Hello and welcome to Views From the Top. My name's James Marley and I'm joined today by Casey McLean, who's the portfolio manager of the Fidelity Australian Opportunities Fund.
Now we've just come off the back of a busy reporting season. We've got a download from the CEOs on what's going on inside their companies. He's going to talk through some of the highlights, the lowlights and the opportunities that he's picked out of the companies he's following.
Casey, what was the main message that you took away from reporting season?
It was an incredibly interesting and volatile reporting season really, and I think the big picture is that we're in the midst of a macro slowdown, but it's not a collapse. If you look at the results, the FY23 numbers were pretty much in line with expectations. The real action was in the outlook statements and the guidance for FY24. What we saw was that revenue was largely in line with with what people were expecting.
But it was at the cost line that we saw the real surprises: wages, interest expenses, capex are going up. That meant that earnings missed and there was about four times the amount of downgrades as there were upgrades for FY24.
We saw some pretty big dispersion between companies in the same sector around that cost outlook. If you think about Westpac (ASX: WBC) in in the banks, their cost growth is running twice the pace of Commonwealth Bank (ASX: CBA) and that's off a lower lower base as well.
Coles (ASX: COL) is similar. They're running well ahead of Woolworths (ASX: WOW). Some of it is one-offs in their supply chain investments but a lot of it is permanent increases in wages, rents and salaries, and interestingly, they called out theft. That's shrinkage in retail speak, a big driver which was up 20% over the year and part of that is that Woolworths invested in technology ahead of Coles and it's made Coles an easier target. That's coupled with the cost of living pressures has meant you've seen increases in theft in their stores.
So costs was the key driver and that's where most of the discussions were focused over the reporting season.
It's all about expectations for markets. If markets expect a bad result and that's what comes out, there's not usually a huge reaction. From what you've heard, how different was reporting season to what you expected and was it better or worse than expected?
On the whole, it was worse than expected in terms of outlook but there were a few surprises.
Firstly, if you think about stock reactions for defensives versus more cyclical companies.
If a defensive company met expectations, it was sold off, whereas if a cyclical company just met expectations, it did pretty well. I think the difference there is the expectations of the market coming into results, but also positioning.
There has been a bit of a rotation out of those defensives.
The other thing that surprised a lot was dividends, particularly in the commodities and the mining space. Even within lithium companies, you saw a big divergence with Pilbara Minerals (ASX: PLS) disappointing on their dividend whereas IGO (ASX: IGO) increased their ordinary dividend, paid a special dividend. In total, it was almost double what the market was expecting and that led to big divergence, even within a very narrow group of companies like lithium.
What about your own portfolio? Was there anything that proved a catalyst for you to make a change, pick something up or dispose of something?
We've been making a few changes over the reporting season flowing into the months ahead. We've been trimming defensives, especially expensive defensives, which are proving less so now, and rotating into cheaper defensives with better, or more visible, earnings outlooks.
What's an example of a less expensive defensive asset?
One we like is Ventia (ASX: VNT) which is in maintenance services.
This is a company that has 95% of their contracts either cost-plus or schedule of rates, meaning they can pass through any cost in inflation. In fact, they can benefit, especially as labour pressures are easing. It trades on low double-digit multiples, has 7% yield and is growing high single digits as well at the top end of their own guidance.
Compare that to the likes of Telstra (ASX: TLS), which is double the multiple. Their growth is starting to slow a bit as well.
I've watched a few of the interviews you've given and read some of your articles. You've talked about holding a cautious view on the consumer and outlined rising costs, rents and other things putting pressure on the consumer. Can you discuss why you think consumer discretionary stocks were one of the few areas that bounced during August?
They were one of the better performing sectors and I think that reflects the expectations coming into the results. They were pretty low and expectations were met and there was a relief rally.
If you look longer term, it's pretty clear that there's a slowdown coming. Growth is slowing and sales are coming down. That is reflected in the FY24 earnings revisions. Macquarie only upgraded one of the 24 consumer discretionary stocks they cover for FY24. It was more a sign of a little bit of relief rather than something more sustained.
We're seeing a slowdown in consumer. It's just not the cliff that some people were expecting. There's still divergence within the consumer discretionary sector.
For instance, home electronics wore the slowdown first and now things are starting to look a bit better. But areas like apparel or fashion that are still to cycle through excess stock are seeing clear changes in consumer behaviour.
Coles talked about a survey of their own customers and they said 90% plan to change their behaviour in response to cost of living pressures. Coles classify their products as good, better and best. What they're seeing is there's a lot of trading down from the better category into the good.
At the same time, a lot of people are shifting from dining out in restaurants to dining in and shifting up from better to best. There are winners and losers out of this trading down environment, but what's pretty clear is that consumer behaviour is changing and it's still playing out.
The other thing you've talked about as a surprising beneficiary of inflation is the services sector. These are less discretionary style spends versus eating out or buying your food from Coles. Talk me through the thesis behind this beneficiary of sticky inflation.
I think services are both a cause and beneficiary of sticky inflation. If you step back, there's two key trends we can see in inflation.
Firstly, the headline inflation has peaked and is moderating, but core inflation is providing stickier than expected in both Australia and the US. When you break it down, headline inflation is mainly goods inflation, the discretionary element, the nice to have.
Once you've bought your TV in COVID, you don't need a second one. You don't need a second coffee machine. Demand is normalising and they are benefiting from supply chain normalisation. Whereas, if you think about the core inflation element, a lot of it is services, non-discretionary items. The essentials like dentists, childcare, hairdressers. The primary cost input there is wages. Wages growth is accelerating and that's pushing up prices in services.
The services companies that are able to pass through these cost pressures without seeing margin contraction are going to benefit. At the same time, if you have an inability to pass it on and cost pressures are hitting consumer spending in some categories, you will see companies with a bad outlook.
Is this something that you're investing in?
Yes. Ventia is a good example of a company that's going to benefit from services inflation, especially give the constraining factor for them has been labour. At the margin level, it's getting easier. They're seeing turnover levels reduced. The number of applicants for job openings are increasing as well.
Kelsian (ASX: KLS), the bus operator, echoes this as well.
They're adding 20 people per month now in their bus operations and are almost back to normal.
Telcos are still a beneficiary. They're trying to implement this new pricing regime around annual CPI increases in mobile, which seems to be sticking.
Another area is insurance, which is probably one of the biggest beneficiaries of sticky inflation given claims inflation. Reinsurance costs have gone up quite a lot from natural disasters and that's leading to rising premiums. At the same time, inflation leads to higher interest rates which is improving their investment returns. The earnings outlook for insurance companies looks quite attractive.
Is that an area you have the fund heavily exposed to?
It is. I think insurance is the key beneficiary of high interest rates rather than banks, where we're seeing a lot of competition on the mortgage side and on the deposit side where term deposit rates are going up quite sharply and bonus savings are going up outside of interest rate increases.
We're going to see this continue, even if interest rates peak. We're going to see continued mix shift within their funding arrangements as banks need to refinance the term funding facility (the almost free money the government gave out during covid).
Do you have a preferred play in the insurance space?
I think the safest and most visible growth is in the brokers where you don't suffer the underwriting risk that general insurers do. That's an attractive sector. They're just benefiting from the premium rate cycle.
Within the general insurers, QBE (ASX: QBE) looks attractive to me.
It's the cheapest of the major insurers. They also have a self-help story where they're improving their business quality, rationalising some lines in the US to improve profitability. I can see a sustained re-rating in that stock as their return on equity rises.
You're not alone in making this call, I've heard you describe the small cap sector as being cheap. It's underperformed relative to large caps for a sustained period of time. It's like the patient on the table waiting for some life to get breathed back into it. Is there anything you saw during August to suggest the outlook is improving?
As you say, the small cap sectors underperformed their large cap brethren by about 20% over the last two years, which is the largest on record. From a share price point of view, we're seeing that underperformance come to an end, but it hasn't yet started to outperform.
If you think about the commentary and economic indicators, it does like like there's a bit of life coming back into the sector. Small caps by nature are heavily leveraged to the macro environment and the economic cycle. There are some signs of positivity there.
If you think about housing approvals. Housing approvals might still be very weak, but housing prices have turned positive and listing volumes are rising now in Sydney and Melbourne.
In mining, exploration activity has been very weak but you've see a round of equity raising by the junior miners which can lead to more activity down the track.
Even within financials, the fund managers and platforms, the flows are improving.
So there's signs of life there, and it's definitely an area we're focused on in the upcoming cycle.
What about corporate activity? Has the phone been ringing for sounding you up for IPOs and appetite for that sort of stuff?
There's been a few raisings and a bit of a pipeline starting to build, but it's relatively thin at the moment.
There's only been one major IPO, Redox (ASX: RDX) recently, which was a moderate success.
I think that window for fresh equity is is opening now, and probably 2024 will be a much better year.
Now for a couple of questions to finish off the back of reporting season. What was a result that impressed you that you may have thought the market missed or flew under the radar?
One that I was focused on was Bapcor (ASX: BAP) who are an auto aftermarkets retailer and wholesaler.
In fact, 80% of their business is in trade or wholesale. Only 20% in retail and their results were largely unexciting. They met their guidance. Revenue grew by 10%. Margins improved in that core trade and wholesale part and that's what you'd expect. Their earnings are even countercyclical in that, when times get tough, you hang onto your car for longer. If it breaks, you have to fix it.
What I think really flew under the radar for them is their cost-out programme, which they call better than ever. They're targeting $100 million in net EBIT benefits by FY25. You compare that to their peak EBIT of $200million, so a 50% upside.
Prior to the results, the market was giving them virtually no credit for that cost programme. Many self-side estimates had zero benefit. What's becoming clear is that there's some low hanging fruit they can pluck to make cost improvements.
They've historically grown through M&A and bolting on new trades, companies, wholesalers. They haven't really talked to each other in terms of procurement, and now they're centralising procurement. They're rationalising their suppliers. Instead of one supplier in the oil field just supplying the trade business or just supplying the wholesale, they're negotiating it company wide and getting pricing discounts.
They're now implementing a hub and spoke supply chain model where the larger stores maintain a bigger inventory of the slow-moving parts, whereas the small stores maintain fast-moving parts and they share inventory amongst them as well.
It's getting much more visible that some of these benefits are really tangible. The stock trades on just mid-teens PE and I think it looks pretty attractive if they deliver even a portion of their cost out.
If reporting season was a health check on the Australian economy, what's the the diagnosis or the report that you would give as we head into 2024?
I think the Australian economy has got a bit of a sniffle but they've popped a codral and they're soldiering on at the moment. The question is whether that sniffle turns into something more virulent and I think the key to that is unemployment.
If unemployment rises much above 4.5%, that's when it could turn into a flu.
But Australia has the medicine to cure anything. We've now got room to cut rates. The population is growing. So even if the market does catch the flu, I think it will be relatively short-lived.
Our base case is that Australia still avoids a recession, at least at the aggregate level. I think within the market and the economy, there's still going to be pockets of stress and opportunities that come out of that.
Thanks very much for coming in today and for sharing your insights from what was, no doubt, a really busy but interesting reporting season.