The worst is behind us: Yarra’s 9 stocks with plenty of upside ahead

The worst is already over for large parts of the equity market, despite many investors remaining paralysed by recessionary fears, says Yarra Capital’s Dion Hershan.

“There are very few words that are as emotive for investors as recession, which often strikes panic but that’s often with no understanding of what it actually means,” says the asset manager’s Chairman and head of Australian equities during a recent webinar.

Key points

• What a recession really means
• When will interest rates peak?
  
• How Yarra is positioned now
  

In his discussion of the current macroeconomic climate, Hershan emphasises the following:

1. Historically, far more recessions are forecast than actually occur
2. Knowing what’s led us here is a key difference this time.

“There’s very little debate about what the root cause is, which we think is critical to the depth and duration. But people are stuck on the headlines without any understanding of what recession actually means,” Hershan says.

“The combination of excess stimulus and supply shocks has created a never-before-seen squeeze in economies and is having a cascading effect on financial markets.”

Hershan believes this is what has led us to our current situation, with inflation high because the fog of COVID began to lift just as supply chains were struggling.

“Economies globally and locally are on that painful journey…you effectively have to destroy the market to get it back into equilibrium and to get inflation lower,” he says.

“Destroying demand is a theme that’s going to permeate through our local economies and globally for some time to come.”

The dangers of being short-sighted

The main problem currently is that too many investors are focused on the short-term and ignoring the bigger picture. Why is that so important?

Because interest rate hikes are already priced into many parts of the equity market. “There should be far less focus on what happens at the front of the curve and what happens every Tuesday once a month,” Hershan says.

“Our view is interest rate hikes and expectations have already had a considered effect and that’s also led to confidence weakening dramatically and activity being curtailed.”

Hershan also addresses what he regards as a major misunderstanding in the market that recessions are something to fear.

“Hysterical commentary” on recession and house prices

“Recessions aren’t fatal. They’re an inevitable part of the typical business cycle. It’s also worth noting that often, by the time a recession is confirmed, financial markets have already softened in advance,” Hershan says.

“Stocks typically bottom about seven months before an economy bottoms – stocks are forward-looking so if you’re waiting for a recession to be over, you’ll probably miss massive parts of the capital appreciation cycle.”

Also on the macro front, he says Australia’s obsession with house price falls ignores the fact that prices rose 37% in the three preceding years. That means the consensus view that average house prices will fall by 15% only means prices are reverting to where they were around 12 months ago.

“It’s not going to cause great hardship or anxiety. To the extent we’re going into a slowdown, we’re doing it from a position of strength, which I think speaks to a lot of resilience”

For example:

• unemployment is at record lows
• Australian consumers are well positioned in terms of debt versus savings

“Net assets held by households are up 47% and the consumer, over the last three years, has considerably de-leveraged. The debt that households have versus the value of assets is only 16%,” Hershan says.
“Most of the press focuses on consumer debt being high, which is true in an absolute sense, but there’s no reference to consumer assets actually being higher.”

Yarra deputy portfolio manager Ed Waller explained how the firm's Broadcap Australian equities portfolio is currently positioned. He again emphasised that investors need to look further ahead and realise what’s already priced in to the share prices of listed companies.

Highlighting some specific stock holdings, Waller highlighted nine companies that satisfy three broad criteria.

Three companies his team regards as having strong industry structures and pricing power are:

• Insurance Australia Group ASX:IAG 
• Carsales ASX:CAR
• The Lottery Corporation ASX:TLC

Within the insurance sector, IAG and Suncorp hold around a 57% market share across their 17 major retail insurance brands. Yarra likes IAG because of its ability to pass on rising input costs. The company also benefits from rising interest rates, as the earnings from its pool of insurance premiums (the float) increase in this environment.

Online automotive sales portal Carsales is favoured because it holds a dominant position in Australia and the increasingly important international markets in which it operates. The firm’s earnings will also likely get a bump as new car volumes pick up again after having been depressed during COVID, as supply chain challenges has resulted in new product shipments being severely restricted.

The Lottery Corporation is a listed company behind well-known gaming brands Oz Lotto, Powerball, Instant Scratch-Its and others. Yarra likes the firm for its infrastructure-like characteristics, with many of the lottery leases it operates held under concessions of up to 40 years’ duration.

In the cyclical space, three companies Waller calls out are:

• Plumbing equipment manufacturer Reliance Worldwide ASX:RWC 
• Australia’s flagship airline Qantas Group ASX:QAN
• Online jobs portal Seek ASX:SEK

And three companies he believes investors can have a high degree of confidence in when looking through the market cycle are:

• Media company Nine Group ASX:NEC
• Building supplies company James Hardie Group ASX:JHX 
• Property settlement firm PEXA ASX:PXA 

Each of these three companies has seen its share price fall more than 30%, having “derated on the economic outlook,” explains Waller.

For the first of these, he believes investors fail to appreciate how much of Nine’s value comes from Domain, with undue emphasis placed on its traditional media business.

Commenting on James Hardie, he notes the company has continued to grow market share, despite the slowdown in housing construction activity globally, which has seen its share price fall 35% in the year so far.

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