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This article was originally published on LivewireMarkets.com on July 17th, 2023
There are plenty of famous pairs in life. John Lennon and Paul McCartney, Tom and Jerry, Mario and Luigi just to name a few. When it comes to investing and specifically investing in stocks, large cap stocks are generally paired with the term “quality”.
That’s because these companies tend to have sturdier balance sheets, larger and more reliable customer bases, and dominant market positions.
And as volatility and uncertainty have spiked across markets, investors have been running into these quality names in droves. But what does quality mean in this environment – and which large-caps are the most worthy of your cash right now?
Livewire’s Buy Hold Sell is here to help separate the good from the bad and the great from the good in the large end of the market. Moderator Hans Lee is joined by Andrew McKie from Elston Asset Management and Rob Crookston from WILSONS to discuss how they find “quality” companies on the ASX.
And just to show our fund managers can put their money where their mouth is, we asked them to pick their favoured large-cap among five pairs of options.
Note: This episode was taped on Wednesday 12 July 2023. You can watch the video, listen to the podcast, or read our edited transcript below.
Edited transcript
Hans Lee: Hello, I’m Hans Lee from Livewire Markets and this is the thematic episode of Buy Hold Sell. Today, we’re talking large caps because these are the stocks that are often touted to best weather the ups and downs of the economic cycle, but which large caps are the cream of the crop right now? Let’s probe those questions with Andrew McKie of Elston Asset Management and Rob Crookston of Wilsons. Thank you, gentlemen, for joining me. Good to see you.
One thing we associate often with large caps is this whole idea about quality and quality investments. So, I’m curious to hear from both of you and maybe, Andrew, we’ll start with you for this one. Are there any specific metrics or standards that you use to evaluate quality?
How do you assess quality?
Andrew McKie: We’re guided by Porter’s Five Forces when we look at quality. If you think of that, what sort of business do we want to own? Dominant market position, unlikely to have a competitor, not easily substituted. They’ve got dominance over their suppliers, and they’ve got a diversified customer base. If you’ve got all those attributes in terms of a business, we would say that is high quality and we would be prepared to pay a premium for that business, which is intuitive, it makes sense. You want to be in a position where you don’t have any competition, you won’t likely have any competition going forward, and so we think that that leads to higher margins and more sustainable business longer term.
Hans Lee: All right, so Porter’s Five Forces for Andrew. What do you guys use at Wilsons?
Rob Crookston: There are two different ways we look at it. We’ve got the quantitative methods, so strong balance sheets, high profitability, strong margins, high returns, and invested capital. And you’ve got your qualitative as well – the calibre of the management team, the long-term strategy. Can this company grow its earnings over the cycle? And that’s really the key as well. Competitive advantage, competitive position is also very important. So, we try and tick a lot of those boxes when we think about stocks.
Hans Lee: Understood. So given where we are in the cycle, Rob, what do you think are some of the more appealing aspects of large caps right now?
Why large caps right now?
Rob Crookston: Well, I think there will still be this flight to quality over the next six to 12 months as we see the economy slow further from here. And as we spoke about, large caps are normally more mature companies, typically a bit more resilient and probably tick a few more those quality metrics that we spoke about earlier.
Hans Lee: Andrew, would you share that view?
Andrew McKie: I think dominant market position for us. That probably leads to pricing power. So in a rising inflationary environment, you’ve obviously got cost pressures. As a business, to be able to pass those on as price increase, maintain margin, that’s probably the key attribute at the moment of large caps.
Hans Lee: So equally then, what would you say is maybe the biggest risk or concern that investors should be aware of with large caps?
What about the risks?
Andrew McKie: Well, interrelated to pricing power, there’s a point where you increase prices so far that you actually undermine demand. So, it’s demand destruction if you like. So, if you’re thinking about the end consumer or for businesses, your end customer, you might be able to sustain price increases for so long before you see that decay in your top line from a demand perspective. So, I think that is certainly a concern, especially as you go into a rolling off GDP environment, and related to that, I think looming is regulatory risk, particularly around consumers. So, if you’re thinking of something like insurance, insurance premiums, cost of living, regulatory oversight of companies that have dominant market positions, that’s likely to come out of this environment.
Hans Lee: What would you say, Rob, to that?
Rob Crookston: It’s not really a concern, but we do look outside the 100 for better growth opportunities. Sometimes we find that within the 100 there can be some crowded trades, especially those loved growth stories that you see in the hundreds. So, we normally find there are better growth stories that are less crowded, so you buy them at a better valuation outside the 100, so we like to look outside at small caps as well as with the larger as well.
What about the price?
Hans Lee: Well, of course, it’s not just about what you buy, but it’s also about the price you pay. So, what metrics do Wilsons use to decide if now is a good entry point for a stock or not?
Rob Crookston: I guess you go for your classic earnings multiples, so price to earnings would be one, but for us, it’s about balancing earnings and earnings growth with that P multiple, so we’re happy to pay a higher price or a higher multiple for a stock as long as it’s coupled with higher growth over the medium term, so we’re looking at PEs but it’s not the be all end all, it’s all about growth as well.
Hans Lee: Andrew, you were talking earlier about paying up for a premium for companies that you deemed to be high quality enough.
Andrew McKie: I think by extension from what Rob was saying, it is. We are a relative growth manager, and we’re style neutral, so we’re happy to pay up for a business from a multiple perspective if the earnings are there to justify that, and so we would always look at businesses on that basis. We keep it pretty simple. We’re glorified valuers at the end of the day, so we value businesses out four years’ time. We then work backwards to work out what the potential return is in today’s dollars based in terms of capital appreciation, dividend and franking credits, which drives our expected return and that really drives our relative decision making. So, if we owned a company that had a negative return on that basis, obviously that would prompt us to make a relative decision, so that’s how we work.
Battle of the Large Caps
Hans Lee: We’re going to wrap this episode up now with a couple of stock picks and what we’re going to do is we’re going to share some pairs of large caps with you both and all you have to do is tell me which one you prefer and why. Andrew, I might stay with you for the first one. We’ll talk about the big miners. You can have BHP with its 9% dividend yield or Rio with its 6% dividend yield. Which one do you prefer and why?
BHP Group (ASX: BHP) or Rio Tinto (ASX: RIO)?
Andrew McKie (RIO): We’d probably lean slightly towards RIO at the moment. They are certainly both well diversified, with world-class assets, world-class management returns, margins, return on equity, cash flows – you can tick all the boxes for both businesses. At the moment from an investor’s perspective, we think on a relative valuation we would lean towards RIO.
Hans Lee: So, Andrew is going with the RIO. Rob, do you share that view?
Rob Crookston (BHP): Yeah, agreed. Both are high-quality businesses, but we’d probably lean towards BHP and that’s really due to the copper exposure in BHP. We are copper bulls. We expect there to be a strong and long copper cycle to come ahead of us, driven by the energy transition and you look at BHP, around about 40% of revenue we expect to be from copper and in FY24, about 20% for Rio is copper. So for us, BHP wins really on that copper view.
Commonwealth Bank (ASX: CBA) or Westpac Banking Corporation (ASX: WBC)?
Hans Lee: Interesting. Rob, we’ll go to the banks for you now. You can have Commonwealth Bank with its four and a quarter percent dividend yield or you can have Westpac with its 6% dividend yield. What do you prefer and why?
Rob Crookston (WBC): We’ll go for Westpac really on a valuation basis. I think CBA is one of the highest-quality banks probably in the world, but it’s also one of the most expensive. So, we think CBA deserves a premium relative to Westpac, but really that premium looks very stretched and has looked stretched since the pandemic. It’s priced for perfection at the moment going into what we think is quite a difficult environment for the banks. So it’s Westpac on a valuation basis.
Hans Lee: Both banks have roughly about 2% net interest margin. What way are you going to follow on this, Andrew?
Andrew McKie (WBC): We’re going to follow Rob into this one as well in terms of Westpac. Clearly, the franchise for Commonwealth Bank is excellent in terms of retail, and return equity is much higher than Westpac. But we don’t think that because it’s quality, that necessarily means Westpac is low quality. And so, I think justifying a 45% premium in terms of valuation on Westpac over CBA is really hard to get to that number, and so we’d be leaning towards Rob as well, and going Westpac at the moment from a total return point of view.
Xero (ASX: XRO) or WiseTech Global (ASX: WTC)?
Hans Lee: Tech stocks now. Andrew, you can pick between Xero, which is up 40% year to date, or you can have WiseTech which is up something in the order of 90% year to date. Which one do you prefer and why?
Andrew McKie (WTC): This is actually quite a simple one for us. We’d definitely go WiseTech out of the two. For Xero, I think the domestic division is a fine, fairly robust business, a dominant position in terms of accounting software, but their growth and expansion are international and if you look at their churn rates versus domestic, if you look at their cost of acquisition of new clients internationally as well, if you look at the competitive context internationally, if you look at how much work they’ve got to do in terms of meet expectations of the market from an EBIT margin point of view, they’ve really got to deliver. Whereas WiseTech is already delivering. They’ve already got a great business, we see multiple pathways for them to continue to grow earnings and although they’re both premium businesses in terms of multiple to the market, we think that WiseTech is worth the bet. It’s more justified in terms of multiple because of the risk.
Hans Lee: Interesting, all right. Go with the company that’s already delivering, I guess. Rob, what do you think? Would you go with Xero or WiseTech?
Rob Crookston (XRO): We like both, we think they’re great growth stories. For us it’s Xero. There are a few more levers that management can pull at the moment. I think the first is pricing, so it’s a pretty mature business in Australia and New Zealand. For us what Xero offers, it’s a cheap price per month. So, we think there can be price increases and that can be above consensus. The other lever is cost. The management has started to do that already. They’re balancing growth and profitability better than the previous management were, and that’s something that we like and we think there can be more cost out. We looked at the cost for Xero, remember, 80% of those costs are what we call ‘growth’ costs. I’m not saying that all of those are going to go, but we think there’s substantial room for more cost out in the business.
Sonic Healthcare (ASX: SHL) or CSL Limited (ASX: CSL)?
Hans Lee: All right, healthcare is next up for this pair. Rob, you can have Sonic Healthcare with a trailing PE ratio of 16 or you can have the big one, CSL with a trailing PE ratio of 61.
Rob Crookston (CSL): For us it’s CSL. We spoke about quality right at the beginning. It ticks all of those boxes that we spoke about. There’s been a bit of a hiccup with the downgrade last month, but that doesn’t really deter us from CSL. I think it’s a short-term hiccup. Consensus got ahead of itself. So, we’re still believers in the medium to long-term story of CSL. Sonic I see it as a COVID winner, a COVID beneficiary. There’s so much uncertainty about where the earnings are going to be over the next couple of years after the sugar hit from COVID, so I’d prefer CSL.
Hans Lee: Andrew, are you going to go the same way?
Andrew McKie (CSL): Yeah, we pick the same. If you look at PEs, you’ve got to look at the E, and so if you look at Sonic, it’s benefited a lot from COVID. It’s a really COVID simple story between the two. COVID beneficiary in Sonic, particularly around laboratory and obviously pathology, and then you’ve got a COVID-impacted business in CSL with a plasma division. So in terms of collections, in terms of cost of collections for plasma, COVID impacted, and then if you look at the Vifor acquisition, we see a clearer pathway for earnings growth from here over the next four years for CSL than Sonic, and so that’s why we’d much prefer, especially after de-rating recently, CSL.
Woodside Energy (ASX: WDS) or Santos (ASX: STO)?
Hans Lee: The last pair is all about energy. Andrew, you can have Woodside with its 11% dividend yield or you can have Santos where of the 20 brokers that market index tracks, 19 of them rate it as a buy. Woodside or Santos?
Andrew McKie (WDS): We’ve got both in the portfolio, we do like the energy transition base load generation demand for LNG globally and we think that’s a long-term thematic. So, both of those are good, but if we had to choose, it would be – pardon the pun – on the side of Woodside. We think more diversified, better returns. If you look at their margins, their return on capital, their cash flows, their gearing. Their balance sheet strength as well is superior to Santos. I think the assets are simpler to understand. So if we had to choose, we’d go Woodside.
Hans Lee: Rob, do you feel the same way?
Rob Crookston (WDS): Like Andrew, we like the long-term thematic for gas and LNG. For us, Woodside at the moment, they’re balancing their production growth and their return of capital to shareholders and we’re seeing that with the dividend yield last year. I think they’re managing that balance better than Santos and I think that’s the reason why it’s outperformed over the last 12 to 18 months.
Hans Lee: Rob Crookston from Wilsons and Andrew McKie there from Elston Asset Management and thank you for joining us. If you enjoyed that episode of Buy Hold Sell, why don’t you subscribe to our YouTube channel and give us a like, and of course, subscribe to the Livewire Markets and Market Index websites. We’ll see you next time for another Buy Hold Sell.
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