Rudi’s View: Banks, Miners & Quality Small Caps

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By Rudi Filapek-Vandyck, Editor

“The strength of the Australian banking sector is difficult to reconcile with the fundamentals.

“The sector has generated an extraordinary total return of ~50% over the last twelve months, despite a tepid earnings growth outlook and increasingly extreme valuations.”

The quote is from Wilsons‘ latest strategy update released this week but it could have been written at any point during the past nine months or so. Banks have surprised friend and foe. Sector valuations look extreme while market forecasts remain for tepid growth. The phenomenon hasn’t been limited to the ASX.

At times, macro forces over-rule conditions on the ground and with the world looking forward to, and preparing for central bank rate cuts, there simply was no stopping the flood of money descending upon the global banking sector.

Meanwhile, resources stocks experienced large outflows as the global economy was clearly slowing, pressured by higher-for-longer interest rates, and ongoing moribund conditions in China.

It created an ever-widening gap between ‘expensive’ banks and ‘cheaply priced’ resources stocks. Brokers started initiating upgrades for BHP Group ((BHP)), Rio Tinto ((RIO)) and Fortescue ((FMG)) but it was clear a catalyst was needed.

That catalyst could have arrived this week with China’s latest stimulus announcement to put more oomph in its sluggish economy, but price action a few days after the announcement suggests there remains a lot of scepticism among investors when it comes to China and its economic trajectory.

Plenty of expert voices around to tell investors not all resources stocks look undervalued. UBS, for example, maintains iron ore is not a sector to get too excited about. 

Two factors are currently undeniably working in favour of resources:

-Large investors can be underweight banks or resources, but given the index weight each represents locally, they cannot be underweighted both. If there is a catalyst to move out of ‘expensive’ into ‘cheap’, as has happened this week, this might well become a self-fulfilling process.

-Traditionally, the November-February period marks a strong performance for China-related commodities. That is only five weeks away.

The above mentioned strategists at Wilsons highlight two additional important points:

-Iron ore miners are equally ‘unattractive’ from a fundamental point of view (Wilsons’ Focus Portfolio is underweight both banks and iron ore miners). Wilsons’ preference lays with commodities that have attractive long-term supply versus demand outlooks, such as copper, gold, oil & gas, and lithium.

-The market is relatively ‘expensive’ in a broader sense with the banks simply priced at the more extreme level (i.e. more expensive among expensive stocks)

Wilsons’ Focus Portfolio retains plenty of exposure to healthcare and technology stocks.

Strategists at Morgan Stanley highlight the duration of this week’s rotation out of banks into commodities-related exposures is dependent on the direction of commodity prices as well as the market’s acceptance of the ‘soft landing’ narrative. Morgan Stanley’s portfolio is Overweight Diversified Miners, gold and energy, with explicit mentioning of uranium.

Earlier in the week, pre-China announcement, JP Morgan had placed everything related to iron ore on a positive outlook, including Deterra Royalties ((DRR)) and Mineral Resources ((MIN)).

UBS, on the other hand, remains bearish on the medium-term outlook for iron ore. This week’s sector update on China stimulus and after plenty of questions from the client base, sees UBS highlighting its Buy rating for South32 ((S32)). Both BHP and Rio Tinto remain Neutral rated. Fortescue and Mineral Resources remain on Sell.

On a broader, global view, UBS strategists believe small caps are poised to outperform (with 3X more floating rate debt than large caps), as remains Quality, and to a lesser extent so do growth stocks.

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Canaccord Genuity strategist Tony Brennan and his team have adopted a different angle, centred around ‘risk’, but their conclusion is the same: it makes sense to build an Overweight position in commodities.

General optimism around inflation falling and central banks cutting interest rates has pumped up share prices in banks, insurers, REITs, discretionary retailers, media companies, and technology stocks; all are deemed to be beneficiaries of lower bond yields.

Certainly in Australia, many of these share price rallies are not being supported by an improving earnings outlook. The banks are but the obvious example. On Canaccord’s assessment, banks in Australia are trading on a higher PE than the broader market; an event without precedent over the past thirty years.

This skews risk towards a correction in share prices if/when earnings disappointment comes to light. What usually follows central bank interest rate cuts is a decelerating pace of economic momentum.

In contrast, food retailing and healthcare services are among the laggards in today’s share market, as are commodity stocks. The Energy and Materials sectors are currently priced on low PEs but also on low expectations, which, on a risk-adjusted basis, makes them relatively more attractive.

In simple terms: resources are priced for more risk that may not eventuate while banks and other segments are priced for very little risk that might prove too optimistic.

Canaccord’s Model Portfolio has removed Wesfarmers ((WES)) and Macquarie Group ((MQG)) and added James Hardie ((JHX)) and Evolution Mining ((EVN)).

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Citi’s previously cautious portfolio stance has become less cautious following the Federal Reserve’s -50bp rate cut, as Powell & Co’s  jump-start lowers the chances of an imminent US economic recession.

Citi’s asset allocation has thus moved towards Overweighting US equities, favouring consumer discretionary, communications and technology. In the commodities space, base metals don’t get more than a rather Neutral view, but Citi still likes precious metals, a lot.

All in all, it’s time for a shift towards a more pro-cyclical portfolio composition, suggest Citi strategists.

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Analysts at Jarden believe Australian investors should remain over-exposed to smaller retail companies. Not only has the recent August reporting season strengthened their conviction, the analysts also point out most of these companies are cycling weak performance numbers from last year, while their multiples have not yet re-rated.

One added observation is the Small Ordinaries index is still yet to bridge the relative performance gap with the larger ASX200 index that opened up since 2022.

Jarden’s key picks are Temple & Webster ((TPW)), Universal Store Holdings ((UNI)), Accent Group ((AX1)) and Nick Scali ((NCK)). Post-August, Jarden has downgraded Lovia Holdings ((LOV)) which is thus no longer part of the top favourites.

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As also explained in our own August Result Season 2024 Wrap ( https://fnarena.com/index.php/2024/09/24/august-result-season-2024-the-wrap/ ), it seems but fair to draw comparisons with 2019 when corporate results, in particular in the second half, were signalling all was not well with general conditions for corporate Australia and sizable dividend cuts fell upon unsuspecting shareholders as a result.

The key reason as to why many investors will not remember it as such is because soon afterwards all attention went to the new epidemic and that closed the books on anything else before or after.

Reece Birtles, Chief Investment Officer at Martin Currie, still remembers 2019 and he warns investors this time around the parallels are there for everyone to see.

Birtles says Martin Currie conducted more than 100 meetings and engagements with local company management teams in August and the key conclusion from these insights is that an exuberant share market seems in contradiction with how tough the situation on the ground is for many companies.

It looks like there’s a veritable challenge ahead for companies to continue growing earnings per share and/or retain their margins. Martin Currie is therefore cautiously avoiding companies that seem priced for perfection. This in particular applies to many in the local Growth segment, suggests Birtles. His preference thus lays with Value stocks that are priced relatively cheaply.

Under normal circumstances, when the cycle moves through a rough patch, as is the case currently, investors find safety in defensive businesses, but Birtles sees risk from too high valuations. Companies he does like instead include South32 ((S32)), Worley ((WOR)) and Flight Centre Travel ((FLT)).

Portfolio managers at T Rowe Price would second that general assessment. They too have shifted general preference towards the cheaper priced segments of the local share market. Apart from elevated valuations, T Rowe Price also finds market participants seem too confident the RBA is about to embark on policy loosening, widely expected to start in February next year.

T Rowe Price is not so sure.

DNR Capital has noted the tough environment has made life difficult for many a small cap company in Australia, and that observation stood out throughout the August results season for the Australian investment manager. The antidote is Quality.

Quality small cap companies managed to outperform, both against their peers as against the broader index, DNR highlights. Some of the stand-out performances have been delivered by Breville Group ((BRG)), Hub24 ((HUB)) and Netwealth Group ((NWL)). The communication by DNR doesn’t spell it out, but we can probably safely assume all three are currently owned by DNR Capital’s Emerging Companies Fund.

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Morgans’ big observation is that mid-cap gold producers have yet to reflect the fact precious metals are now in a new bull market. The broker foresees a general re-rating regardless of company size and where key assets are located.

History suggests, assures Morgans, gold prices benefit hugely from central banks cutting rates.

Model Portfolios, Best Buys and Conviction Calls

Macquarie’s Quant team has identified those defensive names on the ASX most likely to benefit from falling interest rates, including:

-Aristocrat Leisure ((ALL))
-Codan ((CDA))
-Coles Group ((COL))
-Fisher & Paykel Healthcare
-GWA Group ((GWA))
-Harvey Norman ((HVN))
-Netwealth Group ((NWL))
-Pro Medicus ((PME))
-REA Group ((REA))
-ResMed ((RMD))
-TechnologyOne ((TNE))
-Ventia Services ((VNT))
-WiseTech Global ((WTC))

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Barrenjoey’s updated Top Picks:

-Insurance Australia Group ((IAG)) among financials, as well as GQG partners ((GQG)) and Westpac ((WBC))
-Xero ((XRO)), Pexa Group ((PXA)) and Dicker Data ((DDR)) in the technology sector
-Vicinity Centres ((VCX)) and Abacus Storage King ((ASK)) among REITs
-South32 ((S32)), Lynas Rare Earths ((LYC)) and Perseus Mining ((PRU)) among miners and Strike Energy ((STX)) in the oil&gas sector
-ResMed ((RMD))
-Metcash ((MTS))
-Aristocrat Leisure
-Reliance Worldwide ((RWC))
-Brambles ((BXB))
-Seven Group ((SVW))

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Jarden’s Best Ideas among emerging companies (small and mid-cap):

-IPH Ltd ((IPH))
-Temple & Webster
-EVT Ltd ((EVT))
-Dicker Data ((DDR))
-Universal Store ((UNI))
-Nick Scali ((NCK))
-AUB Group ((AUB))
-Webjet ((WEB))
-Integral Diagnostics ((IDX))
-Capricorn Metals ((CMM))
-Michael Hill ((MHJ))
-NRW Holdings ((NWH))
-Light & Wonder ((LNW))
-Pointsbet ((PBH))
-National Storage ((NSR))
-Ingenia Communities ((INA))
-Karoon Gas ((KAR))
-Domain Holdings Australia ((DHG))
-Pepper Money ((PPM))
-Telix Pharmaceuticals ((TLX))

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Stockbroker Morgans’ Best Ideas, freshly updated post the August results season:

-The Lottery Corp ((TLC))
-CSL ((CSL))
-QBE Insurance ((QBE))
-Woodside Energy ((WDS))
-GQG Partners ((GQG))
-WH Soul Pattinson ((SOL))
-ALS Ltd ((ALQ))
-Reliance Worldwide ((RWC))
-Beacon Lighting ((BLX))
-Amotiv ((AOV))
-Universal Store Holdings ((UNI))
-Elders ((ELD))
-Acrow ((ACF))
-Maas Group ((MGH))
-Karoon Energy ((KAR))
-ResMed ((RMD))
-NextDC ((NXT))
-Mach7 Technologies ((M7T))
-Camplify Holdings ((CHL))
-Superloop ((SLC))
-Treasury Wine Estates ((TWE))
-ClearView Wealth ((CVW))
-PolyNovo ((PNV))
-Flight Centre ((FLT))
-BHP Group ((BHP))
-Rio Tinto ((RIO))
-South32 ((S32))
-Dalrymple Bay Infrastructure ((DBI))
-Cedar Woods Properties ((CWP))
-Dexus Industria REIT ((DXI))
-HomeCo Daily Needs REIT ((HDN))
-Qualitas ((QAL))

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Post August, the Asia Conviction List at Goldman Sachs no longer includes Woolworths ((WOW)), but the stock has retained its inclusion for the broker’s APAC Conviction List. The added twist here is those who are responsible for one list are the same as for the other.

Only three other ASX-listed companies are included in both selections:

-Qantas Airways ((QAN))
-Lynas Rare Earths ((LYC))
-Xero ((XRO))

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The select list of highest conviction calls from analysts at Ord Minnett has seen numerous changes post August results.

Gone are Select Harvests ((SHV)), Webjet ((WEB)) and Whitehaven Coal ((WHC)). Instead, Electro Optic Systems, Qoria, SiteMinder and Stanmore Resources have been included.

The full list of Ord Minnett’s Conviction calls consists of the following 14 companies:

-Alliance Aviation Services ((AQZ))
-ARB Corp ((ARB))
-Cosol ((COS))
-EQT Holdings ((EQT))
-Electro Optic Systems Holdings ((EOS))
-Lindsay Australia ((LAU))
-Pinnacle Investment Management ((PNI))
-Qoria ((QOR))
-Red 5 (RED)
-Regis Healthcare ((REG))
-SiteMinder ((SDR))
-SRG Global ((SRG))
-Stanmore Resources ((SMR))
-Waypoint REIT ((WPR))

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Morningstar’s selection of Best Buys on the ASX:

-IGO Ltd ((IGO))
-TPG Telecom ((TPG))
-Domino’s Pizza ((DMP))
-Bapcor ((BAP))
-Endeavour Group ((EDV))
-Santos ((STO))
-ASX Ltd ((ASX))
-Aurizon Holdings ((AZJ))
-Brambles ((BXB))
-Dexus ((DXS))
-SiteMinder ((SDR))
-APA Group ((APA))
-Fineos Corp ((FCL))
-ResMed ((RMD))

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Key Stock Picks for the year-ahead nominated by analysts at Bell Potter:

-Among listed investment companies (LICs); Australian Foundation Investment Company ((AFI)), Metrics Master Income Trust ((MXT)), and MFF Capital Investments ((MFF))

-Agriculture & fast moving consumer goods; Bega Cheese ((BGA)), Rural Funds Group ((RFF)), and Elders ((ELD))

-Technology; TechnologyOne ((TNE)), Gentrack ((GTK)), and REA Group ((REA))

-Diversified Financials; Perpetual ((PPT)), Regal Partners ((RPL)), and McMillan Shakespeare ((MMS))

-Real Estate; Dexus Convenience Retail REIT ((DXS)), HealthCo Healthcare & Wellness REIT ((HCW)), and GDI Property Group ((GDI))

-Retailers; Premier Investments ((PMV)), Universal Store Holdings ((UNI)), and Propel Funeral Partners ((PFP))

-Aerospace & Defence; Electro Optic Systems ((EOS)) and Austal ((ASB))

-Industrials; Brickworks ((BKW)), IPD Group ((IPG)), and Cleanaway Waste Management ((CWY))

-Healthcare; Telix Pharmaceuticals ((TLX)), Cyclopharm ((CYC)), Aroa Bioscience ((ARX)), MedAdvisor ((MDR)), and Neuren Pharmaceuticals ((NEU))

-Gold sector; Capricorn Metals ((CMM)) and Santana Minerals ((SMI))

-Base metals; Aeris Resources ((AIS)), Nickel Industries ((NIC)), and Mineral Resources ((MIN))

-Strategic Minerals; Alpha HPA ((A4N)), IperionX ((IPX)), and Liontown Resources ((LTR))

-Energy sector; Boss Energy ((BOE)) and Paladin Energy ((PDN))

-Mining services; Seven Group Holdings ((SVW)), Mader Group ((MAD)), and SRG Global ((SRG))

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Morgan Stanley’s Australia Macro+ Focus List contains the following 10 stocks:

-Aristocrat Leisure ((ALL))
-Car Group ((CAR))
-CSL ((CSL))
-Macquarie Group ((MQG))
-Origin Energy ((ORG))
-Paladin Energy ((PDN))
-QBE Insurance ((QBE))
-Suncorp Group ((SUN))
-Treasury Wine Estates ((TWE))
-Woodside Energy ((WDS))

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Morgan Stanley’s Macro+ Model Portfolio consists of the following 32 constituents:

-ANZ Bank ((ANZ))
-CommBank ((CBA))
-National Australia Bank ((NAB))
-Westpac Bank ((WBC))
-Macquarie Group ((MQG))
-QBE Insurance ((QBE))
-Suncorp Group ((SUN))
-Goodman Group ((GMG))
-Scentre Group ((SCG))
-Stockland ((SGP))
-Aristocrat Leisure ((ALL))
-Car Group ((CAR))
-Domino’s Pizza ((DMP))
-The Lottery Corp ((TLC))
-Wesfarmers ((WES))
-James Hardie ((JHX))
-Orica ((ORI))
-Coles Group ((COL))
-Treasury Wine Estates ((TWE))
-CSL ((CSL))
-ResMed ((RMD))
-AGL Energy ((AGL))
-Origin Energy ((ORG))
-Telstra ((TLS))
-Transurban Group ((TCL))
-BHP Group ((BHP))
-Newmont Corp ((NEM))
-Rio Tinto ((RIO))
-South32 ((S32))
-Paladin Energy ((PDN))
-Santos ((STO))
-Woodside Energy ((WDS))

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Macquarie Wealth’s recommended Growth Portfolio:

-Goodman Group ((GMG))
-Seek ((SEK))
-Aristocrat leisure ((ALL))
-Northern Star ((NST))
-CSL ((CSL))
-Computershare ((CPU))
-NextDC ((NXT))
-Flight Centre ((FLT))
-Mineral Resources ((MIN))
-Cleanaway Waste Management ((CWY))
-Steadfast Group ((SDF))
-Arcadium Lithium ((LTM))
-ResMed ((RMD))
-Pexa Group ((PXA))
-Treasury Wine Estates ((TWE))
-Viva Energy ((VEA))
-Xero ((XRO))

Macquarie Wealth’s recommended Income Portfolio:

-Suncorp Group ((SUN))
-Telstra ((TLS))
-National Australia Bank ((NAB))
-Westpac Bank ((WBC))
-ANZ Bank ((ANZ))
-BHP Group ((BHP))
-CommBank ((CBA))
-Premier Investments ((PMV))
-Coles Group ((COL))
-Viva Energy ((VEA))
-Atlas Arteria ((ALX))
-Aurizon Holdings ((AZJ))
-APA Group ((APA))
-GPT Group ((GPT))
-Deterra Royalties ((DRR))
-Metcash ((MTS))
-Amotiv ((AOV))
-Charter Hall Retail REIT ((CQR))
-Amcor ((AMC))

In December, Shaw and Partners released its 10 Best Ideas to benefit from the anticipated small caps’ revival in 2024.

The selected ten:

-AIC Mines ((A1M))
-Austin Engineering ((ANG))
-FireFly Metals ((FFM)), previously AuTeco (AUT)
-Chrysos ((C79))
-Gentrack Group ((GTK))
-Metro Mining ((MMI))
-MMA Offshore ((MRM))
-Peninsula Energy ((PEN))
-ReadyTech Holdings ((RDY))
-Silex Energy ((SLX))

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Macquarie’s ASX Quality Compounders

The highest quality compounders’ as identified by Macquarie quant research inside the ASX300:

-James Hardie ((JHX))
-Cochlear ((COH))
-REA Group ((REA))
-TechnologyOne ((TNE))
-ResMed ((RMD))
-Data#3 ((DTL))
-Pro Medicus ((PME))
-Jumbo Interactive ((JIN))
-PWR Holdings ((PWH))
-Netwealth Group ((NWL))
-Aristocrat Leisure ((ALL))
-Spark New Zealand ((SPK))
-Codan ((CDA))
-Clinuvel Pharmacauticals ((CUV))
-Redox ((RDX))

Given Macquarie’s research strong leaning on the past five years, with high barriers to match, the following 11 companies fell just outside the above list:

-Fisher & Paykel Healthcare ((FPH))
-Medibank Private ((MPL))
-Coles Group ((COL))
-The Lottery Corp ((TLC))
-Lovisa Holdings ((LOV))
-CSL ((CSL))
-IDP Education ((IEL))
-Pinnacle Investment Management ((PNI))
-ARB Corp ((ARB))
-Breville Group ((BRG))
-Johns Lyng ((JLG))

My research and All-Weather stock selections are 24/7 available for paying subscribers: https://fnarena.com/index.php/analysis-data/all-weather-stocks/

This week’s Weekly Insights: https://fnarena.com/index.php/2024/09/25/rudis-view-growth-is-not-a-dirty-word/

(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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P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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