Is this sector a value trap or an opportunity for the savvy investor?

August 09, 2023 13:33

Livewire Markets

Consumer discretionary isn't the first sector that springs to mind as a source of return when high inflation and high rates meddle with markets.

Just the opposite. When disposable income and purchasing power go down, so does consumer spending.

Or so the theory goes.

Today's rate cycle has been telegraphed a long way out. Inflation started taking off in June 2020. That was the first real warning sign, at least in the data.

Then the Reserve Bank of Australia (RBA) rolled out its blunt cudgel, initiating rate hikes in May 2021. Take that as warning sign #2 for the consumer.

And yet, someone clearly forgot to tell the consumer.

As the graph above shows, it wasn't until December last year that consumers put their wallets back in their pockets.

Couple this with the fact that consumer discretionary has just nudged ahead of the broader market (see below).

The moral of the story is this: the Australian consumer is a resilient - or naive - creature.

Against that backdrop, and as we move through earnings season, the question needs to asked: is consumer discretionary a value trap or value opportunity?

On this the jury is split. Some fund managers are bullish on consumer discretionary, while others remain bearish. This wire summarises those recent views.

Bulls

Oscar Oberg, Wilson Asset Management

If small caps rally, consumer discretionary will likely lead the way.

"Consumer discretionary is 35-40% of the small caps index."

"We have a bigger exposure [to consumer discretionary] now than what we did say a few years ago. My view is that small caps will outperform the broader market. For that to happen you need consumer discretionary or stocks exposed to the consumer to do well."

Oberg points out that small cap exposure to consumer discretionary goes beyond retail to include automotive, building materials and tourism.

Top exposures:

Flight Centre (ASX: FLT)
Webjet (ASX: WEB)
Temple & Webster (ASX: TPW)
The Reject Shop (ASX: TRS)

Tim Carleton, Auscap Asset Management

Consumer discretionary isn't only a leading exposure for Auscap's Tim Carleton moving forward, it's also been the primary source of return for the fund in FY23.

"What it tells you is that the market is reasonably forward looking, and the lift in interest rates was factored into the decline that we saw for a lot of the consumer discretionary companies in the first half of CY22, or the second half of the financial year 22.

Carleton believes the market has become too pessimistic about the earnings outlook for a lot of retailers.

"At the end of the day, it's valuation that matters, and it's the future cash flows that each of these businesses are going to go generate that will to determine whether there's a compelling opportunity in the market at the moment or not. Our view is that there is."

Top exposures:

ARB Corp (ASX: ARB)
Breville Group (ASX: BRG)
Carsales.com (ASX: CAR)
JB Hi-Fi (ASX: JBH)
Motorcycle Holdings (ASX: MTO)
Nick Scali (ASX: NCK)

Bears

Ron Sargeant, Touchstone Asset Management

Sargeant continues to be cautious on consumer discretionary.

As he outlines in this comprehensive piece, shrinking savings buffers, the mortgage rate cliff, monetary policy lag, and overcooked earnings consensus numbers all point to ongoing difficulty for the sector.

"Households will face more challenging conditions over the next 3-6 months, as will companies with increasing costs. This pressure on households will likely broaden out to other sectors, such as the banks."

While we are clearly of the view that consumer spending will weaken, perhaps significantly, we are mindful that consumer stocks may start to recover well before the fundamentals improve.

Jacob Mitchell, Antipodes

Mega cap tech has carried the S&P500 this year.

But according to Jacob Mitchell, the game might be over for consumer-facing mega-cap tech.

"We don't see the case for top line acceleration in consumer facing mega cap tech in 12 months time."

"We would be more constructive on the cloud-facing companies or the companies that are adopting artificial intelligence in existing software platforms like Oracle, SAO, and Microsoft."

Chris Kourtis, Ellerston Capital

Kourtis is extremely bearish on the back end of the calendar year.

"Second half is going to be a really tough half economically, which then sort of flows into earnings expectations."

Consumer discretionary, in Kourtis' view, will lead the sell-off.

"A lot of the retail stocks that have reported recently, they've hit a brick wall."

Neutral

Paul Taylor, Fidelity International

For Taylor, consumer stocks should start rebounding when the economic slowdown decelerates, not when it's accelerating.

"Markets look one to two years ahead anyway. So they're really trying to work out how close we are to the bottom, and that's when you'll see the second derivative response in consumer stocks.

"[But] I definitely don't think it's now, we've got a bit to go."

Conclusion

Clearly, the jury is split. But even among many of the bears, the question is more one of timing. The recovery in the consumer will follow the recovery in the economy. And as Taylor points out, the market prices a year ahead. If that continues to hold true, then consumer stocks may be well placed to rally sooner rather than later.

........

Livewire gives readers access to information and educational content provided by financial services professionals and companies ("Livewire Contributors"). Livewire does not operate under an Australian financial services licence and relies on the exemption available under section 911A(2)(eb) of the Corporations Act 2001 (Cth) in respect of any advice given. Any advice on this site is general in nature and does not take into consideration your objectives, financial situation or needs. Before making a decision please consider these and any relevant Product Disclosure Statement. Livewire has commercial relationships with some Livewire Contributors.