Rudi’s View: Navigating The Post-August Complexities

This story features COLLINS FOODS LIMITED, and other companies. For more info SHARE ANALYSIS: CKF

In this week's Weekly Insights:

-Navigating The Post-August Complexities
-Best Ideas and Conviction Calls
-FNArena Talks

Navigating The Post-August Complexities

By Rudi Filapek-Vandyck, Editor

Active fund managers. They are usually brimming with optimism because, as some like to remind us all, pessimists don't make much money.

Yet, at a recent industry panel conversation none of the managers on stage expressed anything other than caution and trepidation for what investors should expect from the Australian share market in the next 12-18 months.

The same reluctance dominates most strategy updates post-August from investment banks and stockbrokers; there are no repeats of the more dire warnings some issued in early 2022, but all seem to temper what could be too-high expectations for the months ahead.

This might somewhat surprise for it is not as if the local share market has rallied hard this year. After a slightly negative return for 2022, year to date in calendar 2023 the ASX200 Accumulation index is up circa 6% but half of that stems from dividends. The ex-dividends gain of less than 3% could easily disappear throughout what is traditionally the weakest period of the year up until mid-October.

The recent August results season in Australia wasn't an all-out inspiring event, but any massacres remained confined to individual companies and, overall, there have been plenty of positive surprises on forecasts that had become too cautious.

The main worry, however, is more directly linked to asset valuations generally.

We need to talk about valuations

In your typical industry lingo, we're now talking about the Equity Risk Premium, short cut ERP. This is the mathematical comparison investors apply for listed equities relative to government bonds. The higher the ERP, the lower the valuation and return from equities. What has many an expert puzzled is how low this ERP has become, and nobody genuinely knows why.

Traditionally, during times of heightened risks and uncertainties, share markets price in a higher ERP which equals cheaper share prices to account for the extra risk of disappointment, but this time around the ERP has simply shrunk, and shrunk further. The good news, as we all witnessed over the past 18 months or so, is that none of the more dire scenarios have (thus) played out.

The flipside of this market observation, as explained in a recent strategy update by UBS, is that the ERP for US equities has only been lower on two occasions over the past one hundred years; in the late 1920s/early 1930s and in the late 1990s/early 2000s. As every investor knows, in both cases what followed next is best avoided as first followed the Great Depression and later on the bursting of the TMT bubble.

Nobody is making any such prediction this time around, also because the ERP is not a reliable instrument for timing the next downturn. But UBS strategists do make the point historically there is a "decent" relationship to medium and long term investment returns. Whenever equities have in the past been priced as expensively, relative to bonds, the return for the following decade has only been a paltry 3% per annum.

Australia's Trading Range

In Australia, the relative valuation of the ASX200 is equally higher than what history suggests, as also signalled by the index's average Price-Earnings (PE) ratio of circa 15.4x. Historically, the average PE is circa -100bp lower around 14.4x.

Equity valuations don't exist in a vacuum, of course, which is all too often a mistake made by investors. What supports share prices, or otherwise, are forecasts for profits and dividends. Here the recent August results season has once again presented investors with a true smorgasbord of corporate strengths and weaknesses that have led to changes in how analysts and strategists view opportunities and risks for investors locally.

Ever since share markets bounced off their lows late last year, the ASX200 has remained inside a trading range that has seen the index rally towards 7600 and fall to 6900. More often than not rising and falling bond yields have been the prime instigator.

With most economies expected to weaken in the quarters ahead, Economics 101 suggests a pause in central bank tightening should lead to lower bond yields, but then the rally in oil prices might trigger a spike higher in inflation yet again.

What has managers and strategists cautiously optimistic for the year ahead is the fact that lower bond yields should provide support for equities, as they have done on multiple occasions already this year. The offset is slowing economic growth will put current profit forecasts to the test.

There is, of course, no silver bullet to avoid share market turbulence and, reading between the lines of expert views and assessments, market volatility is here to stay for the foreseeable future. One way to deal with it is through more active buying and selling, as recommended by some.

Lessons From August

One of the key features that separated Winners from Losers in August was the ability for management teams to control costs and protect the profit margin. A cautiously optimistic Wilsons believes corporate results have provided plenty of indications that cost pressures are abating and thus Australian companies should start benefiting from a recovery in margins.

Screening the ASX200, Wilsons analysts have identified nine companies that are poised for margin recovery. Their favourite is Collins Foods ((CKF)), which has been added to the Focus Portfolio, a basket of high conviction ASX-listed exposures.

The other eight are: Amcor ((AMC)), ARB Corp ((ARB)), Bapcor ((BAP)), Boral ((BLD)), Domino's Pizza ((DMP)), James Hardie ((JHX)), Reliance Worldwide ((RWC)), and Wesfarmers ((WES)).

But in a share market that is at the index level forecast to possibly make no net gains by mid-2024, outperformance throughout the year ahead might well be determined by what is not owned in the investment portfolio.

One favourite basket for the nomination of Sell ratings remains the ASX-listed retail sector, despite the fact those companies surprised most in August.

Goldman Sachs just reiterated its Sell ratings for Coles Group ((COL)), Domino's Piza ((DMP)), and Premier Investments ((PMV)). The underlying narrative to retain a cautious stance generally on companies overly exposed to consumer spending domestically is that RBA rate hikes still haven't been fully passed on to mortgage holders in Australia, while large parts of the country are by now running out of savings.

UBS suggests investors best avoid big ticket retailers with its analysts reserving a Sell rating for Harvey Norman ((HVN)), and also for Accent Group ((AX1)), Domino's Pizza, Premier Investments, and Super Retail ((SUL)).

Sector analysts at Canaccord Genuity have labelled the market's response a "low quality sentiment rally" but are still prepared to stick with Buy ratings for Lovisa Holdings ((LOV)) and Dusk Group ((DSK)).

Could there be an opportunity in smaller cap stocks that have lagged their larger peers? Stockbroker Morgans suggests investors should broaden their view, away from local large cap technology companies a la Wisetech Global ((WTC)) and Xero ((XRO)), and screen for better value in the smaller cap space instead.

Morgans likes AI-Media Technologies ((AIM)), Ansarada ((AND)), Attura ((ATA)), Objective Corp ((OCL)), and, still, Siteminder ((SDR)). The latter has put in one mighty rally since July.

While punishments for disappointment in August have been harsher for smaller cap companies, analysts at Morgan Stanley do point out the growth outlook appears better for smaller caps in comparison with the constituents of the ASX100. From this perspective it makes sense to at least consider smaller cap companies for portfolio inclusion for the year ahead.

Equally interesting is that ResMed ((RMD)), whose shares have sold off a whopping -30% on a disappointing quarterly margin and speculation about competition through weight loss drugs from Eli Lilly and Novo Nordisk, has continued to garner support from local fund managers and healthcare sector analysts.

Not that any of it has stopped the share price decline to date.

Those strategists who had picked ResMed as one of their core holdings for the year ahead are sticking with their choice. Fund managers who weren't necessarily paying attention are definitely now. Healthcare analysts continue to express their surprise about the sudden selling pressure and their support for the shares medium to longer term.

Healthcare analysts at Macquarie retain ResMed as their second most favoured exposure on the ASX, behind CSL ((CSL)) and ahead of also-favourites Monash IVF ((MVF)) and Regis Healthcare ((REG)).

Macquarie's response: "We see the growth outlook as favourable, supported by increased new patient set-ups and share gains, with potential upside from outcomes associated with the Philips consent decree. Current valuations are near 10-year lows reflecting concerns in relation to GLP-1 RA which we see as overstated."

The over-arching issue remains that demand for GLP-1 drugs from both manufacturers is in a steep hockeystick up-trend and everyone can have a big guess as to how, to what extent, and when exactly this might impact on ResMed's sales trajectory.

The healthcare sector in general has -uncharacteristically- been one of the underwhelming performers throughout the August results season. However, market forecasts suggest the sector can continue to recover from its post-covid slump while other sectors feel the impact from slower economic momentum.

A late cycle set-up (if that's what we are experiencing) traditionally can be very unkind to energy producers, miners and other cyclical companies, but supply reductions by OPEC and Russia, and successful stimulus in China, can potentially shape a different scenario for the months ahead.

One observation is resource analysts have started to yet again adopt a stronger-for-longer view for iron ore pricing, triggering upgrades for the likes of BHP Group ((BHP)), Fortescue Metals ((FMG)) and Rio Tinto ((RIO)) recently. Those in favour of more gold exposure are equally turning more enthusiastic.

Macquarie, for one, remains constructive on lithium pricing over the medium to longer term, while acknowledging prices are likely to remain volatile in the here and now.

On the other hand, recession calls for European countries including France and Germany are gaining more traction while a recent survey by S&P revealed some 60% of investment managers remain convinced the US economy will still experience a mild recession, exact timing unknown.

In contrast with Australia where the bias for earnings estimates remains negative, in particular for the top end of the market, forecasts in the US have started to rise again on stronger-for-longer economic scenarios, though the advent of artificial intelligence is already making an impact too.

It's Complicated

Taking a helicopter view, Barrenjoey assures investors the outlook both in Australia and abroad remains "complex" as the lagging impact from significant tightening by the world's central banks is taking longer than expected.

Barrenjoey's preferred portfolio exposures try to combine all of the above, representing a non-typical set-up to deal with the complex environment ahead.

With a Neutral weighting to Consumer Staples, Barrenjoey's portfolio has Overweighted exposures to Energy, Insurance, Healthcare, Telecommunications, Mining, and Industrials. Remaining out of favour: Consumer Discretionary, Utilities, Technology, Online Classifieds, Builders, and Banks.

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This is the third, and final, installment on the August reporting season in Australia.

The previous two:

https://www.fnarena.com/index.php/2023/09/06/rudis-view-outlook-negative-with-plenty-of-silver-linings/

https://www.fnarena.com/index.php/2023/09/13/rudis-views-august-2023-winners-losers/

Soon the FNArena Results Monitor will zoom in on companies reporting between now and December:

https://www.fnarena.com/index.php/reporting_season/

Best Ideas and Conviction Calls

Goldman Sachs' list of Conviction Buys in Australia and New Zealand currently consists of nine ASX-listed companies:

-Endeavour Group ((EDV))
-Fisher & Paykel Healthcare ((FPH))
-Lifestyle Communities ((LIC))
-Macquarie Technology Group ((MAQ))
-Qantas Airways ((QAN))
-REA Group ((REA))
-Rio Tinto
-Woolworths Group ((WOW))
-Xero

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Over at Morningstar, the list of Best Buy Ideas includes the following 11:

-a2 Milk Co ((A2M))
-Aurizon Holdings ((AZJ))
-ASX ((ASX))
-Bapcor
-Kogan ((KGN))
-Lendlease Group ((LLC))
-Newcrest Mining ((NCM))
-Santos ((STO))
-TPG Telecom ((TPG))
-Ventia Services Group ((VNT))
-Westpac Banking ((WBC))

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Barrenjoey works off eight different themes:

-For Commodities; Lynas Rare Earths ((LYC)), Predictive Discovery ((PDI)), Santos, and Worley ((WOR))
-Best-in-Class global franchises: Aristocrat Leisure ((ALL)), CSL, GQG Partners ((GQG)), Wisetech Global, and IDP Education ((IEL))
-Price inflation: Brambles ((BXB)) and Metcash ((MTS))
-Critical software: Hansen Technologies ((HSN))
-Leverage to interest rates: Latitude Financial Group ((LFG)), National Australia Bank ((NAB)), and QBE Insurance ((QBE))
-Cheap growth: Pinnacle Investments ((PIN)) and Seek ((SEK))
-REITs: Charter Hall ((CHC))
-Corporate restructuring: Premier Investments

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Morgan Stanley's Australia Macro+ Focus List still hasn't changed since late January this year. The ten constituents thus remain:

-Aristocrat Leisure
-CSL
-Goodman Group ((GMG))
-IDP Education
-Macquarie Group ((MQG))
-Northern Star Resources ((NST))
-Rio Tinto
-Suncorp Group ((SUN))
-Telstra ((TLS))
-Treasury Wine Estates ((TWE))

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Macquarie's recommended Growth Portfolio:

-Aristocrat Leisure
-Computershare ((CPU))
-CSL
-Goodman Group
-Carsales ((CAR))
-Pilbara Minerals ((PLS))
-The Lottery Corp ((TLC))
-Mineral Resources ((MIN))
-Northern Star
-Flight Centre ((FLT))
-NextDC ((NXT))
-Cleanaway Waste Management ((CWY))
-Steadfast Group ((SDF))
-Ramsay Health Care ((RHC))
-ResMed
-Netwealth Group ((NWL))

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Macquarie's recommended exposures for an Income Portfolio:

-Telstra
-ANZ Bank ((ANZ))
-Suncorp Group
-National Australia Bank
-CommBank ((CBA))
-Westpac Banking
-BHP Group
-Coles Group
-Atlas Arteria ((ALX))
-APA Group ((APA))
-GUD Holdings ((GUD))
-Aurizon Holdings
-Premier Investments
-Deterra Royalties ((DRR))
-GPT Group ((GPT))
-Metcash
-Charter Hall Retail REIT ((CQR))
-Amcor

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Wilsons' Focus Portfolio has added Collins Foods, as reported earlier. To accommodate the extra inclusion, the portfolio trimmed its holdings in James Hardie and Telstra, now the InfraCo sale has been put on hold.

FNArena Talks

I have been invited to MC this year's ATAA National Conference dinner, while presenting on Sunday morning: "Investing fundamentals are not what they seem".

The ATAA National Conference this year takes place on October 20-22 inside Sydney's Sheraton Grand Sydney Hyde Park.

https://ataa.clubexpress.com/content.aspx?page_id=22&club_id=582546&module_id=572833

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I have not been invited to present at this year's National Conference from the Australian Investors Association (AIA), which happens this weekend September 24-26 at the Royal Randwick Racecourse in Sydney.

To attend the Conference for free, use the code 'AIA20' while signing up here: 

https://www.aiainvestx.com.au/event/b5a8bc49-d3ff-46a3-b765-84a4208e4022/websitePage:b8115d31-e9d7-4e92-80e2-b4e4f8a0f6c8

FNArena Subscription

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(This story was written on Monday, 18th 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.

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(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.)  

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