Rudi’s View: FY23 Returns – Details Matter

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

In this week's Weekly Insights:

-Earnings Forecasts: Slip Slidin' Away
-FY23 Returns: Details Matter
-Small Caps In Focus

By Rudi Filapek-Vandyck, Editor

Earnings Forecasts: Slip Slidin' Away

The Australian share market has been doing it tough in July, following a rally in June that nobody was genuinely able to properly explain, except, of course, those market commentators that are always brimming with optimism, no matter what the circumstances.

Meanwhile, beneath the surface, the trend in earnings forecasts is accelerating, in the wrong direction.

On UBS' assessment, consensus forecasts are now falling rapidly and markedly, the past few weeks removing -0.6% and -1.4% off the average projected EPS forecast for FY23 and FY24 respectively.

Main victims are resources companies, both materials and energy sector, as well as healthcare (the CSL-effect), real estate and consumer discretionary.

The safest sectors, as things stand right now, are utilities, technology and the insurers.

No surprise, UBS strategists are advising investors to position portfolios in favour of the latter two sectors, accompanied with reliable, stable dividend payers, which includes utilities, insurers, and the infrastructure sector.

According to UBS, the consensus EPS forecast for FY23 has now landed at 3%. That number stood at 6.5% six months ago. In similar fashion, the general forecast for FY24 is now a negative -3.2%. Six months ago this number was a minimally positive 0.3%.

The biggest culprits for the below-average growth forecast for FY23 are Materials and Healthcare and, to much lesser degree, communication services and real estate. For next year, Energy is shaping up as the biggest loser, with Materials and Financials equally in negative territory.

The strongest prospects for growth in FY24 seem to be for Utilities and Healthcare. But as always, stock selection will be all-important.

The UBS research also reveals Australia is yet again seriously lagging the rest of the world when it comes to EPS growth forecasts with the FY24 forecast for developed markets sitting at 9.5%.

For Emerging Markets the corresponding number is 18.2%. Even the US forecast still sits at 11.3%, though that remains the subject of heavy debate the world around as many remain convinced there's too much optimism baked into that number.

Companies that have enjoyed upgrades to forecasts locally include AGL Energy ((AGL)), Coles Group ((COL)), Collins Foods ((CKF)), Core Lithium ((CXO)), Johns Lyng Group ((JLG)), Metcash ((MTS)), and Woolworths ((WOW)).

Among the many more that have seen analysts taking a knife (or worse) to estimates are 29Metals ((29M)), CSL ((CSL)), Domino's Pizza ((DMP)), Liontown Resources ((LTR)), Seek ((SEK)), TPG Telecom ((TPG)), and Woodside Energy ((WDS)).

FNArena publishes weekly updates on changes in local analysts' forecasts and projections affecting ratings, valuations & targets, and forecasts.

This week's update:

https://www.fnarena.com/index.php/2023/07/10/weekly-ratings-targets-forecast-changes-07-07-23/

FY23 Returns: Details Matter

I came across the following eye-witness report a number of years ago.

A fund manager is presenting his fund's performance and proudly announces: average return over the past two years is 25% per annum.

One disgruntled attendee in the audience stands up from his chair and shouts: I'm calling BS! I personally have invested in your fund and I can tell everyone the fund hasn't gone anywhere since.

Fund manager, unperturbed, moves to the following slide showing his fund gained 100% in year-1, then declined by -50% in year-2. 100 minus 50 = 50, divided by 2 = 25%.

I've never established whether this anecdote actually took place in real life, but the underlying message remains unchanged: investors should remain cognisant of how finance generally is covered and reported on, while always trying to ascertain whether the finer details do not contradict the headline impressions, or offer a much more insightful background and context.

Those among you who may not be great with mathematics might now be thinking: what's wrong with the story above? Who's correct and who's not?

The straightforward answer is there's a lot wrong with that story, but also: both the fund manager and the angry investor are correct. The fund manager, however, is using the audience's dislike for maths and details to his own advantage, like a good old snake oil salesman.

Like with so many things in finance; one needs both a broader context and the finer details to get to the true picture.

In the example above: if an investor had invested from day one in Year-1, say $30,000, then that capital would have first doubled to $60,000 (100% gain) but subsequently reverted back to the original investment as that is what a decline by half (-50%) amounts to.

The result is a great outcome for marketing purposes (25% per annum!) but not great at all for the investor whose capital went backwards because of fees and inflation.

****

In the never-ending debate between actively managed investment funds and passive ETFs and other listed instruments, it is my observation many a professional investor knows how to outperform the broader market during times of plenty of sunshine (Risk On, bull markets) when taking on risk gets rewarded in spades, but things can go off the rails quite quickly, and quite devastatingly so, when the overall market environment deteriorates.

Investors might keep this in mind over the coming weeks as fund managers and industry consultants are no doubt preparing for a Good News marketing story.

The ASX200 Accumulation index, which includes the dividends paid out throughout the year, has generated a return of no less than 14.78% for the year ending on June 30. Some foreign indices have even done significantly better.

A few things to keep in mind:

-In Australia, the market performed best in H1 while in H2 the bulk of returns were generated in the June rally, which subsequently evaporated again in July

-Such environment usually emphasises the importance of dividends, but banks have been weak in 2023, with the market preferring insurers instead

-While the lists of top performers all contain small caps, it's been a heavily polarised landscape and large caps, as a group, have outperformed their smaller peers

-FY23 has once again highlighted the sweet spot in the Australian share market lays inside the MidCap50; effectively the ASX100 minus the Top50

-The final month of FY22 saw markets take a deep dive into the abyss, creating a low point from which this year's 12 month returns are being calculated

The importance of not simply staring oneself blind on twelve month's performance numbers shows up in many forms and disguises. Take Perpetual's global innovation fund, for example.

With a return of 44%, the fund is sitting on top of Morningstar's performance rankings for FY23. No questions about it, this is a fantastic outcome, but it looks a whole lot less impressive when we take into account this fund lost nearly -50% in the previous year.

Let's assume our angry investor in the opening anecdote had taken his $30,000 and given it to the Perpetual fund to manage two years ago. Today, his capital would have eroded to $30k minus 50% = $15,000 times 44% = $21,600, meaning he effectively lost -$8,400 over that period.

****

When FNArena started the All-Weather Model Portfolio back in early 2015, we promised investors we'd manage the downside by investing in Quality growers and reliable, sustainable dividend payers.

But markets are never 100% predictable and while Quality on average falls a lot less than the majority of listed equities, the past eight years have shown plenty of occasions when extreme volatility ruled the landscape, leaving no protection at all for equities, no matter the Quality, resilience or growth prospects.

How best to deal with these circumstances remains a never-ending dilemma.

Some investors put their faith in that all shall be okay in the long run, buying more at substantially lower prices if they have the means to do so. Certainly, it's great to buy shares at beaten-down prices, but what if the bottom's not in until -25%, or even -50% lower?

The opposite approach is to reduce the portfolio's exposure, so that losses remain smaller. The consequence of that approach is that subsequent gains are likely to be smaller too, as, let's face it, we're unlikely to reallocate funds back at the absolute bottom of the sell-off.

But here's the rub: a portfolio that doesn't fall as much, needs only smaller gains to keep the overall return positive. I think the merits of building up a sizable level of cash during times of extreme duress have been well and truly proven in the past couple of years.

This time around last year, the All-Weather Model Portfolio held 35% in cash and thus managed to limit its losses to -3.93% in June and -2.59% for FY22.

In comparison, the ASX200 Accum lost -8.76% in June last year and -6.07% for FY22.

Yes, the All-Weather Portfolio proudly outperformed throughout those testing, extremely volatile times. But the portfolio's performance for the year thereafter is measured off a higher base, which creates an extra hurdle when measuring the performance for the following year.

To illustrate the importance of the starting point, consider the following: up until mid-June the All-Weather Portfolio, even with 20% in cash, was outperforming the broader index on 3, 6 and 12 month comparison but then a strong rally ensued in resources and market laggards, and the comparison shifts to a much lower point (for the index) by the end of June last year.

In the end, the All-Weather's performance remains better on 3 and 6 month comparisons, advancing 2.91% and 8.91% respectively versus 1.01% and 4.46% for the ASX200 Accum. For the full twelve months, the All-Weathers added 12.71% against 14.78% for the index, suggesting 'underperformance'.

Though the irony of the difference in starting points should not go lost: the index started -3.48% lower than the All-Weather Portfolio and subsequently only performed better by 2.07%. It might seem I am making a big deal out of minor details few others appear to be concerned about, but consider the importance of it when a fund reports it has gained 15% over FY23 after losing -22% in the year prior, to name but one example.

Ultimately, any assessment of success or otherwise needs to be made over a longer horizon. One prediction we made at the time of establishing the All-Weather Portfolio is that investment returns would amount to 7%-8%, on average, over time.

The average per annum return achieved for the All-Weather Portfolio since early 2015 is circa 9.25% – meaning we've done better than promised over the past 8.5 year period.

For reasons of comparison: the average annual advance for the ASX200 Accum is 7.16% for the past 5 years and 8.56% for the past decade.

Ultimately, the key purpose of running the Portfolio is to back up my research, but also: to prove that one can invest in Quality companies, irrespective of their premium valuations.

I think we can safely conclude the Portfolio has proved just that over the past 8.5 years, while providing me also with priceless market insights along the way.

****

One intriguing observation is the repeated relative outperformance in Australia of the MidCap50; that segment of companies not large enough to be part of the ASX50 but on average too large to be included with the many smaller caps listed on the ASX.

Talk to any small cap investor this year and they will assure you times have been extraordinarily challenging. The S&P/ASX Small Ordinaries, for example, generated 8.45% in FY23 total return, but only 1.32% for the first six months of 2023.

In comparison, the MidCap50 is up 4.60% for the six months ending June 30, which is similar to the ASX50, but for the full financial year the gain is 17.97%. Over three years (13.50%), five years (8.80%) and ten years (14.40%) – the outperformance from this segment on the exchange is quite persistent.

Do we know why? Are there any conclusions or insights we can draw from it?

My own view is this segment includes those success stories from the small caps space that are able to grow into a much larger size, and ultimately become part of the ASX50 large caps.

Micro caps and small cap companies will always have an attraction, because such companies can grow rapidly from a low starting point, which can translate into outsized share price gains in a short time. But only few can turn that operational momentum into a sustainable, long-term growth story.

In other words: the best out of the bunch eventually end up in the first half of the ASX200, and if they're truly successful they continue advancing through the rankings until they leave this segment through the front door, i.e. they join the ASX50. Another way of approaching it is through the balance between risk and reward.

Since companies that keep climbing through the ranks have proven the merits and success of their products and services, I'd argue they represent a much better risk-reward balance, in between smaller peers that yet have to prove themselves and the larger sized companies that can be quite sluggish in their growth.

I haven't done or seen any dedicated data analysis, but logic tells us companies that have strongly contributed to the MidCap50's relative outperformance in Australia include Cochlear ((COH)), ResMed ((RMD)), Seek ((SEK)), Treasury Wine Estates ((TWE)) and Xero ((XRO)) but also Fortescue Metals ((FMG)), Mineral Resources ((MIN)), and Pilbara Minerals ((PLS)).

All are part of the ASX50 today, but for many years these companies have been growing their business, climbing the ranks of the ASX, to ultimately join the Top50 on the Australian bourse. Before they got there, these companies helped the MidCap50 consistently outperform all other segments on the ASX.

This doesn't mean we should ignore these companies from the moment they enter the Top50, but equally valid: not every member of the MidCap50 will be a generator of long-term outperformance; picking the winners remains important.

A quick glance through my curated lists (further below) reveals this segment is amply represented, even without a specific focus on mid-caps.

Readers familiar with my research won't be surprised to read companies included are Ansell ((ANN)), Carsales ((CAR)), REA Group ((REA)), Steadfast Group ((SDF)), TechnologyOne ((TNE)), WiseTech Global ((WTC)), and others.

As far as general observations go: I think the numbers and the facts speak for themselves.

****

When it comes to investing and the share market, Mike Tyson described the experience of the past years best: "Everybody has a plan until they get punched in the mouth".

Wall Street legend Bob Farrell's rule number ten also springs to mind: Bull markets are more fun than bear markets.

To say that events, extreme polarisations and momentum switches have tested investors to the max in the three years past can only be a grave understatement. While much of today's public discourse is whether equities are still in a bear market or not, a prudent investor would be prepared for challenging times ahead.

Our view that prudence is best in the slipstream of the steepest central banks tightening cycle ever, and still ongoing, has been repeatedly and severely tested over the past 16 months. Oddly enough, it has not relegated the All-Weather Portfolio to significant underperformance, even despite the Portfolio carrying 20%-plus in cash, and 5% in gold.

But not everything has worked out as planned, and at times changes and amendments needed to be made.

Among the newcomers that joined the Portfolio throughout tumultuous and volatile times are Dicker Data ((DDR)), Steadfast Group ((SDF)) and HomeCo Daily Needs REIT ((HDN)). The first two additions have contributed positively, but the REIT has been weighed down by bond market volatility, which we always knew was a key risk.

At some point, the bond market will provide relief. In the meantime, we are enjoying a prospective dividend yield in excess of 7%. Dicker Data shares equally offer a juicy yield, expected to grow to 6% next year. Insurance broker Steadfast has performed better; its shares are trading on a much lower implied yield.

In terms of your typical income-oriented investments, one of the Portfolio's largest exposures remains Telstra ((TLS)), which, apart from a 4% yield, offers upside through asset sales and much improving industry dynamics.

Dialling back the risk-taking, and reducing the overall equity exposure by lifting the percentage held in cash (and gold), has meant saying goodby to some investments that we would have liked to still own today. But as the old expression goes: one cannot make an omelet without breaking some eggs.

Sometimes sacrifices need to be delivered for the higher cause, in this particular case: limiting capital losses and remaining prepared for tougher, challenging times ahead.

Stocks that remain high on the Wish List include Breville Group ((BRG)), Pro Medicus ((PME)), REA Group, Seek, WiseTech Global ((WTC)), and Xero ((XRO)).

The most prominent disappointment in the Portfolio relates to CSL with new management issuing a rare profit warning towards the end of the financial year. Most importantly: the forecast remains for EPS growth in the order of 14%-18% in FY24.

It goes without saying, even the highest Quality growth stock on the ASX is not 100% immune to bad news! But it doesn't by any means imply that CSL's growth story is nearing its end.

With confidence that this year's set-back is just that, a delay in the post-covid recovery, the Portfolio has responded by purchasing more shares on persistent weakness.

CSL is now the largest single exposure, which is likely to act as a bonus once investors start looking for reliability and Quality during times of corporate stresses and duress.

****

The All-Weather Model Portfolio is run in cooperation with Vested Equities through self-managed accounts (SMAs) on the WealthO2 financial platform. For more info: send us an email.

Paying subscribers have 24/7 access to my curated lists, which form the preferred hunting ground for the Portfolio:

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

Small Caps In Focus

Last week, I participated in a feature on small cap companies for Livewire Markets.

I offered six names that are worthy of investors' attention; three are owned by the All-Weather Portfolio, the other three are included in my curated lists.

–Dicker Data

Quote: "It was sold down quite heavily last year and as a consequence is today offering a high yield. I have a lot of confidence it will continue to perform in the years ahead."

–Steadfast Group

 "I've done well out of it since purchasing it and used share price weaknesses to add to my position."

–IDP Education ((IEL))

"I bought more when it was sold down. I think the market has been very harsh and there's a lot of shorts on it. That can go either way, prices could stay low for longer. I'm hoping that good news will come out at some point and prices will go up a lot."

Three on my radar:

–Audinate Group ((AD8))

"It's not profitable yet but it's getting there. I think it could be a future success story for the ASX. I'll be watching the August reporting season as I suspect it will be very volatile."

–Objective Corp ((OCL))

"I'm a big fan of TechnologyOne ((TNE)). The stock has been one of the best performers on the stock exchange over the past two decades. I see similar characteristics in Objective, which I tend to describe as mini-TechnologyOne. I think Objective has strong potential."

–Ebos Group ((EBO))

"They'll be on the 'do not touch' list for many for a while because they are going to lose a big contract in 2025. They are a very good operator and I think they deserve the benefit of the doubt that they can come out stronger down the track."

The quote that summarises my view:

"We are now moving into tougher economic conditions. Rate hikes in Australia, Europe and the US are really now starting to hit. Smaller companies are more vulnerable in this environment. Some of them have cheap valuations but are they cheap enough based on the risks?"

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, 10th July, 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).

Click to view our Glossary of Financial Terms