11 October 2024
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This article was originally published on LivewireMarkets.com on May 3rd, 2023
Australia’s housing downturn is over – if you believe much of the recent commentary. And at least until Phil Lowe’s shock announcement yesterday, there was an overwhelming view that the Reserve Bank of Australia’s cash rate hiking cycle was done.
Juxtaposing these views with those seen earlier in the year are stark indicators of just how volatile these times are. And yet, equity market volatility – both in Australia and the US – has been muted in recent weeks, as emphasised by Innova Asset Management’s Max Pacella.
He spends most of his time glued to the macro situation in the US but emphasises how closely events there influence what happens in Australia. And the same applies of the “volatility on, volatility off” environment that has unfolded in the US and locally.
Pacella notes that realised volatility of the ASX 200 last week was just 5%, which he describes as “insanely low levels”. This follows from what he’s observed in the widely regarded CBOE VIX index in the US, which is currently near the low levels hit during the 2021 bull market.
Source: Bloomberg
“It’s part of a broader dynamic that is also reflected here. In March, you had this increase in volatility, fears about SVB and other things that all brought to mind the real and present dangers,” he says.
These events heralded recognition by investors that monetary policy was starting to “break things”. But this caution was short-lived, as demonstrated by the low levels of equity market volatility last month.
You can read more about how Pacella thinks about this volatility here. But the overarching point is that of investor complacency, which in itself can create opportunity.
“If you believe that risks are present but not priced in – such as a recession, a credit crisis or some other slowing of economic growth (and therefore company earnings) – then you want to avoid markets where tail risks are being priced away,” he says.
Pacella urges investors to focus primarily on trying to understand the dynamics at play here, rather than making wild portfolio tilts trying to benefit from some perceived edge.
Asked how investors should respond, he says it’s as much about what to avoid: “you really don’t want to own anything that’s exposed to these clear and present risks that most people don’t have any advantage forecasting.”
As a Value-focused fund manager, he’s favouring defensive cyclical stocks that are under-priced.
Investing in a choppy market
For a sense of how other professional investors are responding, I spoke with Elston Asset Management’s co-portfolio manager Bruce Williams. Among other strategies, Elston runs a style-neutral Australian equities large-cap fund that invests in up to 30 companies from the ASX 100.
Williams believes investor optimism remains too high, particularly around expectations for company earnings.
“We expect them (company earnings) to be wound back over the course of the year. Not massively so, but we think things will be more difficult,” he says.
Noting that many Australian companies have been successfully passing cost pressures through to their customers so far, Williams emphasises that “at some stage, aggressive price rises will result in customers buying less.”
“We think this year, companies will have a choice to make between maintaining volumes – but at lower margins. Or when it comes down to the strategy of the business, if they want to take market share, they may do that by not passing through all the cost pressures,” Williams says.
“Either way, we think top line revenue growth will be fine but at the margin there may be some sacrifices.”
Where are company valuations headed?
Recalling the investor euphoria of January, Williams believes share price performance was driven not by growth in earnings but by PE multiple expansion.
He’s glad to say his team didn’t buy into the euphoria but instead became more defensive – a response that was borne out in the half-yearly company reporting season in February when a majority of companies either met or exceeded his expectations.
On aggregate, he regards company valuations as more realistic now than they were 12 months ago but says “The devil is in the detail”.
Williams believes Energy and Materials are the outliers, with many companies in these sectors trading at very low PE multiples because they’re continuing to over-earn. That’s because of the ongoing strength in commodity prices – particularly iron ore – and higher energy prices driven by the Russia-Ukraine war.
As the earnings of companies in these sectors normalise, he expects to see a slight increase in their PE multiples.
But the Industrial, Healthcare and Telecommunications sectors are still trading above their long-term averages – so he sees little chance of PE multiples expanding in these areas.
How Elston is positioned
The Elston portfolio was overweight to cyclical sectors coming out of COVID. But in the last six months, the team has been adding to its structural growth allocation, based on its view that cyclical growth will be more elusive in a slowing economy. This view has been further bolstered by contracting PE multiples in structural growth companies, which has increased their comfort in buying them.
“We’re still reasonably positive on energy because we think all the government intervention and the lack of clarity in the operating environment will lead to reduced future supply,” Williams says.
“Particularly with gas, we expect a structural shortfall, even just from new projects not coming online within the expected timeframes.
One of Elston’s portfolio positions here is Worley (ASX: WOR), but Williams emphasises this is driven primarily by his energy transition thesis rather than anticipated supply challenges.
Structural growth stocks
CSL Limited (ASX: CSL)
Williams acknowledges the global biotechnology firm isn’t a particularly novel choice, given it’s such a well-established company that’s become almost a household name domestically. But he references the difficulty its core blood plasma business faced throughout the pandemic and its subsequent recovery and current setup for more structural growth.
It’s also currently rated as a STRONG BUY according to Market Index’s broker consensus. As of 1 April, 18 brokers rate the stock as a buy, two as a hold, and one as a sell.
Source: Market Index
Carsales.com (ASX: CAR)
The online automotive portal also presents as a BUY according to Market Index, with 11 buy ratings, six holds and only two sells.
Investment bank Citi recently initiated coverage of Carsales.com with a BUY rating and a price target of $25.80 – an 11% premium to its latest closing price.
Source: Market Index
IDP Education (ASX: IEL)
A provider of international student placement services and English-language testing services, IDP Education owns and operates language schools in Australia and Southeast Asia.
Market Index’s broker consensus view rates it as a STRONG BUY, with 14 brokers rating it a buy, two holds and one sell.
Credit Suisse’s 13 March rating of OUTPERFORM set a price target of $35.50 for IDP Education – a 30% premium to its latest closing price.
Source: Market Index
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