Phase One: The Quality recovery

To borrow a famous quote from Winston Churchill and make it my own:

"You can depend upon the share market to do the right thing. But only after it has exhausted every other possibility."

And so it is with great delight that I have been witnessing the return of buyers to share prices in some of the highest quality and resilient business models listed on the ASX. Think CSL (ASX:CSL), Cochlear (ASX:COH) and ResMed (ASX:RMD), but also Amcor (ASX:AMC), TechnologyOne (ASX:TNE) and Woolworths (ASX:WOW).

Both analysts and investors might at times find it difficult to warm towards these High Quality stalwarts. Usually because the valuation never looks as attractive as for lower quality, smaller cap and cyclical companies 

But it is my observation when times really get tough and uncertainty dominates the broader picture, these are the Go-To companies that will stabilise and rise first amidst turbulent and volatile times.

Always difficult to pinpoint exactly when that moment arrives, but in 2022 it seems to have arrived in early June, just before share prices for the likes of BHP Group (ASX:BHP), Woodside Energy (ASX:WDS) and Fortescue Metals (ASX:FMG) started to break down. Take a look at share price graphs for the likes of CSL, Cochlear, Woolworths and TechnologyOne and admire how strong the rebound is that has occurred over the past six weeks.

I think we can now conclude the market is comfortable with valuations for these High Quality companies following this year's general de-rating as bond yields had to reset from exceptionally depressed yields. At the same time, with the risk of an economic recession looming, or at the very least a significant slowdown, the apparent rebound is equally the market's call on (much lower) earnings risk.

In simple terms: amidst a multitude of risks surrounding the upcoming August reporting season, as well as the eight months ahead of next year's February season, where do we all think the greatest risks lay for downgraded earnings and reduced dividends?

I think the market is showing us where the risks are the lowest.

The beginning of the equity markets recovery

Traditionally, a recovery in share prices of CSL & Co marks Phase One in the equities market recovery, so which sectors might be up next?

With a rare exception of, maybe, coal prices, I continue to see large question marks obfuscating the outlook for iron ore, base metals, oil & gas, precious metals, EV battery materials, steel and most other cyclicals. 

Serious questions remain about what exactly is happening inside the Chinese construction industry; what will happen in Europe during the upcoming winter; or the duration of the strength and direction of the US dollar.

These unanswered enigmas all represent additional risks on top of the one key question in mid-2022: how recession-proof exactly are those businesses?

Note: even if there won't be a recession anytime soon, it is most likely that question will still be asked by nervous investors.

My focus thus naturally shifts towards technology and smaller cap growth companies, as well as to the local REITs. All three market segments have been trading under serious duress this year, as first excessive exuberance needed to be priced-out and then the natural de-rating kicked in from higher bond yields.

There is one caveat that needs to be highlighted: that optimism that has been creeping into share markets these past weeks is based upon a general belief that inflation will peak soon, as well as that bond yields will mostly trade sideways from here onwards, i.e. the peak in 10-year bond yields is well and truly past us; at least for the time being.

These are all-important requirements for those three sectors to experience a sustainable recovery from beaten-down share prices. Plus, of course, the next question that will be asked is: how recession-proof exactly are those businesses?

If ever anyone has the feeling that investing during a raging bull market is so much easier, well, that feeling is probably 100% correct.

One problem with local technology and smaller cap growth companies is most have a rather limited track record and, with exception of the exceptionally brief recession of 2020, there's no reference or framework for how these business models operate when confronted with economic stress tests.

Which is probably why, being a cautious investor, approaching the upcoming reporting season with a great deal of caution seems but the logical thing to do. And that's assuming August does not come too early in today's cycle, leaving key questions for the next eight months.

Either way, I am of the belief that, here too, the market is providing investors with valuable clues as to the various risk profiles of companies that are either technology or promising high growth small cap opportunities.

I am generalising now, but there should be very little surprise as to why shares in TechnologyOne have not nearly fallen as much as, say, Kogan (ASX:KGN), Nuix (ASX:NXL), Redbubble (ASX:RBL) or Zip Co (ASX:ZIP), and they have been quicker in staging a noticeable recovery.

Mr Market can be a highly unreliable weather vane, and the next tantrum might be but another economic update away, but my experience is that when it comes to separating the wheat from the chaff, i.e. identifying which companies are High Quality and which ones are certainly not, Mr Market's communication is often loud and clear, and correct.

Note, for example, how both Objective Corp (ASX:OCL) and WiseTech Global (ASX:WTC) issued a positive market update in July. Yes, of course, one can potentially make a higher return out of a share price that has fallen a lot further, but what is the real trade-off when adjusted for the risks involved, as well as when taking a longer-term view?

Lower quality fly-by-nighters tend not to perform well over a longer period of time. This is the confusing message the share market throws at bargain hunters: it does not account for the risks involved.

Having said all of that, certainly following the firm bounce in share prices since early June, there should now equally be a degree of caution when buying into the local High Quality names. If they're in the portfolio already, congratulate yourself. Your decision from the past has once again been vindicated.

But as also indicated by current valuations and price targets for those stocks, buying now runs the risk of low returns in the immediate, and there always remains the risk for disappointment in August, for higher bond yields, or for inflation to stick around for longer.

This is the share market, remember? Other opportunities will present themselves. 

Most analysts say Real Estate Investment Trusts os REITs appear undervalued

Some of the most obvious opportunities, it would seem, are among local REITs. 

Just about every sector analyst has conducted a general review of the sector over the past two months, and not one has drawn a different conclusion to most ASX-listed REITs seeming undervalued.

The one requirement for this sector to genuinely and sustainably close the gap between share prices and intrinsic valuations is for investors to become comfortable with the outlook for bond yields (thus: inflation and central bank policies), about which we can all make various forecasts, but this can take a while, still.

Since most REITs are, operationally, in good health, which also applies to balance sheets, investors can opt for the waiting game, while confidently cashing in relatively high distributions to shareholders.

Exactly how to play this sector is very much dependent on personal views and preferences. Sector heavyweight Goodman Group (ASX:GMG) is usually singled out as a lower-risk exposure, but it also pays out a rather low yield in distributions. See the earlier remarks about quality and risks, which also applies to REITs.

Potentially higher returns, including a higher yield in distributions, can be derived from owning Charter Hall (ASX:CHC) or Qualitas Real Estate Income Fund, while the likes of HomeCo Healthcare & Wellness REIT (ASX:HCW), HomeCo Daily Needs REIT (ASX:HDN) and Charter Hall Retail REIT (ASX:CQR) look well-undervalued.

Some in this sector, like Waypoint REIT (ASX:WPR), are now closing the gap with analysts' targets rather rapidly.

Investors should, however, not ignore that parts of the sector might still have vulnerable balance sheets combined with the potential for disappointing operational performances. Macquarie in a recent report highlighted Scentre Group (ASX:SCG), Charter Hall Long WALE REIT (ASX:CLW) and Dexus Industria REIT (ASX:DXI) within this context.

JP Morgan, on the other hand, has nominated GPT Group (ASX:GPT) as its least preferred A-REIT because of low interest rate hedging, significant vacancies inside the Office portfolio and a higher geared balance sheet, ahead of a likely devaluation in asset values.

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