Morgans: 5 high conviction stocks in July

We currently expect the S&P/ASX 200 index to finish the year around the current level, but the outlook, particularly this late in a sustained business cycle, is becoming more vulnerable.  

Liquidity conditions are at an inflection point 

Abundant liquidity and accommodating monetary policy have been significant tailwinds for markets since the Global Financial Crisis. The ASX 200 accumulation index has returned 10% per annum since the official cash rate was slashed from 7.0% to 3.25% in 2009. This is despite earnings barely nudging above 0% growth over the corresponding period. In the US, since the Fed dropped the effective Fed Funds rate to 0-0.25% in 2009, the S&P 500 total return index has netted investors 14.5% per annum despite seeing only half the earnings growth (7%) over the same period. 

Moving forward, conditions aren't as favourable. 

Central banks have provided the backstop when financial conditions deteriorate, but this is no longer the case. The Fed did not veer from its commitment to normalising policy in March despite the 12% plunge in the Dow in February. In June, the European Central Bank announced it would taper and end its asset purchase program despite the potential fallout from Italy's precarious political situation. 

Historically the withdrawal of liquidity coincides with a reversal of carry trades and bursting of asset bubbles. We think market disturbances will be more pronounced from now on, but we don't expect an imminent fallout. Opportunities are few and far between, but they do exist. 

Two changes to our list this month 

We add Kina Securities (KSL) and remove Cleanaway Waste Management (CWY) from our list in July. We remain positive on the prospects for Cleanaway but recent share price strength has compressed potential investment returns. We will look for opportunities to buy the stock at better valuation points, or revise our fundamental outlook if new information is released at the FY18 result in August. 

Five high conviction stocks in July 

Our high conviction stocks are those that we think offer the highest risk-adjusted returns over a 12-month timeframe, supported by a higher-than-average level of confidence. They are typically our preferred sector exposures. 

Here are our five high conviction stock picks this month: 

Kina Securities (KSL) 

KSL is a diversified financial service provider in PNG. The group has two operating divisions, Kina Bank and Kina Wealth Management. 

Key reasons to buy Kina Securities: 

• We think the stock remains mispriced by the market, and expect KSL will produce a record FY18 profit. We forecast a dividend yield of 10.8% for 2018 and 14% for 2019, yet it still trades at a ~22% discount to its IPO price. 
• The recent ANZ PNG acquisition adds significant inherent value in our view. KSL paid only goodwill, yet the deal is 25-35% accretive post synergies. 
• KSL's underlying business metrics continue to track solidly – delivering 20% loan growth, credit quality has been improving and backed by a strong capital position (~17% pro-forma and well above the regulatory minimum of 12%).  

We retain our Add recommendation.  

Suncorp Group (SUN) 

Suncorp is a financial services conglomerate offering banking, general insurance, life insurance, super and investment products. 

Key reasons to buy Suncorp Group 

• We think 1H18 was the low point for SUN's ITR (Group Insurance Margin) and we see a clear pathway for the ITR to rise above SUN's 12% target level. 
• We also expect SUN to produce a solid 2H18 group result assisted by strong reinsurance protections. SUN remains at a substantial 4 PE point discount to IAG in FY19, and we expect this gap to close if management can deliver on stated FY19 management targets. 
• The sale of SUN's life business is also a small catalyst in our view. A sale is largely earnings neutral, but will enable capacity for buybacks. It also improves SUN's ROE by 1% and SUN's RoNTA by 4%. 

We retain our Add recommendation.  

Westpac Bank (WBC) 

Westpac is Australia's oldest banking and financial services group, with operations throughout Australia and New Zealand. 

Key reasons to buy Westpac 

• WBC has a relatively low risk profile in terms of loan book positioning and low reliance on treasury and markets income. 
• The bank stands to benefit most from re-pricing of investor home loans.
• We expect WBC to comfortably meet APRA's 'unquestionably strong' capital benchmark through undiscounted dividend reinvestment plans. 

We retain our Add recommendation.  

CML Group (CGR) 

CGR provides small business financing solutions, primarily debtor finance (invoice factoring) and equipment finance to small-medium enterprises (SME) in Australia. 

Key reasons to buy CML Group 

• CGR is the second largest non-bank provider of debtor finance in Australia.
• The group is well capitalised to continue to deliver organic growth via its increased scale and improving market share.
• In our view, CGR has the potential to outperform earnings expectations over the next two years, in part via executing on its recent acquisition (meaningful potential cost synergies). This is coupled with a relatively undemanding valuation of approximately 12x FY19 PE. 

We retain our Add recommendation.  

PWR Holdings (PWH) 

PWR designs and produces cooling solutions for the high performance automotive industry and has an established track record in servicing motorsports, including Formula One, NASCAR and V8 Supercars. 

Key reasons to buy PWR Holdings 

• PWH is a world leading automotive cooling business that delivers technically advanced solutions to elite motorsports customers (eg. Formula 1, NASCAR)
• FY17 was a year of currency headwinds and higher investment costs and with that now largely out of the way, FY18-20 are set to be much stronger years.
• Key growth opportunities include: 1) capturing a greater share of customer spend on cooling solutions; 2) partnering with OEMs on high performance/low production run vehicles; 3) increased presence and entry into adjacent markets; 4) increased penetration in the US automotive aftermarket segment; and 5) opportunities in emerging technologies (Tesla, Google etc). 

We retain our Add recommendation.

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