Fidelity's high conviction picks for disinflation and reflationary times

This article first appeared in Livewire Markets on 11 July 2023

There’s no prizes normally for guessing what types of companies are typically represented in an Australian portfolio. After all, coal and iron ore have been the historic structural supports for the Australian economy, while the Big Four banks continue to be reliable dividend payers. 

But Casey Mclean, portfolio manager for the Fidelity Australian Opportunities Fund, views the opportunity set differently.

While his highly concentrated fund favours materials and financials, it is underweight the banks and construction-related commodities (i.e. iron ore and coal). In fact, Mclean argues times are likely to get tougher for both these industries and he’s looking at other industries to gain from inflation and other global trends in the coming year.

For example, the fund’s overweight to materials comes from consumption-related commodities and building materials.

“Consumption-related commodities are more exposed to structural growth elements like decarbonisation. Think lithium for EVs, copper for solar and grid or rare earths for wind turbines. There are much better growth prospects here long term. Demand is supportive and supply keeps getting pushed back,” he says.

In this Rapid Fire, Mclean shares how he is positioning the Fidelity Australian Opportunities Fund for the coming market, the rationale behind two of the Fund’s biggest positions and where his high conviction picks in materials and financials lie.

What is one area of the market that has huge potential, but no one is paying attention to?

Small cap equities

Over the last two years, they've underperformed the broader market by about 20%, which is the biggest period of underperformance on record according to our technical analysts. When you think about the sort of composition of those small caps, they're generally quite highly leveraged to the cycle and to the macro environment. 

Although growth is slowing now, when that cycle does turn, a lot of these companies are going to be really well positioned. A lot of them are trading on trough multiples at this point in the cycle. It’s definitely an area I think will be more of a focus in coming periods.

What market themes are you monitoring for your portfolio in the coming year?

The main themes remain inflation and interest rates and that’s going to be the central tenant to performance for the foreseeable future. I think the dialogue is changing a bit and it will evolve over the next 12-18 months.

This year, it’s about disinflation. When we come to next year, the discussion could change to reflation and that’s going to be driven by the stickiness of services inflation, which is driven by wages growth. There are going to be winners and losers out of this.

The biggest loser is going to be the consumer discretionary sector because interest rates will stay high. The costs of non-discretionary components of household budgets, like childcare and the dentist, will stay high because wages are the vast majority of their underlying cost bases. This places pressure on discretionary goods spending. Some of that is already flowing through the household goods sector where there’s been multiple profit warnings and weaker results. There’s still a lot of play out.

On the flip side, I think the beneficiary of inflation and interest rates remaining higher for longer is the insurance sector. 

Inflation means they are able to increase their premiums at double digit rates for the medium term. This is aided by the amount of natural disasters we’ve had in Australia and in markets like the US which pushes up reinsurance rates.

The other side of the earnings equation is the investment returns they make when they invest the premiums. When interest rates were near zero, returns were poor. Now the interest rates are much higher, they’re earning good returns on that as well. The outlook for their earnings looks pretty strong over the medium term.

Australia is heading into El Nino which typically bodes poorly for bushfire season. Does that change the prospects for insurers?

It doesn’t change a great deal, it just changes the risk from floods to fires. There’s always something in Australia that is a risk. There’s always something you’ve got to be aware of, and unfortunately the worse the disasters are on a medium-term basis, the higher the premiums will go up to compensate for these disasters.

The long-term trend is for increased prevalence of these disasters and people need to be more insured to offset that risk from a household level.

What are the risks that insurers will lose some of their customer base as a result of inflation challenges and premiums rising?

There are two sides: personal insurance and commercial.

There’s much less risk in the commercial lines of insurance. There are often regulations around what companies need to have insurance for.

The alternative to personal insurance is to take out no insurance and self-insure. That is a trend when economic times get tougher, but I think insurance remains an essential. Catastrophes happen and people are very reluctant to cancel their insurance. There’ll be more shopping around as people try to find better prices, but that’s not a new trend either.

Woodside Energy (ASX: WDS) is one of your biggest overweight holdings. In light of the green transition, why is this company still a critical player?

When you think about the smaller or emerging countries around the world, gas really is the most viable source for base load power. I see it as complementary to renewables for the next few decades. 

Asian economies view it as a transition fuel and it’s something they plan to use while getting other low carbon base load energy sources online which takes a long time.

Australia is still an important source of exports to the global economy. While the viability of Australian gas exports has been undermined a bit by government policy, it remains one of the lowest cost sources out there. Gas will be well placed until the US supply hits the market late this decade.

In addition to that, Woodside is investing in hydrogen. It’s relatively small but has the potential to be a large market over the long term.

Woodside has good lower risk growth projects in low-risk jurisdictions as well. It’s attractively placed through its growth prospects and has a few catalysts over the medium term, like the sell down of their stake in Scarborough. (ASX: CAR) is another one of your overweight holdings. What is the rationale behind this?

The first reason is its scalable business model. 

It’s the same the world over when you think about selling a used car. You either trade it in through a dealer or you sell it privately. Carsales’ dominant ‘winner takes all’ positioning in Australia has come about because of the strategies they’ve implemented here. They’re now rolling out the strategies that have made them successful here in new markets overseas.

They bought the second-place player in Korea and they’re now the dominant player in that market and in that process, they’ve created huge shareholder wealth. They’ve just increased their stakes in Brazil and they’ve made another acquisition in the RV, trucks and power sports market in the US.

The second reason is that they’ve got multiple levers they can pull to increase yields.

They’ve made a more refined pricing algorithm around different pricing brackets for used cars and refined it around things like postcodes. They’re introducing new guarantee products in Korea. The most exciting product is their new ‘instant offer’ product just launched in Australia.

The beauty of it is that it allows them to get two bites of the cherry and profit twice from the same car sale. 

This is how it works. When you’re a private seller of a used car, the best price you can get is if you do it yourself. A lot of people initially pay $150 to list it on the website. People come around and kick the tyres and it’s a troublesome process. After a while, they decide it’s too hard. They go back onto the website and do instant offer where they plug in the details of their car, take a few photos and get a price back and the dealers will buy it off them instantly at that price. The dealer pays Carsales $500 for the privilege. They’ve been able to charge twice for the one car. They’ve only rolled it out to 70 or so dealers and there’s a long way to go. It can also be rolled out to additional markets.

In the short term, we’re seeing a bit of recovery in listings and volumes after covid. As the supply for new cars has normalised, people then turn over their used cars.

Overall, we see potential to compound earnings in the low teens for quite a while as they roll out these strategies to new markets.

Financials and materials are the biggest positions in your portfolio. Why is this?

We’re heavily overweight insurance and underweight the banks and that’s due to who we see as the real beneficiaries of inflation and interest rates.

The banks face an increasingly competitive market in mortgages and deposits. For example, rates on bonus savings accounts continue to go up outside of interest rate changes and that’s going to drag up prices on things like term deposits. We’re also reaching the phase of the market cycle where stresses increase. The cash rate above 4% seems to be a key pain threshold for mortgage holders and I think we’re going to see an increase in bad debts coming through.

We’re underweight construction-related commodities and overweight consumption-related commodities and building supplies.

We have a negative view on Chinese property which construction-related commodities like iron ore and coal are highly leveraged to. Chinese property demand is incredibly weak in 2023 and sales are down on the previous year. 

Given the political environment, we don’t anticipate major stimulus so we don’t see this trend changing. This means lower starts and weaker completions.

Consumption-related commodities are more exposed to structural growth elements like decarbonisation. Think lithium for EVs, copper for solar and grid or rare earths for wind turbines. There are much better growth prospects here long term. Demand is supportive and supply keeps getting pushed back.

Our view on overweighting building materials related to the US housing cycle which has been much more benign than expected. They typically have 30-year fixed mortgages. Once you’ve locked in low rates, you don’t want to move so you’ll do renovations and remodelling. Those looking to buy find limited turnover of secondary housing and are forced to build.

What’s your highest conviction position at the moment?

CSL (ASX: CSL) is operating in a very consolidated industry where some players are financially struggling. There will be increased price discipline over the long term, and better margins and returns.

CSL is a really innovative company and always defending against threats from competing products.

They have a product in trial at the moment, CSL 112, which is designed to flush cholesterol from your arteries after you have a heart attack. It’s a huge market and the product is derived from plasma that they’d previously discarded. That’s their modus operandi. Do more out of the same plasma product, derive more and gain more earnings potential from being a plasma leader.

I also back their management in terms of its ability to derive value out of acquisitions, like the Vifor Pharma acquisition.

CSL is a stock that can compound earnings in the mid teens over the very long term and it’s reasonably attractively priced at the moment.

What stocks would you avoid?

We avoid the lowest quality companies in the market. 

To us, that is companies that have over-leveraged balance sheets and haven’t earned their cost of capital across a full cycle. They might also have very poor cash flow and are often serial issuers of equity. 
It doesn’t rule out immature companies in early lifecycle, we take a longer-term view on those and how profitable they might be at maturity.

The chart: the strength of the ASX Materials sector

ASX 200 Materials v ASX200 for the past 12 months. Source: Market Index

Where do you see as the key drivers for returns in the materials sector going forward and how is the portfolio accessing those drivers? Can it continue to sustain its generally strong performance?

The key to the performance is commodity prices themselves. If you look at the composition of the sector, it’s heavily skewed towards iron ore and bulk commodities. That leads into our view that if construction-related commodities are going to be weak due to weakening Chinese property demand then the sector won’t outperform as a whole.

You need to be much more stock-specific or commodities-specific when picking stocks in that sector going forward. We view the best medium-term prospects as being the consumption-related commodities.

To finish on a lighter note, what celebrity does your fund embody?

Tom Hanks. He’s always dependable but can be the life of the party and have fun when needed. We’re really trying to make sure the fund doesn’t capture all the downside in down markets and then enjoy all the upside when the music is playing.