Don’t ignore these Quality stocks sitting on our doorstep

Australian investors should remember that many high-quality companies reside in our market, explained First Sentier Investors' David Wilson and Christian Guerra in a recent investor webinar.

“There are many Australian companies that are high quality in nature, which is something that at times, we as Australians underappreciate. 

But Australia is a very good place where companies can be incubated,” said Wilson, First Sentier’s head of Australian equities, growth.

Wilson and Guerra, First Sentier’s head of research, Australian equities, used the words “resilient” and “robust” to sum up the local market on the back of the February earnings season. This was demonstrated in the high number of earnings beats versus misses that were reported, with around 40% of companies delivering results ahead of expectations.

Speaking about the banking sector, Guerra noted that margins continue to decline across the big four banks, but this is slowing. This reflects an easing of the competitive pressures in both their mortgage and deposit businesses.

“That dynamic of an improving margin outlook is discounted into bank share prices, with the sector now trading on about 15 times earnings versus the five-year average of about 13 times, so that better outlook on margins is being priced in by the market,” Guerra said.

He also noted that even after the more than 400 basis points of rate rises from the Reserve Bank of Australia, the asset quality across the local market remains “quite benign”.

“At banks, we are seeing a rise in arrears but they’re off incredibly low levels and are still below long-term averages,” Guerra said.

“On the business side, the non-performing loan ratios have barely moved. It must worsen from here, we need to bear that in mind, but I’d highlight that bank provisioning is very strong and bank capital levels are well above regulatory requirements”.

Why a weaker China isn't a disaster

Turning to the resources sector, Wilson spoke about China’s softer economic growth, but emphasised that it is still delivering “reasonably solid” GDP growth of around 5%.

While China’s economy gradually moves away from its troubled property sector, he noted that its ongoing demand for iron ore has been reflected in the performance of both BHP Group (ASX: BHP) and Rio Tinto (ASX: RIO), which reported earnings of US$6 billion and US$11 billion in the six months to the end of December.

“They’re getting an iron ore price of around $120 a tonne – you’d normally expect $70 – and demand is still quite strong out of China, despite the softness in the economy,” Wilson said.

Referring to the challenges among lithium producers, where prices of spodumene, lithium carbonate and lithium hydroxide are down almost 20% from their highs of 2022, he noted this is feeding through to the business models of several Australian names.

“You are getting balance sheets and corporate structures tested through this period. And we’ve seen some mergers, some curtailment of production…you are seeing some creative destruction taking place, where the lithium business can right-size itself,” Wilson said.

“It’s in a state of flux – we saw some weak numbers coming through in reporting season and you are seeing businesses put to the test, but companies are responding to these new lower prices.”

Two key groups in AI

On the topic du jour of artificial intelligence, Guerra's team groups companies into two main areas:

• AI enablers, and
• AI beneficiaries.

In the first of these, which he referred to as the “picks and shovels” of the AI revolution, two local examples are Megaport (ASX: MP1) and NextDC (ASX: NXT), a leader in cloud networking and data centres, respectively.

Among AI beneficiaries, Guerra names companies from multiple industries, including:

• Healthcare – Pro Medicus (ASX: PME)
• Software – Xero (ASX: XRO), Wisetech (ASX: WTC)
• Financials – Commonwealth Bank (ASX: CBA), and
• Travel – Flight Centre (ASX: FLT).

Though such firms are branching into new technologies, Guerra emphasises their research on the companies remains the same as for others, looking at the quality of their balance sheets over 10 years.

“What is different is what we capture in our forecasts. For the AI enablers, it’s about the revenue stream,” he said. Pointing to the example of NextDC, it’s the rapid demand growth for their data centres, to help power AI development, that will drive revenue.

And for AI beneficiaries, tracking their total addressable market (TAM) growth is key.

What is Quality?

Wilson explained the importance of being bottom-up in identifying quality firms, looking at individual companies’ balance sheets and business models rather than skewing toward any broader sectors or industries.

Coming back to the earlier point about Australia’s high proportion of quality stocks, Wilson also mentioned the technology sector as a source of quality growth. He referred to Seek (ASX: SEK), REA Group (ASX: REA) and CAR Group (ASX: CAR), which have paved the way for others including Xero, Altium (ASX: ALU), Wisetech, and Megaport (ASX: MP1).

He also named CSL Limited (ASX: CSL), Aristocrat Leisure (ASX: ALL), and James Hardie Industries (ASX: JHX) as local examples of quality.

The key metrics the First Sentier team looks for in finding such companies include:

• Return on equity (ROE) and return on invested capital (ROIC)
• Balance sheets that aren’t carrying much debt.

Management teams are another crucial consideration, both in terms of their environment, social and governance practices and how they conduct themselves, including succession planning.

“Quality companies do well over long periods because they can absorb shocks, their business models can cope with regulatory oversight,” said Wilson. He cited the big Australian supermarkets Woolworths (ASX: WOW) and Coles Group (ASX: COL) in the context of the parliamentary inquiry into the cost of living.

“You want companies that have a robustness through cycles, you also want them to be able to grow, which fits very well within a geared strategy. And those things are available in Australia.”

Why invest in Australian Equities Growth?

Investing in a blend of growth and quality stocks, David and his team create portfolios designed to outperform through market cycles. Beyond investing for growth, their focus on companies with great risk management and stable earnings has provided a ballast for portfolios in falling markets.

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