Rudi’s View: Market Reflects Risk & Opportunities

This story features GOODMAN GROUP, and other companies. For more info SHARE ANALYSIS: GMG

In this week’s Weekly Insights:

-Market Reflects Risk & Opportunities
-All-Weather Model Portfolio

By Rudi Filapek-Vandyck, Editor

Market Reflects Risk & Opportunities

It is easy, probably too easy, to be deterred by what looks like richly priced asset prices, but if the years past have shown one key message for investors, it is that present ‘valuation’ is only one aspect of the investment proposition.

It is much more difficult to understand the broader context in the background and why a valuation that looks beyond ‘normal’ can still be an attractive investment. I think this is one reason as to why the adage of bull markets climbing a wall of worry equally applies today.

Markets are forward looking. All investors understand the basic principle, but not so much when forward-looking translates into above-average valuation multiples in anticipation of better times ahead.

The last time we were all confronted with seemingly eye-watering PE multiples happened after covid temporarily closed down societies.

Those voices warning about an impending market crash based on historically outsized PE multiples have long gone silent as they ignored the one key reason why valuations at that time had to be well-above the long-term average: the subsequent recovery in earnings and cash flows would automatically pull back multiples to more moderate levels, and that’s exactly what happened in 2021.

It is true large parts of highly-valued equities experienced a tough time throughout most of 2022, but that was a consequence of bond markets resetting from exceptionally low yields, with follow-on impact on equity multiples, irrespective of where those multiples were at.

The carrot of rate cuts

Since this time last year, equities are at it yet again, rallying hard to push average market multiples well above long-term averages, simply because central banks were preparing for rate cuts. That process has now well and truly begun. The RBA will join-in at some stage, exact timing still unclear.

But equities have not subsided, not even when the historical pattern of seasonal weakness in September would have suggested this might happen. So, is this the mother of all bubbles, as some narky observers have declared it is, or is there a better, more accurate explanation, just as was the case back in 2020 and 2021 (as it equally applied back in 2009 and in 2001)?

The first thing to note is that if/when rising bond yields impose a negative correction on equity valuations generally, then the opposite happening allows for valuations to rise again.

This process becomes even more ‘logical’ when those benefiting from lower yields are also benefiting from the newest megatrend on the menu, one that most likely will stick around for much longer and plausibly will re-shape the decade ahead for businesses and economies.

That’s simply par for the course, or, to put it differently: normal investor behaviour. Shares in Goodman Group ((GMG)) and NextDC ((NXT)) and the likes are now expressing general investor confidence that many billions in investment will be made in new data centres and this should -all else remaining equal- translate into above-average growth for such beneficiaries for multiple years into the future.

There is another, equally important factor in play: lower yields support and stimulate economic activity.

The broadening of the market rally

The larger part of Australian businesses listed on the ASX has had a tough time since 2022, as yet again proven throughout the recent August results season, which ranks among the worst locally post 2013 (that’s how far the FNArena data history stretches).

History suggests what usually follows a coordinated global tightening cycle is economic recession, in which case today’s market ‘exuberance’ would look painfully misplaced. But that is clearly not what equity markets are reflecting. Instead, general confidence is rising that central banks, and governments, might be able to pull off that rather rare outcome: a ‘soft’ landing.

Recent economic data, including Friday’s non-farm payroll upside surprise have only further strengthened general confidence in a different outcome this time around.

There are, of course, no guarantees. If/when the economic picture deteriorates to the point where such a favourable outcome becomes less plausible, valuations will have to shrink and today’s prices and multiples will be judged as utter fantasy in the months to follow.

The fact authorities in China are now actively stimulating their sluggish domestic activity levels adds further credence to the ‘soft’ global landing scenario, though, admittedly, still does not guarantee such a favourable outcome.

One of the dangers with the market’s forward-looking optimism is there remains plenty of potential for mishaps and disappointment until rate cuts and lower bond yields start positively impacting on economic activity. Witness, for example, the numerous ‘punishments’ that have occurred in August locally.

Australia’s AGM season

The upcoming AGM season in Australia, which increasingly acts like a mini-results season for the ASX, might well deliver more of the same. Last week, analysts at Macquarie lined up their favourites and better-be-careful warnings for upcoming AGM trading updates.

Companies expected to deliver a positive catalyst for their share price include Amcor ((AMC)), Charter Hall ((CHC)), Flight Centre ((FLT)), JB Hi-Fi ((JBH)), Qantas Airways ((QAN)), Treasury Wine Estates ((TWE)) and Worley ((WOR)).

Outside the Top100, Macquarie is equally optimistic for Auckland International Airport ((AIA)), Propel Funeral Partners ((PFP)) and Harvey Norman ((HVN)).

Companies expected to potentially surprise negatively include Dexus ((DXS)), Vicinity Centres ((VCX)) and WiseTech Global ((WTC)).

Outside the Top100, Macquarie preaches caution towards Domain Holdings Australia ((DHG)), Domino’s Pizza ((DMP)), Global Lithium Resources ((GL1)), Jumbo Interactive ((JIN)), Nine Entertainment ((NEC)), Star Entertainment ((SGR)), and Seven West Media ((SWM)).

Note how Macquarie’s analysis mentions more smaller-cap companies and REITs on the ‘potentially negative’ list for the months ahead. Both segments are considered integral to the market’s broadening momentum upwards in anticipation of next year’s economic recovery, but this does not remove the associated risks in the shorter-term.

Equally noteworthy, the mentioning of local star-(out)performer WiseTech Global has coincided with a 90 pages in-depth study released by analysts at RBC Capital in which the observation is made that supply chains are ‘evolving’ post covid-interruptions, with software playing a central role in creating more agility and flexibility for companies, while also lifting productivity and reducing costs.

Supply chain software is projected to outgrow the software market generally in the years to come, with Gartner forecasting 16% CAGR by 2028. Key beneficiaries of this new trend should be sector giants SAP and Oracle, but also ASX-listed WiseTech Global.

Post a tremendous share price rally thus far in 2024 (up circa 75%), RBC Capital sticks with a Sector Perform rating for WiseTech, awaiting a better entry point, but common sense tells me if Gartner’s projections prove correct, and management at WiseTech continues to execute on plans and promises, a much lower share price might well remain a pipedream, or turn into a very brief phenomenon in case misfortune does happen.

A similar logic is likely to apply to another local star stock, with Pro Medicus ((PME)) announcing on Monday a sizable contract renewal from Mercy Health. The most remarkable characteristic of the announcement is the price for ongoing services in the next eight years is 172% higher than the two previous contracts.

It has led to analysts at RBC Capital commenting as follows: “The improved terms on the contract in conjunction with increased volume reinforce the thesis that Visage delivers strong ROI for clients.”

The same observation has been made in the past about WiseTech services and lasting benefits for its clients in global logistics.

The market doesn’t need any additional confirmation that companies such as WiseTech and Pro Medicus are growing strongly, and will continue to do so for much longer. And we might as well throw in Macquarie Group ((MQG)), Car Group ((CAR)), REA Group ((REA)), Hub24 ((HUB)), Aristocrat Leisure ((ALL)) and TechnologyOne ((TNE)) as well, among others.

But what about the likes of ALS Ltd ((ALQ)), Charter Hall ((CHC)), Dicker Data ((DDR)), NRW Holdings ((NWH)), Objective Corp ((OCL)), Seek ((SEK)), Strike Energy ((STX)) and Whitehaven Coal ((WHC)) among many, many others?

Those are the questions that need to find a conclusive answer in the months ahead.

Reasons for optimism

If we take an optimistic approach, and there will be no economic recession, a bigger war in the Middle East or resurgence in inflation, there seems to be plenty on the horizon to genuinely get excited about, including several megatrends that should stick around for much longer, and make their impact felt across large parts of the business community.

The positive outlook from megatrends does not simply stop with Gen.Ai, but also still includes the electrification of everything, the energy transition, the digitisation of business and decarbonisation/clean energy. All require investments and virtually guarantee a sizable pick-up in capex. In the US, the reshoring of manufacturing adds a specific additional capex and growth driver.

One extra positive surprise that is not necessarily on many an Australian investor’s radar might well be located across the Tasman Sea, where the RBNZ is believed to be contemplating a sharp easing cycle in order to kickstart the domestic economy back in gear. By early next year the official cash rate in New Zealand (currently 5.25%) is projected to be below that in Australia.

A recovery in the Kiwi economy should also benefit ASX-listed companies with sizable exposures. Recent research by Morgan Stanley has highlighted ANZ Bank ((ANZ)) and National Australia Bank ((NAB)) among the banks, alongside Insurance Australia Group ((IAG)), Dicker Data, Fleetpartners ((FPR)), Harvey Norman, and Ampol ((ALD)), in addition to most NZ-headquartered businesses, of course, including Fletcher Building ((FBU)), Sky Network Television ((SKT)) and Spark New Zealand ((SPK)).

Among emerging economies, a new credit cycle is seen for countries including India, Indonesia, Malaysia and Brazil, driven by both public and private investments, while also benefiting from the West de-coupling from China.

Even without the growing demand for data centres, most countries are in need of substantial investment in resilient electrification infrastructure and renewables.

Reasons for caution

In terms of risks, there remain plenty, as is pretty much always the case. One year after Oct 7, Israel sees a future at war, the Wall Street Journal headlined on Monday. One strategist at Morgan Stanley reported: “Clients are asking how much upside this shift could provide to Chinese growth and whether we are entering a new cycle. I have quipped that we are hopeful but not yet confident.”

It goes without saying, if a recovery in the global economy puts a rocket under commodity prices, the upside for producers and explorers in mining and energy can be beyond investors’ wildest expectations, potentially.

Even without economic recession, global growth can still disappoint to the downside before resuming an upward trend. And let’s not forget the upcoming US presidential election on November 5.

Investors’ attention seems very much focused on the differences in policies between the two main candidates, but I worry Republicans around Trump have put so many preparations in place that can support them in reversing or challenging unfavourable outcomes at the ballot box.

The next shock might well show up in the days immediately after the US political contest.

In terms of current market forecasts, the ongoing debate in the US is all about whether forecasts are not too high, in particular for 2025 when a number of present tailwinds might be no more or might turn into headwinds instead. The Q3 US results season starts on Friday.

In Australia, the opposite debate is opening up.

Post the disappointing August results season, the local FY24 consensus EPS forecast has tumbled to a negative -5.4% while the prospect for EPS growth in FY25 has now shrunk below 2%. Might this be the bottom in the cycle?

Strategists at UBS think the answer is ‘yes’. UBS can see the ingredients forming for a renewed up-cycle in analysts’ expectations with average EPS growth more likely to end at 6% by mid-2025 instead of the current dismal, below-trend and below long-term average number that has resulted from ongoing downgrades implemented by analysts up until today.

Taking a leaf from history, UBS posits the year post the Federal Reserve starting to lower interest rates is usually beneficial for Australian equities, as long as no economic recession follows. Those forthcoming upgrades to earnings projections should alleviate some pressure off valuations, say the strategists.

Meanwhile, the forward-looking PE ratio for the ASX200 has now surged above 18x, a number not seen since covid or the dot com boom. The index composition has changed over time, and analysts’ EPS projections are still declining, which in combination with rising share prices leads to what looks like a very unfavourable average PE multiple.

UBS is projecting the ASX200 at 8500 by mid next year.

See also last Thursday’s: https://fnarena.com/index.php/2024/10/03/rudis-view-agl-gpt-james-hardie-qantas-pilbara-xero/

And Weekly Insights one week ago: https://fnarena.com/index.php/2024/10/02/rudis-view-ten-highflyers-with-more-upside-potential/

All-Weather Model Portfolio

The switch in market momentum in September has meant the All-Weather Model Portfolio could not keep up with the local index, but that’s not such a bad thing in light of the significant gap in performance over the year past.

Among the positive contributors for the Portfolio in September were WiseTech Global, Goodman Group, Aristocrat Leisure, Macquarie Group, TechOne and gold. All these positive contributions have accumulated over multiple years, which fits in well with the underlying philosophy as well as the core of my personal research.

Model Portfolios, Best Buys & Conviction Calls

This section appears from now on every Thursday morning in a separate update on the website. See Rudi’s Views for the archive going back to 2006 (not a typo).

FNArena Subscription

A subscription to FNArena (6 or 12 months) comes with an archive of Special Reports (21 since 2006); examples below.

(This story was written on Monday, 7th October, 2024. 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