Rudi’s View: Outlook Negative, With Plenty Of Silver Linings

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In this week's Weekly Insights:

-Outlook Negative, With Plenty Of Silver Linings
-Conviction Calls & Best Ideas

By Rudi Filapek-Vandyck, Editor

One of the stand-out features of the August results season has been the resilience of household spending in Australia, which proved pivotal in keeping the balance of the season skewed towards not-as-bad-as-feared outcomes from discretionary retailers in particular.

But to me the bigger issue that surfaced throughout the month was how vulnerable our traditional defensives turned out to be in the face of higher input costs, skilled labour shortages, rising wages, rent increases, and costlier debt.

Ahead of August, I worried about extreme volatility and relentless punishment in case of perhaps only mild disappointments. That inkling has certainly been proven correct. On UBS's assessment, August 2023 has been one of the most volatile and challenging reporting seasons in local history.

And traditional defensives have played an active, prominent role in contributing to August's notable spike in share price volatility as the likes of Coles Group ((COL)), Endeavour Group ((EDV)), Ramsay Health Care ((RHC)), Transurban ((TCL)) and Telstra ((TLS)) all managed to disappoint one way or another, leading to immediate selling pressure once their financial results had been communicated.

As a group, Defensives have largely trod water post covid and lockdowns, and some, including Coles, Ramsay Health Care and APA Group ((APA)), have no doubt left many a loyal shareholder with a sense of dissatisfaction as shares are today trading at levels last seen during pre-covid years.

This is quite remarkable and I suspect surprising to most investors and share market strategists given the rapid reset in global bond yields and central bank cash rates over the past 20-plus months, triggering widespread anticipation of much slower growth ahead for economies across the globe.

In such an environment, Investing 101 tells us defensive assets and businesses should be on investors' target list to preserve capital, secure income, avoid major disasters and still achieve at least moderate capital gains.

But this time around the overall defensive experience has been underwhelmingly mixed at best, and that's assuming portfolios were not overly exposed to Coles, Ramsay Health Care or ResMed ((RMD)) which recorded share price falls of respectively -12%, -12%, and -24% just in August.

It remains yet to be seen whether disappointment to date makes investors more apprehensive towards this segment on the local share market. Post August, corporate Australia is forecast to be en route for negative profit growth, on average in aggregate, and for less dividend payouts over the twelve months ahead.

Not exactly an environment in which defensives cannot or won't make a come-back, especially given most of the post-covid headaches are seen to be reducing already.

Within this context, I note model portfolio managers at Wilsons recently added Amcor ((AMC)), believing those shares are now poised for outperformance as the valuation looks attractive and further downside for earnings is seen as unlikely.

(Un-)Healthy Healthcare

Apart from supermarkets, the country's largest telco and utilities, the local healthcare sector has been for many years the logical go-to destination on the ASX when times became tougher, but healthcare yet again produced multiple prominent disappointments this August season.

ResMed, the world's number one manufacturer of CPAP devices assisting people with sleep apnoea, missed market forecasts by some -5% on slower-than-anticipated margin recovery, but its share price has undergone a seldom witnessed de-rating (-24%) as hedge funds and shorters in the US, where the shares are also listed, play winners and losers from immensely popular anti-obesity drugs marketed by Eli Lilly and Novo Nordisk.

Analysts covering the company and its sector believe the assumption that sleep apnoea is simply a result of obesity and that ResMed's growth will be stunted because of popular weight-loss pills is misplaced and misguided, but most investors will be hesitant to catch the proverbial falling knife, instead biding their time and see when exactly those shares find support.

An equally dramatic de-rating has taken place for private hospital operator Ramsay Health Care, long considered to be a Quality backbone stock for investment portfolios throughout Australia. But the long term uptrend on historical price charts has flatlined since 2016, with last month's sell-off pushing the shares to their lowest level since 2014.

Ramsay's disappointment in August has left analysts with a veritable smorgasbord of questions, ranging from the sustainability of higher operational costs (permanently lower margins?), to the hospital operator's true negotiating power versus health insurers, the need to diversify into costly out-of-hospital care, and the company's viable options when governments feel the pressure of budget constraints.

Ramsay's balance sheet is also burdened by a mountain of debt, so no surprise the company is intending to find a buyer for its Asian JV, Ramsay Sime Derby, to provide relief.

Though the shares look on most assessments undervalued, assuming some kind of normalcy can return in due course, Ramsay Health Care has very few Buy-rated believers left among healthcare analysts in Australia. Most experts don't see a quick fix on the horizon, though a sale of Ramsay Sime Derby might be positively received, and prefer to wait-and-see what the future brings along.

Ten times bitten, twelve times shy?

With the notable exception of high quality, small cap superpower-in-ascendency, Pro Medicus ((PME)) and large cap Cochlear ((COH)), healthcare was one sector mostly on the receiving end in August.

All of Ansell ((ANN)), APM Human Services International ((APM)), Audeara ((AUA)), Australian Clinical Labs ((ACL)), Capitol Health ((CAJ)), CSL ((CSL)), Healius ((HLS)), Integral Diagnostics ((IDX)), Monash IVF ((MVH)), Nanosonics ((NAN)), Polynovo ((PNV)), Sonic Healthcare ((SHL)), Telix Pharmaceuticals ((TLX)), and others in the sector, were unable to awaken the fire in investors' belly.

In contrast with Ramsay and ResMed, analysts are left with a whole lotta less unanswered questions about the outlook for healthcare stalwarts such as CSL, Cochlear, Sonic Healthcare, Monash IVF and some of the smaller representatives, as covid-related headwinds are considered not permanent, and wearing off.

This in itself should prepare the sector for making a "healthy" come-back over the coming 12-24 months, all else remaining equal.

August Revealed The Strong

August revealed the Australian consumer is still remarkably resilient, though a variety of indications were equally provided that suggest the coming months might extend and deepen the true impact from steep RBA tightening.

Nevertheless, investors as well as analysts seem in agreement things might not get as bad as feared, not even when more negative impact is still in the future.

Thus August showed a notable improvement in general sentiment towards retailers such as Accent Group ((AX1)), JB Hi-Fi ((JBH)), Lovisa Holdings ((LOV)), Nick Scali ((NCK)), Premier Investments ((PMV)), Super Retail ((SUL)), The Reject Shop ((TRS)), and Universal Store Holdings ((UNI)).

General resilience in discretionary spending is also feeding into more optimism regarding next year's outlook for Australian banks.

Irrespectively, Harvey Norman ((HVN)) will be kicked out of the ASX100 index on Friday, September the 15th, with popular lithium exposure Liontown Resources ((LTR)) joining instead.

True strength emanated from the insurance sector and from leisure and tourism with the likes of Auckland International Airport ((AIA)), Camplify Holdings ((CHL)), Corporate Travel Management ((CTD)), Experience Co ((EXP)), Flight Centre ((FLT)), Helloworld Travel ((HLO)), Hotel Property Investments ((HPI)), Qantas Airways ((QAN)), and Tourism Holdings Rentals ((THL)) either meeting or beating already high expectations, with strong operational momentum projected to continue into FY24.

Elsewhere, optimists spotted early green shoots for Ardent Leisure ((ALG)), though Kelsian Group ((KLS)) disappointed (yet another carrying the 'defensive' label), and questions remain around the year ahead for hotels and cinemas operator EVT Ltd ((EVT)), also the owner of the ski resort in Thredbo.

Higher Yields Are Negative

Higher bond yields means those with debt are facing a costlier outlook, either today or when debt needs to be refinanced.

This proved one of the recurring negative revelations during August as analysts, generally speaking, had been underestimating by how much exactly the cost of debt had increased for the likes of Amcor, Ramsay Health Care, and numerous others.

The rising cost of debt is in particular a formidable negative for ASX-listed REITs, many of whom are now effectively ex-growth, often through the combination of higher operational expenses, top line pressure, falling asset prices and higher interest from debt.

Under different circumstances, one would expect to see an uptick in asset sales, but these are not normal times for the sector, as also signalled by the Australian Financial Review reporting on Monday some $2.5bn in large shopping centre assets have been for sale in Australia for more than a year – but prospective buyers remain elusive.

A similar conundrum awaits owners of offices. Investors are worried those assets are worth a whole lot less than yesterday's valuations as industry dynamics remain opaque and uncertain.

In the share market, securities of the likes of Cromwell Property Group ((CMW)), Growthpoint Properties Australia ((GOZ)), and Unibail-Rodamco-Westfield ((URW)) are trading well below analysts' underlying valuations, but your average investor is happy to leave any such opportunities to the daring value investor with higher appetite for risk, and unlimited patience.

The A-REITs sector in Australia entails many more sections and options, think industrial development a la Goodman Group ((GMG)), but also childcare centres through Arena REIT ((ARF)), storage facilities, and non-discretionary retail landlords. A number of REITs with such alternative exposures is being re-rated post financial updates in August.

One example is the HomeCo Daily Needs REIT ((HDN)), which is held inside the FNArena/Vested Equities All-Weather Model Portfolio. Its securities have appreciated by close to 12% over the past two weeks, significantly reducing the gap with FNArena's consensus target, which on Monday is still close to 8% higher.

The independently trading HealthCo Healthcare & Wellness REIT ((HCW)) is showing a similar upgrade move, with its securities trading -6.4% below the consensus target. One gets the feeling at least part of the investment community is feeling more confident in the outlook and asset valuations for selected REITs.

The local number one for the sector, heavyweight Goodman Group ((GMG)), has equally received a positive re-rating in August. FNArena's consensus target for Goodman Group only sits a smidgen above the upgraded share price, with the added observation that target is significantly impacted by a much lower contribution from Ord Minnett/Morningstar.

Goodman Group has been an exception among large cap, high quality defensives in August, releasing financial results that attracted virtually no doubt or criticism, supporting ongoing optimism about its future growth potential.

Also, while everyone's attention had been directed towards NextDC ((NXT)), Megaport ((MP1)), Macquarie Technology Group ((MAQ)) and Appen ((APX)) to jump on this year's bandwagon of regenerative AI, it turned out Goodman Group is the AI champion on the ASX.

As one of the world's largest developers of industrial assets, some 30% of Goodman Group's projects under development now consists of new tech data centres.

At the smaller end of the market, investors have equally re-rated technology distributor Dicker Data ((DDR)) with its FY23 financials injecting renewed optimism about the outlook for the company's margins. Dicker Data is the exclusive distributor of Nvidia chips in Australia.

Non-Bank Financials Feeling The Pain

One sector that showcased its fragility and vulnerabilities in August concerns the non-bank financials; small cap lenders and services providers like Pepper Money ((PPM)), Liberty Financial ((LFG)) and Latitude Group Holdings ((LFS)), as well as Resimac Group ((RMC)), MoneyMe ((MME)), Australian Finance Group ((AFG)), and others.

Higher funding costs, increased competition and budget pressures for households have the potential to become kryptonite for the sector overall and financial results in August suggested there's pressure coming from all corners – nobody thinks this is the end of it.

Analysts at Citi are the only ones who've published a general assessment post August results. Unsurprisingly, they remain hesitant and cautious. Credit risk is still up in the air. Citi thinks investors at large will be waiting for a peak and moderation in funding costs in combination with a tangible inflection in volumes.

Earnings forecasts for all companies in this segment have been reduced significantly.

August In Numbers

Having updated on 385 companies, including many more smaller cap companies than in the past, FNArena's Results Season Monitor has designated 111 reports as a "beat", against 167 in line and 107 missing the mark. It is important to note these assessments are not made purely on net profit or earnings per share coming in higher or lower than analysts forecasts.

Any guidance for the year ahead is equally taken into account, as well as specific details that impact on forecasts and valuations post result releases.

Today's numbers will still change in the days ahead, but hopefully not by much. On current assessment, these stats suggest total "beats" have outnumbered "misses" by 28.8% versus 27.8%, but is this genuinely a positive?

FNArena has been monitoring results since August 2013. Over that decade, most result seasons finished with more beats than misses. Usually the gap in favour of beats is a lot wider. Plus estimates had already been significantly reduced prior to the season. Plus estimates have yet again been downgraded noticeably for the financial year ahead.

On current consensus forecasts, the average EPS for the ASX200 is poised for a -6.2% drop in FY24, with the outlook for the ASX100 even worse: -7.2%. A lot of this can be attributed to China and the miners, which marked yet another notable disappointment in August.

Banks and Resources are all-important for the Australian share market, but both sectors can often obfuscate what exactly is going on elsewhere. If we exclude both from forecasts, earnings growth in FY23 stands at circa 9.2% positive and is expected to grow by a positive 8% in FY24.

This does not negate the fact that dividends were often a cause for disappointment in August. On CommSec calculations, 26% of companies cut their dividend, while 47% increased it, and 14% maintained it.

Of the Top 10 dividend payers in Australia, all of BHP Group ((BHP)), Fortescue Metals ((FMG)), Woodside Energy ((WDS)), and Rio Tinto ((RIO)) lowered their payout; which immediately shows why total dividends fell by -2.5% from a year ago. Ironically, on CommSec data more companies than usual paid out a dividend in August; 87% of companies versus a long-term average of 85%.

The general expectation is that total dividends will yet again shrink further by this time next year, also because this time many a REIT will pay out less too.

If we look into the finer details, the difference between "beats" and "misses" comes down to exact 4 results; 111 versus 107. That difference can easily be explained by the discretionary retailers, of which more than 50% (9 out of 17) released a better-than-feared performance last month.

Take out the retailers, and we end up with more misses.

Of more importance is Macquarie's forecast that earnings estimates still have a way longer to travel south before they find a bottom. History suggests shares cannot sustainably rally when earnings estimates are still being downgraded.

Not making the case for the local share market any easier is the observation that valuations, generally speaking, are near an all-time high when measured against bond yields (the so-called Equity Risk Premium or ERP is near an all-time low).

The combination of these two factors is keeping Macquarie cautious in its expectations and portfolio positioning.

Hopefully some of the lessons learned from the August results season can assist us all with navigating the swings and roundabouts in the months ahead.

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FNArena's Corporate Results Monitor: https://www.fnarena.com/index.php/reporting_season/

Conviction Calls & Best Ideas

Portfolio managers at Wilsons have added Amcor ((AMC)) as a potentially returning outperformer for the year ahead, while NextDC ((NXT)) and Cleanaway Waste Management ((CWY)) have both been removed.

While the underlying sentiment for NextDC remains positive, Wilsons suspects most of the gains have been made in the short term from the data centres operator who guided to higher costs ahead in order to bring a record harvest in new demand on line.

The investment thesis for Cleanaway never played out, so that story can be best summarised as "disappointing". Clearly, Wilsons is not of the view that past disappointment will lead to outperformance any time quickly, instead looking for more attractive opportunity elsewhere.

The Portfolio's exposure to Xero ((XRO)) has been slightly increased, with the managers describing it as "one of the most impressive tech stocks on the market".

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(This story was written on Monday, 4th September, 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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