Since the start of 2022 we have seen an acceleration in inflation all around the world. The US reported 8.6% last week, the UK reported 9.0% last month and in Australia RBA Governor Lowe warned this week that inflation would hit 7% by December.
Higher inflation has caused bonds to sell off very markedly all around the world led by US bonds. This has seen the Australian government’s 10-year bonds trade at levels not seen in a long time. In August 2021 yields were as low as 1.1%, then at 3% in early 2022 and now this week bonds traded above 4.0% for the first time since 2014.
High inflation has put pressure on central banks everywhere to tighten monetary policy and this is causing great uncertainty and falls in sharemarkets globally. Central banks around the world – including the RBA – are now in a situation where they have to engineer a slow-down in demand to contain inflation, while trying to maintain economic growth and not push their economies into recession.
While the situation will remain uncertain for a period of time, it is clear that equity markets are now, slowly, returning to fundamentals where profits, cash flows and solid balance sheets matter.
What does this mean for Investors Mutual’s portfolios?
Given the many uncertainties, we are maintaining our cautious stance while continuing to look for attractively-valued, well-established, profitable companies which we believe have strong competitive advantage and are run by competent, experienced management teams. We believe these types of companies are best placed to withstand the current economic uncertainty and grow over time.
These are our current thoughts:
- We continue to stay away from the unprofitable speculative ‘growth’ or tech names, such as Megaport and Zip Money, as we believe most of these companies continue to look overvalued, even though many have declined by 60 or 70% so far.
- We remain cautious on cyclical areas such as those exposed to consumer spending, home building and media spend. Having said this, some of the higher-quality stocks in these sectors – such as Nine Entertainment and Wesfarmers – have fallen very rapidly, so we are looking at levels at which to buy into these types of stocks.
- We remain cautious on many resource stocks. With very high prices for many commodities, markets are pricing in continued strength in price and demand into what will be a weakening global economic outlook as we enter the second half of 2022. While many of the stocks in this sector look optically cheap on a price to earnings basis, we do not think the earnings are sustainable for many of these companies once supply chains normalise and new capacity comes to market.
- We also remain wary of the major banks. While higher interest rates may potentially help the banks as their net interest margins may improve, increased competition in the sector means that these benefits may not be as high as previously experienced in rising interest rate scenarios. In addition, there are two other headwinds the banks must face:
- Rising interest rates will also slow credit growth in the housing and business sectors
- Bad debts may also rise as some borrowers struggle under higher interest rates in a slowing economy
So where are we finding opportunities?
We continue to like companies that have self-help initiatives they can undertake internally. Examples include:
- Brambles, which announced a strategic review which we expect to unlock value amongst its divisions.
- Telstra, where in the next year or so, the company hopes to unlock value in its attractive InfraCo division, that earns substantial, government-backed revenues.
There are also some companies which we believe are actually benefitting from the current turmoil in supply chains, but where the benefit has been overlooked by the market. Orica, for example, now faces less competition than before from imports due to supply shortages in explosives and is also in a position to be able to pass through many of the cost increases it is seeing. Aurizon too should benefit as it’s due to reset contracts with customers of its rail network in mid-2023 and will be allowed to increase the revenue it earns due to higher inflation and bond rates.
We are also finding opportunity in the Real Estate Investment Trust (REIT) sector, which we have been cautious on for some time. It has fallen 25-30% fairly rapidly, with many stocks now trading at substantial discounts to Net Tangible Assets (NTA). While we need to adjust our valuation versus prior expectations, the falls we’ve seen are beginning to offer a margin of safety and attractive yields in some names that we believe are defensively positioned, with low gearing, secure tenants and long lease profiles.
To conclude, while markets will likely stay volatile and uncertain in the near future, given the concerns over rising interest rates, we will continue to stick to our quality and value investing style that has provided attractive and less volatile returns for our clients for more than two decades. While the current volatility has, of course, impacted our portfolios, we remain defensively positioned in well established, profitable companies and look forward to investing in new ideas as market opportunities present themselves.
The Investors Mutual Australian Share Fund invests in a diversified portfolio of quality ASX-listed industrial and resource shares identified as being undervalued. The Fund aims to provide a rate of return (after fees and expenses and before taxes) which exceeds the return of the S&P/ASX 300 Accumulation Index on a rolling four-year basis.
