Australian equities: Is the market too optimistic?

Ask Peter Bell — Co-founder and Director at Bellmont Securities — whether he thinks the Australian stock market is optimistically priced, and he believes there is wide dispersion in the optimism priced into certain sectors of the market.

“Looking at the market, what we’re seeing right now are a lot of fund managers moving to defensive exposures, such as large caps and non-cyclical businesses. At the same time, we’re seeing really heavy sell off in some of those unloved sectors where there are difficulties in moving forward, like consumer discretionary and small listed companies,” says Peter.

“I believe there is wide dispersion in terms of how the Australian equities market is priced, which may be completely appropriate if you look at the environment over the next 12 months. However, if you’re a longer term investor — five years out — you can look beyond this short-term focus on whether there will be an economic downturn over the next year or so. By doing so, it introduces investors to some real opportunities in the relative valuation of stocks in different parts of the market.”

David Wanis, CFA — Founding Partner, CIO and Portfolio Manager at Longwave Capital — agrees that small caps are currently unloved, with many investors abandoning this part of the market to go defensive, as they seek to weather inflation and general market uncertainty. But despite this, David believes there are good opportunities in the small caps sector.

According to Hamish Tadgell — Portfolio Manager at SG Hiscock — the economy is currently very uneven, with some sectors prospering, while other sectors are doing it tough. This is showing up in how the economy is performing at different speeds, which then feeds through to different performance across sectors and stocks. Some of this is cyclical, but some of it is also the result of structural changes that are occurring, like digitisation and energy transition.  

Hamish believes ‘digitisation’, particularly in terms of artificial intelligence (AI), is a key theme and opportunity in Australian equities. However, although there’s a lot of talk in the market about AI, he remains a little sceptical about it.

“Initially, I think AI will provide some benefits, but every company is going to have a ‘bot’ and be using AI at some point, which will just become a cost of doing business. However, I acknowledge there will be some obvious beneficiaries of AI, like the companies providing the hardware and data centres.”

Another area around digitisation that interests Hamish is cloud computing. He believes the take-up of cloud computing is still relatively sluggish. He cites research from Amazon Web Service (AWS), which records only 10-15 per cent of enterprises having migrated to the cloud. However, he believes this will change, as companies post-COVID are now thinking differently about how they use technology — for example, with remote working — which is driving changes in digital behaviour.

As bottom-up investors, Bellmont Securities steers clear of trying to predict themes that drive markets. Instead, like Longwave Capital, it has a very strong focus on the management of companies, choosing to invest in businesses with an experienced management team that has a proven track record of identifying themes and taking advantage of these themes in their own businesses.

“We’ve got a strong focus on founder-led businesses,” says Peter. “We like businesses where the founder has built the business from zero to listing on the stock market, and where they deliver the sorts of profitability, stability and growth which pass our quality screens. These types of businesses, with good management, have been able to position themselves appropriately for many of those big macro trends that are happening.”

And in terms of those macro trends, Peter believes the travel sector is a good example. He says companies in this sector got “absolutely hammered” during COVID, and while the sector is beginning to recover, it’s still far from being fully priced by the market. As an example, he points to one of Bellmont’s larger holdings, Corporate Travel Management.

“It has gained massive market share over the last few years. It emerged from COVID as a much stronger business, and yet we’re still seeing the share price substantially below where it was pre-COVID,” says Peter. “Corporate Travel Management is a high-quality business with an ongoing tailwind (as the corporate travel sector returns) and yet, that’s not really being priced in by the market. It’s an interesting thematic to take note of.”  

A behavioural trend Hamish has identified, which he believes is changing the investment landscape, is around discounted cashflows — a valuation method that estimates the value of an investment using its expected future cash flows.

“Discounted cashflow is a very good discipline in terms of forecasting cashflows for businesses, but I think it’s caused a disconnect in how people think about valuations for businesses,” says Hamish. “Companies are not able to access finance in the same way they were able to 12-18 months ago. Now they have to conserve cash and manage their balance sheet and capital structure more carefully, because the ability to raise capital has become much harder. This is a behavioural change that the market is still adjusting to.”  

One of the behavioural aspects that concerns Peter is increasing short-termism in the market. He believes too many people are fixated on what is going to happen in the economic environment in the next 12 months.

“Woolworths’ earnings have gone nowhere in a decade or more. It’s trading at 28 times earnings. However, you’ve got retail companies that are still growing their earnings strongly in this current environment, but they are trading on single digit multiples. In terms of generating increased earnings for your aggregate portfolio over the next 5-10 years, does it make sense to ignore these growing companies? Absolutely not,” says Peter.

“I think short-termism, trying to predict the unpredictable, is wrong. For something to be worth focusing on it has to be important and knowable. What the economy is going to do in the next 12 months is important but it’s not knowable. So, focus on what you can know, and that’s investing in good businesses where their earnings are going to be substantially higher in 5-10 years’ time, and buy them at a reasonable price. Stick to the fundamentals.”

With a growing appetite by investors for environmental, social, and governance (ESG) investments, Peter is quick to concede that the biggest problem with this sector is the differing definition of ESG by investors.

“The ESG factors that you might be concerned about, might not be the same factors that other clients are concerned about,” says Peter. “It’s very difficult to put together a portfolio that meets everyone’s ESG concerns.”

He believes managed accounts are a powerful vehicle for managing ESG concerns, because the structure enables advisers to build exclusions and investment substitutions in the individual portfolios of clients.

“For those clients who have strong views about particular companies, like exposure to fossil fuels, platforms can exclude those types of securities from their portfolios. We think that’s the best way to deal with ESG. Doing a one-size-fits-all portfolio just doesn’t work and will hamstring your returns.”

David agrees: “When it comes to ESG, it is the client’s choice. Managers need to be transparent with what they’re doing, so clients can make an informed choice about whether the manager is appropriate for their investment needs, objectives, and ESG outcomes.”

SG Hiscock thinks about ESG from the perspective of how companies are managing 21st century business risks. Hamish says that comes back to the quality of the management when dealing with ESG issues.

“COVID has seen a lot more focus on the ‘social’ part of ESG, such as stakeholder engagement — like employees and customers,” says Hamish. “The ‘social’ part of ESG has been front and centre through COVID, such as working from home.

“A lot of issues companies are facing are around the ‘social’ element of ESG, with Qantas being a prime example of how it has dealt with its employees and customers. This soft intangible does go to the heart of businesses, because it affects their equity risk premium. That’s why we spend a lot of time thinking about the ‘social’ part of ESG, and how it will impact the value of a company over the long-term, particularly if they don’t look after their key stakeholders.”