We recently undertook a three-part webinar series entitled ‘Quality stocks in focus’ which provided updates on how we are positioning our portfolios in the current environment.
In the first webinar, Senior Portfolio Manager & Head of Research Hugh Giddy and Senior Equities Analyst Tim Wood outlined how we are actively positioning our large-cap share funds.
Hugh Giddy reiterated our philosophy of investing in good quality companies with sustainable earnings and cashflows, run by experienced management and which are trading at a reasonable valuation. He outlined how very low interest rates in recent years had driven share prices higher, and that as we entered the COVID-19 crisis, non-bank industrials stocks were at record valuation levels. While these corrected in the March selloff, the subsequent recovery had driven prices and risks to potentially even greater highs.
Giddy then discussed in detail our view of Brambles. The firm is a global leader in the pallets industry and distribution of fast-moving consumer goods, has a significant global presence, and is number one or two in the markets in which it operates. We have a very favourable view of the firm’s management and focus on generating free cashflow.
In IML’s view, Brambles is currently reasonably valued, with a solid, defensive business.
Tim Wood then gave IML’s view of Metcash. The investment team had recently spent considerable time talking to various supermarket operators, customers and suppliers to understand the key dynamics and the outlook for the supermarket sector. Wood outlined that IML likes Metcash because of its relatively attractive valuation and its ability to produce a sustainable and growing dividend and that it was a stock which we believed had limited downside.
Wood also gave an overview of our views on the iron ore industry.
China remains the “gorilla in the room”, accounting for 58 percent of all global iron ore demand in 2019, and is deploying substantial stimulus to make sure its economy can continue to grow.
On the supply side, Brazilian giant Vale announced plans in 2018 to ramp up its iron ore production, but a dam collapse in 2019 had constrained this. China is also moving to open up significant new and very high grade supply by developing the gigantic Simandou iron ore mine in Guinea in Africa, as it is one of the highest-grade iron ore deposits in the world.
While supply had been interrupted by temporary closures in Brazil due to coronavirus restrictions, our view is that Brazil’s supply will ultimately come back. Our estimate of the long-run sustainable price for iron ore is therefore not the current $100 per tonne, but rather $60 per tonne. We are cautious about the outlook for iron ore stocks – while near-term earnings ratios look attractive, these are based on unsustainable earnings due to the spike in the iron ore price. Wood warned against the belief that current dividend yields from iron ore producers are sustainable out into the future. In commodities, IML defines ‘quality’ companies as those with low cost of supply, a long asset life, and a good balance sheet, examples being Newcrest Mining in gold and Alumina in bauxite mining and alumina refining.
In the second webinar, Portfolio Manager Michael O'Neill and Equity Analyst Bruce Du discussed how they’re sourcing solid, reliable income.
Michael O’Neill provided an outline of the current environment for investing in income-generating stocks.
With cash and bonds currently yielding well below one percent, investment in equities has become a necessity for many investors looking to fulfil a desired income objective, but it’s important not to take on unnecessary risks.
Looking at the individual sectors, O’Neill argued that although the banks are in a stronger capital and funding position than before the Global Financial Crisis in 2008, the outlook is less positive. Household debt is at record highs and still rising, loan repayment deferrals are making the extent of bad debts extremely uncertain, returns from the sector are likely to be structurally lower, and the dividend outlook is clouded. IML is therefore finding better value among non-bank industrials which can provide a more secure dividend stream.
Discussing real estate investment trusts (REITs), O’Neill stated that while valuations were being supported by low rates, the COVID-19 lockdowns had accelerated the trend to online shopping, which was negatively affecting the retail sector, while office property values are at peak cycle valuations with increasing supply and demand currently extremely uncertain. Our focus remained on REITs which did not have too much debt, and which have defensive anchor tenants and long weighted average leases. We currently own BWP Trust, Charter Hall Retail, and Shopping Centres Australasia Property Group.
O’Neill then outlined how IML is positioning the Equity Income Fund for anticipated additional market volatility, by targeting quality industrials with strong balance sheets and dividends and avoiding speculative stocks and exuberant valuations in the technology and mining sectors or overgeared companies. If there is another market correction, the stocks in the Equity Income Fund, underpinned by sustainable dividend yields and solid balance sheets, should provide a safe haven compared with many other companies which are being priced for a V-shaped recovery. We are also keeping a reasonable cash holding, looking to acquire good quality companies at good prices in the event of a correction. Importantly we continue to deploy simple option strategies to generate additional income in an environment where the outlook for earnings and dividends remains very unclear for many companies.
Bruce Du then discussed our views on two core Equity Income holdings, AusNet Services and Amcor. Victorian electricity and gas distributor AusNet is a core holding because the firm’s key assets are regulated and earn highly recurring and predictable revenues and earnings, which in turn is providing very high levels of cashflows and earnings certainty. AusNet has also consistently been able to grow its assets over time.
We also favour AusNet because of its downside protection qualities.
The electricity assets operate under a revenue cap and hence do not take any volume risk, with customer credit risk borne mostly by the large integrated energy retailers, which have very strong balance sheets. AusNet is currently trading on a 5.5% dividend yield for financial year 2021, which IML expects should be able to grow by two to three percent per annum over time.
Amcor is one of the world’s largest primary packaging suppliers with operations all around the world. Amcor’s operations are highly cash-generative and have produced steady earnings and dividend growth over time thanks to organic growth as well as through bolt-on acquisitions. Like AusNet, we believe Amcor has sound downside protection characteristics. Over 95 percent of sales are to fast-moving consumer goods companies such as Nestle, Unilever and Pepsi, which all have sound balance sheets, which reduces any credit risk to Amcor.
All this means Amcor’s revenues and earnings should remain steady going forward at a time of great economic uncertainty.
Marc Whittaker outlined how low interest rates, momentum-driven speculation, and overoptimistic investor expectations are crowding out fundamentals in higher-priced, higher-risk sectors such as medi-tech and buy now pay later stocks. The small-cap index is trading near all-time highs, although much of the recent rally was driven by a narrow range of stocks and sectors.
Whittaker then explained our focus on de-risking the portfolio, avoiding the froth and bubble, and rotating out of cyclicals and into good quality defensive industrials with reasonable valuations – companies with strong cashflows and recurring earnings which should be resilient in a low-growth environment. The focus is on maintaining a portfolio with sustainable earnings from a diverse range of sectors, by investing in companies which have strong franchises with long duration assets and that can grow under their own steam independently of the state of the economic cycle, for example through acquisitions and cost-outs.
On these grounds, we currently see opportunities in sectors such as packaging, gaming, utilities, and telecommunications, but remain cautious about areas where valuations have been driven too high.
IML also has cash in the portfolio to take advantage of opportunities, but only at the right price.
Lucas Goode then discussed IML’s rationale for owning Integrated Research and SeaLink Travel Group. Integrated Research is a market leader in provision of software which monitors and diagnoses IT infrastructure, payments, and communications networks to keep them running even while faults occur. IML favours the business because of its extremely capable management team, wide competitor moat, growing recurring revenue base, high incremental margins, and because it’s trading at a comparatively reasonable 24 times earnings.
Goode also discussed the rationale for owning ferry, bus, and tram operator SeaLink. The transformative acquisition of Transit Systems had made the combined operations a business with a very high proportion of contracted revenue and high-quality recurring earnings and entrenched competitive advantages. The combined business’ weighted average contract expiry of around five years also provides defensive qualities.
Finally, Marc reiterated that remaining disciplined and adhering to the established process of owning companies with strong and enduring competitive advantages, recurring earnings, run by capable management, that can grow, and which are available at a reasonable price, remains key to managing risk and deliver sound long-term risk-adjusted returns.
IML has a conservative investment style with a long-term focus and aims to deliver consistent returns for clients. To find out more, please visit our website