The environment of the market has shifted dramatically. With whispers of inflation, bubbles and bond yield prices rising, we have adapted our portfolio to reflect the evolving market. In this article Vince Pezzullo, Deputy Head of Equities discusses why cyclical stocks are an attractive part of the market and reflects on reporting season and the sectors that performed and disappointed. He also provides eight Australian and global stock ideas for the month ahead.
Economic re-opening afoot
The broad economic backdrop continues to be a complex mixture of opportunities and risks. The Australian and US economies continue to recover ahead of expectations. A dramatic steepening in the yield curve – with both Australian and US 10-year bond yields spiking but official cash rates staying near zero - has sparked a large rotation in equity markets. Expensive growth stocks have been crushed whilst value stocks, like many in the Perpetual Equity Investment Company (PIC) portfolio, that are geared to economic re-opening have enjoyed a bounce.
However, other risks such as inflation are also presenting themselves. COVID-19 virtually shut down global production last year, but demand was sustained through extraordinary stimulus measures from governments around the world. As companies ran down their spare inventories a mixture of supply dislocations and trade tensions has led to long waits for new consumer goods. As factories struggle to get production back online and rates for transportation and logistics surge, we believe the economy will likely experience a bout of inflation. There are also fears that the massive new US$1.9 trillion stimulus delivered by the US Congress is “too much, too late” in the cycle as consumer demand roars back to life. Like the stimuli in 2020 this is not indirect monetary stimulus likely to be trapped in bank reserves but a “hard money” fiscal injection, delivered directly into the hands of consumers with a high propensity to spend it.
In this environment we have continued to position the portfolio in a select mix of cyclical value stocks which we believe will benefit from the recovery.
We have also invested in mining companies that we think will do the same and also act as an inflation hedge, and a handful of companies that we believe are high quality, trading at reasonable prices and will benefit from structural growth.
Reporting season stars
Many key stocks in the PIC portfolio performed well through reporting season. Domestic industrial PWR Holdings Limited (ASX: PWH) was the top contributor to absolute performance in February for the PIC portfolio, rising 23.5%. Revenue at the automotive engineering firm rose 25% whilst rising volume, scale and efficiency gains helped push up margins and deliver a staggering 90% increase in net profit. We also considered the half year results from insurance broker AUB Group Limited (ASX: AUB) to be impressive, with the CEO delivering on his new strategy ahead of expectations. AUB’s core broking business did well, whilst the newly acquired BizCover stake (an online distribution platform) also contributed. Tight cost controls and the “hubbing” of smaller brokerages to generate back office synergies continued to pay off. Underlying net profit after tax for half year financial year 2021 rose 44.2% and the stock surged 17.4% for the month. As a result, AUB was the second largest contributor to absolute performance.
Amongst miners, OZ Minerals Limited (ASX: OZL) was the top contributor to the PIC portfolio with its share price rising 20.0% in February. OZL announced their full year results for financial year 2020 in February with net profit after tax rising 30% from $164 million in 2019 to $213 million for 2020. This was led by consistent production from Prominent Hill and a successful commissioning of the Carrapateena mine in South Australia.
We also have a position in Iluka Resources Limited (ASX: ILU) which performed well with the stock up 15.0% for the month. ILU reported a net profit after tax of $2.4 billion, although this included a $2.2 billion gain from the demerger of Deterra Royalties Limited (ASX: DRR), an iron ore royalty stream business. ILU is the largest producer of zircon and rutile in the world. Zircon is used in tile manufacturing as a hardening agent and rutile is a titanium dioxide feedstock mainly used in pigment for paints. The company also entered into a feasibility study to become the only fully integrated producer of rare earths in Australia by utilising stockpiles at its operations in Eneabba, Western Australia as well as feed from the Wimmera project in Victoria. Whilst it might cost $1.2 billion to develop the plant, mine and refinery required to create the rare earths business, we believe this could be an extremely valuable business by the second half of the decade.
We view banks as pro-cyclical stocks and have already observed normalisation following their high degree of caution during the height of COVID-19 through lowering the payout ratio for dividends and managing their capital position. Following APRA’s lift on the restriction on banks to cap dividend payouts at 50% of profits in December, we expect the banks to resume their payout ratios relatively soon. As at 28 February 2021, National Australia Bank Limited (ASX: NAB), ANZ Banking Group (ASX: ANZ) and Westpac Banking Corporation (ASX: WBC) together comprised 9.3% of the PIC portfolio. We expect our position in these banks will benefit in regard to portfolio return and generating franking credits for the portfolio.
Global businesses experiencing structural growth
Amongst the global stocks that have been identified, we have invested in what we consider to be excellent structural growth businesses that are trading at reasonable valuations and which we intend to own for a long time. For example, we have held our two largest positions in the PIC portfolio, Flutter Entertainment Plc (LON: FLTR) and La Francaise Des Jeux (PAR: FDJ), since 2019. Our research shows that FLTR has strong global sports betting and gaming brands with growing market share and strong cashflow generation. FLTR’s profit margins exceeded 30% and they have been a big winner from the shift from retail to online during COVID-19. In fact, 95% of FLTR’s revenue is generated online. FLTR has a track record of building profitable, market leading online positions in newly regulated markets and thus we see them very well placed to benefit as further global markets open up. The recent market leading position they have built in the rapidly growing US market is evidence of this.
We view FLTR as one of the highest quality businesses we have ever come across and their management team have demonstrated they are capable and long-term thinkers.
Whilst predicting stock movements month to month and year to year is difficult, we have little doubt that Flutter will be a much bigger business in 5 years.
Moreover, FLTR is committed to responsible gambling practices with a wide range of policies on responsible gambling and routine engagement with customers who may be at risk. FLTR continually invest in customer and staff education, drive collaboration across the industry and look at these initiatives as a short and long-term priority.
La Francaise des Jeux (PAR: FDJ) delivered an excellent result for financial year 2020 and returned 4.4% for the portfolio in February 2021. FDJ is a lottery monopoly which is shifting rapidly to online digital sales. We typically see profit margins of online sales being double retail sales. Therefore, we expect FDJ to deliver ongoing margin expansion as sales shift online resulting in a very attractive long-term profit growth outlook. We believe this will help grow the already solid 5% free cash flow yield of the business. The company also has €580 million in net cash on its balance sheet, equating to around 8% of its market capitalisation.
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