One thing investors should covet above all others, and a few sectors that have it

Dion Hershan

Yarra Capital Management

Insurance is certainly on the minds of many in Australia’s East right now. Large areas of the nation are still underwater and in others, the mammoth clean-up ahead will include nervous phone calls to check on flood coverage. That’s just one part of the broad insurance universe that we at Yarra Capital Management are backing in Australian equities.

As we also saw in the half-year corporate reporting season just ended, the market characteristics that dominated over the last decade contrast markedly with what's driving them now. 

We're heading into a different era, where inflation is large, persistent, and pervasive and it's cascading across the world, but also corporate Australia.
That will likely come at the expense of profit margins and will result in higher interest rates. More inflation and higher interest rates are classic headwinds for equity markets.

In this environment, there will be clear winners and losers. The highest quality companies have one thing that many investors covet above all others in the current environment: pricing power. 

The losers tend to be in sectors with high share price multiples that are underpinned by real assets. Where can you find the winners? Learn more in the video below, where you'll also hear about some of our favourite themes and how we're backing them.

Edited transcript

What are your key takeaways from the half-yearly reporting season?

"You'd have to characterise reporting season as being a strong period. We certainly saw a recovery in the economy during the reporting period. In many respects, it has been a jagged, V-shaped recovery. GDP is above where it was before COVID levels. Corporate profitability exceeds where it was before COVID levels. Dividends are recovering, and frankly, there's broad-based strength. 

There are many issues to contend with. Performance is always going to be uneven by stocks and by sector, but you'd have to say it was probably one of the strongest reporting seasons we've seen and that's in part because there have been enormous amounts of monetary and fiscal stimulus which is cascading through to corporate Australia.

What investment themes have you added to the portfolio more recently?

We've been gradually transitioning the portfolio and among three of the more distinct themes that we're pursuing as investors today is the insurance sector. Frankly, if you look at the fundamentals of the sector at the moment, it's in a really difficult predicament. Claims are elevated, costs are elevated, and profitability is we think temporarily depressed. We've tilted our portfolios quite significantly towards insurance, really with a view that at some point claims will normalise. There is very strong pricing power in the insurance sector. High claims and a good industry structure leads to strong pricing. We also think insurance is one of the few sectors that will actually benefit from rising interest rates. Most companies are losers, insurance companies tend to be winners.

In our portfolios, we've also gone further overweight the resources sector. In the last six months, we've added gold to our portfolios. We've added energy with a particular focus on energy services. We think energy services is entering the sweet spot because high prices and underinvestment is really going to be a catalyst for a lot more activity going forward. 

We are also adding a few technology names to our portfolios but on a very selective basis. Valuations are pulling back dramatically, even for some high-quality franchises. And we think this is a temporary rather than a permanent dip, and one that we're going to capitalise on.

What’s your market outlook?

It will get more difficult from here. The last 10 years were characterised by falling interest rates, which boosted asset prices and profitability. We now very much feel we're heading into a different era. What is pretty clear is inflation is large, it's persistent, and it's pervasive and it's cascading across the world, but also corporate Australia. We think that'll come at the expense of profit margins. 

We also think inflation's rise will also result in higher interest rates. More inflation and higher interest rates are classic headwinds for equity markets. Within that, there we sectors that are winners and losers. As we said, high multiple, high valuation, real asset companies typically tend to suffer when interest rates go up. 

Some obvious winners are banks, insurance companies, and companies with really strong pricing power and that's very much where we have directed our portfolios.

The other thing we need to be mindful of in the outlook is that activity post-COVID is starting to normalise. For some companies, normalisation actually means a big step down in their activity. You're going to see that in the supermarkets, you'll see it in healthcare, you'll see it in some retailers. 

Conversely, some companies will be massive winners as activity becomes reinstated. You'll see it in travel, you'll see it in consumer services, and you'll also see it in some industrial companies. We are very much trying to pick through the market and identify those opportunities.

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Dion Hershan
Executive Chairman and Head of Australian Equities
Yarra Capital Management

Dion is Executive Chairman and Head of Australian Equities. He is responsible for leading the Australian Equities team, and is a Porfolio Manager focussed on large cap equities. Prior to transitioning to Yarra Capital Management, Dion was the...

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