latest update from ASIC, total short positions in the shares have now increased to 10.93%, making IDP Education the most shorted stock on the ASX. Note the number two, Flight Centre ((FLT)), has been on top of the list for many months and it did not stop its share price from rising from below $15 to near $22, but it's all weakness now in line with the market generally.

As a small investor, extra conviction is needed to stand up against shorters, which is a battle many prefer to avoid. The All-Weather Model Portfolio copied the play book for NextDC and increased its exposure to IDP Education in the days following the Canadian announcement.

It might be a while before we find out the wisdom or otherwise behind that decision.

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Given my research focuses on corporate Quality supported by a so-called long runway of structural growth, it should be no surprise healthcare companies are omnipresent across my lists, as well as in the All-Weather Portfolio.

The healthcare sector has been the best performing on the ASX over the past two decades, with daylight second. Post the 2020 pandemic, however, the sector is carrying more headwinds and question marks than at any other time throughout that period.

Share prices are trending sideways and even an industry stalwarts as is CSL ((CSL)) has been forced into a profit warning this time around. Longer term, AI presents both threats and opportunities while shorter term a lot can be traced back to the 2020 pandemic and societal lockdowns that either hit operations hard or turned companies into temporary giant beneficiaries.

In both cases, the ex machina impact needs to be cycled through. Pandemic winners need to find their old mojo back without the excessive gains and those negatively impacted clearly need more time to genuinely get back to normal business. In both cases, investors today need to look through temporary headwinds and adopt a longer term view.

I'd say this applies to Ansell ((ANN)), Cochlear ((COH)), CSL, Fisher & Paykel Healthcare ((FPH)), ResMed ((RMD)), and Sonic Healthcare ((SHL)). For Fisher & Paykel Healthcare and ResMed there's a new development that is likely to weigh on share prices in the form of appetite-depressing diabetes medicines such as Ozempic and Wegovy, increasingly popular in human society's battle with obesity.

What's easier than a pill a day to wipe the kilos away?

Obesity is one megatrend that has supported multiple sections of modern day healthcare services providers, including treatments for sleep apnoea. The latest "fashion" might offer easy comfort, but it's not without multiple side-effects, including nausea, diarrhoea, constipation, sagging bottoms and faces, hair loss and even thinning fingers.

It will be interesting to find out what companies' response will be to questions asked in August, no doubt.

One healthcare company that has suffered recently through an event outside its control is New Zealand-born Ebos Group ((EBO)). In short: competitor-in-trouble Sigma Healthcare ((SIG)) secured itself a new lease of life through -effectively- selling its corporate soul to the Devil, in this particular case: Chemist Warehouse, and in doing so, snatched a big contract away from the much better run Ebos Group.

The latter now has the challenge at hand to replace this loss, from FY25 onwards, which is likely to weigh on the share price, for now. Based upon the company's track record since listing on the ASX in late 2013, it probably pays to give management the benefit of the doubt, and time.

Note: at the time of the Sigma surprise, Ebos Group shares were trading at an all-time high, which might serve as an indication of how this company was performing, and the market's appreciation of it, including but not solely related to the Chemist Warehouse contract.

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All in all, what my research into All-Weather Performers tries to achieve is to identify those companies that enjoy enough of structural trend support to continue generating shareholder wealth for many years into the future. The Quality tag usually comes with market leadership and size, as well as a positive track record, on top of a habit of R&D and investments.

All Weather Performers are the antithesis of investing in cheap, undervalued assets, while their track record proves a higher PE ratio is not a deterrent for creating attractive, sustainable wealth for shareholders. But it's a big ask to be extraordinary, and to remain extraordinary, which is why my list of All-Weather Performers is quite condensed.

Since we are living through a once-in-a-lifetime era of new technological developments, my selections of stocks also include Emerging New Business Models and Prime Growth Stories. In all cases, I try to identify those companies that have higher Quality and sustainability in their growth trajectory than the average ASX-listing.

Now that bond yields are becoming less of an influence overall, I have felt more confident to re-include old familiar favourites for dividends in addition to Telstra, but there is no room for any retailers given the context and challenges in Australia.

Apart from the section dedicated to Dividend Champions, changes made have remained few and far between, surely a sign of support for those companies selected?

Maybe worth highlighting: I did remove Ramsay Health Care ((RHC)) not so long ago from my lists, and have now decided to also remove Domino's Pizza ((DMP)). In both cases, shareholders have enjoyed rewarding experiences over extended periods of time, but those halcion years truly ended a while ago already.

There are now way too many question marks about future potential and trajectory. This is an important lesson too: sometimes exceptional companies stop being exceptional. Or maybe they all do, allowing for plenty of time?

Paying subscribers have 24/7 access to a dedicated section on the website: https://www.fnarena.com/index.php/analysis-data/all-weather-stocks/

The FNArena/Vested Equities All-Weather Model Portfolio does not own all the stocks included in my selections, but picks and chooses predominantly from these lists, and only sporadically makes changes.

FNArena Subscription

A subscription to FNArena (6 or 12 months) comes with an archive of Special Reports (20 since 2006); examples below.

(This story was written on Monday, 26th, 2023. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer 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: contact us via the direct messaging system on the website).

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