The enduring appeal of ASX financials, energy and other "inflation resistant" stocks

The Tyndall AM team looks back at how Australia’s listed companies performed through February amidst various trends and challenges, including the impact of rising interest rates, higher insurance claims, elevated energy costs and a tightening regulatory environment.

I am joined by Jason Kim (Portfolio Manager), Michael Maughan (Portfolio Manager), and Stefan Hansen (Senior Analyst) to discuss this and more in our earnings season wrap.

Transcript

Brad Potter

CBA (ASX: CBA) was the only bank that reported in this reporting season. The other banks report later on in the year. CBA disappointed, it was down 5.7% on the day and continued to fall during the month and underperformed the market quite substantially.

The biggest disappointment really was around net interest margins and the bank called out headwinds such as mortgage competition, deposit competition, and also higher wholesale funding rates which resulted in the net interest margin suggesting that it's peaking and will roll over from here. However, I suspect given what we've saw in some of the smaller banks, and National Australia Bank (ASX: NAB), that perhaps it is a CBA issue rather than a sector-wide issue at the moment. CBA remains extremely expensive, trading at 2.7 times net tangible assets compared to 1.3 to 1.8 times of the other three majors. And it also is trading at three to four percentage points higher on a P/E basis to the other banks, so remains extremely expensive and is an underweight in our portfolio.

The February reporting season played out pretty much as we expected. Demand remained strong, and so the revenue line across many sectors was pretty solid. 

However, on the cost line, many companies really couldn't recover higher costs that we were seeing across the market. Labor was the standout cost that many companies were calling out. We saw that really across everything from mining companies like BHP (ASX: BHP) and Rio Tinto (ASX: RIO), all the way to construction companies and developers like Downer (ASX: DOW) and even the Coles (ASX: COL) and Woolworths (ASX: WOW) of the world we're really calling out the cost side and we really expect that to be a continuing thematic for a little while longer. And then given that reserve banks around the world are continuing to raise rates, we're going to start to see stress on the revenue line as demand actually falls off.

Jason Kim

The insurance sector’s performance during the February reporting season was a little bit mixed. We saw very strong performance from QBE (ASX: QBE), which just happens to be one of our major overweights in the portfolio. Suncorp performed well – maybe not quite as well as QBE – and IAG (ASX: IAG) was a little bit mixed.

At Tyndall, value is a very important consideration. We saw a lot of value in QBE and we do see further upside in the case of Suncorp (ASX: SUN). The team managed operations quite well in the face of rising claims inflation, but going forward we do see further benefits from rising interest rates which benefits their investment returns from their premium float. And more importantly, what we do need to see is claims inflation settle down as well as the heightened level of catastrophe activity also starts to normalize.

What we have seen is three La Niña’s in a row of the excessive rain. And, unfortunately, in New Zealand very recently we've seen some major events, but weather forecasters are saying that we might see a more normal year this year. And if we do, we should see some great performance over the next 12-18 months from the insurers.

We do believe that the insurance sector offers very attractive opportunities in the face of more normal kind of interest rates and inflation levels. 

And they do have reasonable pricing power. Having said that, we believe that QBE offers a more unique opportunity as they've gone through a significant management reset of the last couple of years under the new CEO Andrew Horton. He's been more conservative, under promising and trying to deliver on what he does.

Not only should we see earnings rise, but that consistency should result in a multiple re-rating for the company. It's now currently training at 10 times forecasted earnings. That's really quite low for a company of this calibre. Once the consistency does occur, we should see that 10 times expand to a much higher level, and that's the significant upside that we see in this stock.

Michael Maughan

In terms of dividends in this reporting season, we saw that they continue to be strong. Earnings is what drives dividends, and what we saw in this period was that costs were either up or higher than expected, but revenues so far have been able to keep up. So the margin impact has been pretty minor so far.

In terms of reported results, balance sheets are strong, so payout ratios are able to continue to be strong at the margins. We’ve seen a little bit more investment in on-market buybacks – because of a lack of franking credits – and small increases in capex at some companies.

In terms of the results and which companies really surprised or delivered on dividends during this period, Woodside (ASX: WDS) had a standout 80% payout ratio, despite the fact they've got a really significant pipeline of investment ahead of them. And that's because with the BHP merger, they're in a great position to be able to produce, explore, and invest for growth and deliver dividends and returns to shareholders along the way.

The other part of the market that was really strong was the energy retailers. So Ampol (ASX: ALD) and Viva Energy (ASX: VEA) had a really strong period and strong dividends to follow that. What we saw there was with airlines back, the demand supply equation for the refining business is more in their favour. And then on the retailing side, it’s a very rational market. Their retailing strategies are going really well, so that’s another area that really delivered.

What we've learned in reporting season is there is going to continue to be that breadth of dividends available in the market. We are going to be able to go where the value is in the market, be it in the cyclicals, or the miners who are going to continue to pay not at the peak levels of the they were at, but they're going to continue to pay strong dividends.

The energy imbalance in terms of the underinvestment over the last 10 years is going to continue. They're going to generate strong cash flows. We love those defensive yield names – Telstra (ASX: TLS), Coles, and the banks – because they've been really resilient to inflation and that's what we want them to be there for.

Looking forward, I think there's some really good opportunities for growth in stocks that were affected by the pandemic. GUD Holdings (ASX: GUD), which sells auto parts, was affected by the disruption to supply chains for new cars. They've started to improve, but there's a lot more to come for them, including paying strong dividends. Sky City (ASX: SKC), with its casinos in Auckland, is returning to pre-pandemic levels, but with a hotel and a convention center to come to drive growth in 2024 and 2025 and, again, reinstating the dividend.

So, we think some of these companies that are coming out of the pandemic have got some real upside to drive growth as well as yield.

Stefan Hansen

The big oil and gas players performed relatively well this reporting season. They were coming off the back of particularly strong oil and gas prices in 2022, so we knew that the results were going to be good.

For Santos (ASX: STO) in particular, the results were a small miss on underlying basis. But given those strong energy prices, free cash flow was a record for the company. That led to better-than-expected dividends and also saw the balance sheet continue to de-lever through the year to a level which gives us more comfort in their ability to deliver on these growth projects.

There is a potential asset sale that was announced last year and if that does get delivered – the sale of a small stake in PNG LNG – that will continue to provide that deleveraging to the balance sheet and create scope for additional capital returns beyond our base case expectations.

Of course, investment in Santos is not without risk. Despite the high energy prices of last year, there were some government intervention issues and regulatory issues with the offshore regulator around the Barossa project. That will continue to weigh on the stock, but we expect that to get resolved over this year. And then the delivery of these projects really is the key value driver in our view for Santos.

Iluka (ASX: ILU) is a huge beneficiary of the decarbonization thematic through its investments in rare earths. The result is mainly focused around their current production, which is mineral sands. It was a good result in line with their expectations and the dividend was slightly ahead. The guidance they gave was better than market expectations and the market outlook for mineral sands they gave was also quite positive. The key for us is the decarbonization rare earth thematic, and that's the area where we think the market is yet to fully value.

Iluka is currently building the Eneabba Rare Earths project. And that is mostly funded by the federal government's critical minerals facility. And that'll be developed over the next couple of years and allow Iluka to supply rare Earths into the Western world markets as those governments pursue their decarbonization goals.

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