Insights

• Morgans research analysts re-set their sector views, strategies and best ideas as dynamic forces continue to challenge markets.
• Our approach in equities currently favours stocks with compelling risk/reward profiles among quality cyclicals and select mid-to-small caps.
• Preferred equity sectors include staples, healthcare and financials along with select travel exposure.

Our base case remains a cyclical slowdown / mild recession

Our Asset Allocation Update – 2024 Outlook discusses three possible economic scenarios in 2024 and their investment implications in terms of portfolio asset allocation. Our base case scenario expects economic growth to contract in the first half of 2024 before returning to growth later in the year. Sticky inflation will keep interest rates higher for longer. Equities will likely remain rangebound until there is more certainty on the interest rate trajectory either peaking/falling.

This scenario could have an interesting dynamic around small and mid-cap stocks. These companies were derated in 2023 as they grappled with higher interest rates, and their risk-reward profile looks attractive despite the recession risks. With central banks on high alert for persistent inflation, short-dated, high-quality credit should form the core part of the fixed income allocation. A mild recession would be positive for property because a small amount of inflation is positive for real estate. Furthermore, REIT prices have declined materially, which could lead to opportunities in areas that investors have overlooked in 2023 (retail/commercial REITs).

Given Australia’s economic sensitivity to falling commodity prices, investors need to tread carefully over the next 3-6 months. As tailwinds from commodity prices fade, we think above-average earnings growth for the market will be harder to come by. Accordingly, we prefer a targeted portfolio approach, tilting toward what we believe are the best relative opportunities and the best risk/return profile e.g., small caps, quality cyclicals.

Morgans sector analysts have downgraded their rating on the Telco sector to Slightly Underweight (from Neutral). Telco sits in the expensive defensive basket with the positives looking priced in. The sector could easily see downside risks, potentially as a funding source for a rotation into growth sectors in 2024.

Relative 3-month asset class performances

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

Our best ideas are those that we think offer the highest risk-adjusted returns over a 12-month timeframe supported by a higher-than-average level of confidence. They are our most preferred sector exposures.

Additions: This month we add Super Retail Group (ASX:SUL)

Removals: This month we remove Commonwealth Bank (ASX:CBA) and Accent Group (ASX:AX1).

Large cap best ideas

Westpac Banking Corp (ASX:WBC)

WBC has a similar asset base, funding mix and domestic retail concentration as the premium priced CBA. However, its growth, profitability and ROE have been significantly weaker than this larger competitor, which is ultimately reflected in WBC’s lower earnings and asset-based trading multiples and higher cash yield. If WBC can materially improve its business performance (this is not without significant risk of disappointment) then an investment in its stock could deliver attractive returns as the share price rerates upwards and cash returns to investors lift.

Wesfarmers (ASX:WES)

WES possesses one of the highest quality retail portfolios in Australia with strong brands including Bunnings, Kmart and Officeworks. The company is run by a highly regarded management team and the balance sheet is healthy. We believe WES’s businesses, which have a strong focus on value, remain well-placed for growth and market share gains in a softening macroeconomic environment.

Treasury Wine Estates (ASX:TWE)

It may take some time for the market to digest TWE’s acquisition of Paso Robles luxury wine business, DAOU Vineyards (DAOU) for US$900m (A$1.4bn) given it required a large capital raising. The acquisition is in line with TWE’s premiumisation and growth strategy and will strengthen a key gap in Treasury Americas (TA) portfolio. Importantly, DAOU has generated solid earnings growth and is a high margin business. It consequently allowed TWE to upgrade its margins targets. While not without risk given the size of this transaction, if TWE delivers on its investment case, there is material upside to our valuation. The key near term share price catalyst is if China removes the tariffs on Australian wine imports.

Santos (ASX:STO)

The resilience of STO's growth profile and diversified earnings base see it well placed to outperform against the backdrop of a broader sector recovery. While pre-FEED, we see Dorado as likely to provide attractive growth for STO, while its recent acquisition increasing its stake in Darwin LNG has increased our confidence in Barossa's development. PNG growth meanwhile remains a riskier proposition, with the government adamant it will keep a larger share of economic rents while operator Exxon has significantly deferred growth plans across its global portfolio.

Macquarie Group (ASX:MQG)

We continue to like MQG’s exposure to long-term structural growth areas such as infrastructure and renewables. The company also stands to benefit from recent market volatility through its trading businesses, while it continues to gain market share in Australian mortgages.

CSL Limited (ASX:CSL)

While shares have struggled of late, we continue to view CSL as a key portfolio holding and sector pick, offering double-digit recovery in earnings growth as plasma collections increase, new products get approved and influenza vaccine uptake increases around ongoing concerns about respiratory viruses, with shares trading at 25x, a substantial discount (20%) to its long-term average.

ResMed Inc (ASX:RMD)

While weight loss drugs have grabbed headlines and investor attention, we see these products having little impact on the large, underserved sleep disorder breathing market, and do not view them as category killers. Although quarters are likely to remain volatile, nothing changes our view that the company remains well placed and uniquely positioned as it builds a patient-centric, connected-care digital platform that addresses the main pinch points across the healthcare value chain.

Transurban (ASX:TCL)

TCL owns a pure play portfolio of toll road concession assets located in Melbourne, Sydney, Brisbane, and North America. This provides exposure to regional population and employment growth and urbanisation. Given very high EBITDA margins, earnings are driven by traffic growth (with recovery from COVID) and toll escalation (roughly 70% by at least CPI and approximately one-quarter at a fixed c.4.25% pa). We think TCL will continue to be attractive to investors given its market cap weighting (important for passive index tracking flows), the high quality of its assets, management team, balance sheet, and growth prospects.

QBE Insurance Group (ASX:QBE)

With strong rate increases still flowing through QBE's insurance book, and further cost-out benefits to come, we expect QBE's earnings profile to improve strongly over the next few years. The stock also has a robust balance sheet and remains relatively inexpensive overall trading on 8x FY24F PE.

Aristocrat Leisure (ASX:ALL)

We have three key reasons for being positive on ALL. They are: (1) long-term organic growth potential. ALL is better capitalised than many of its competitors and has what we regard as a strong platform to continue investment in design and development in both its land-based gaming and digital businesses; (2) strong cash conversion and ROCE. ALL is a capital-light business despite its ongoing investment in Gaming Operations capex and working capital. It has a high level of cash conversion and ROCE; and (3) strong platform for investment. ALL has funding capacity for organic and inorganic investment in online RMG, even after the recent buyback. Its current available liquidity is $3.8bn.

Mineral Resources (ASX:MIN)

MIN is a founder-led business and top tier miner and crusher that has grown consistently despite barely issuing a share over the last decade. Also helping our investment view is that MIN’s diversification leaves it far more capable of tolerating volatility in lithium markets than its peers in the sector. We see MIN’s lithium / iron ore market exposures as an ideal combination to benefit from the China gradual recover. We also see MIN as well placed to grow into its valuation, even if we see unexpected metal price volatility, given the magnitude of organic growth in the pipeline.

South32 (ASX:S32)

S32 has transformed its portfolio by divesting South African thermal coal and acquiring an interest in Chile copper, substantially boosting group earnings quality, as well as S32's risk and ESG profile. Unlike its peers amongst ASX-listed large-cap miners, S32 is not exposed to iron ore. Instead offering a highly diversified portfolio of base metals and metallurgical coal (with most of these metals enjoying solid price strength). We see attractive long-term value potential in S32 from de-risking of its growth portfolio, the potential for further portfolio changes, and an earnings-linked dividend policy.

Goodman Group (ASX:GMG)

GMG represents c.27% of the ASX A-REIT index and is one of the few offshore earners in the A-REIT space. GMG rarely screens cheap against domestic peers, but within the context of its offshore peers, it consistently delivers higher returns at lower levels of leverage and at a comparable price to book ratio. Growth in Assets Under Management and development completions are a key determinant of value and an AUM of A$80bn (US$50m) is comparatively modest in a global context, whilst A$7bn (US$5.5n) of completions pa we see as likely sustainable. With continued increases in interest rates and persistent inflation (most notably construction costs), risks abound the REIT sector. This drives our preference for beds and sheds, reflecting the strength of those underlying operating markets. Given the duration risk from higher rates, we prefer more active managers who can grow AUM and add value from an active buy, build, manage strategy. To this end, strong balance sheets are also key to navigate any deterioration in book values.

Qantas Airways (ASX:QAN)

QAN is trading at a material discount compared to pre-COVID multiples, despite having structurally higher earnings, a much stronger balance sheet, a better domestic market position, a higher returning International business and more diversification (stronger Loyalty/Freight earnings). The strong pent-up demand to travel post-COVID should result in a healthy demand environment for some time, underpinning further earnings growth over FY24/25. QAN’s balance sheet strength positions it extremely well for its upcoming EBIT-accretive fleet reinvestment and further capital management initiatives (recently announced another A$500m on-market share buyback at its FY23 result).

Morgans clients can download our full list of Best Ideas, including our mid-cap and small-cap key stock picks.

Your Wealth is a half-yearly publication produced by Morgans, that delves into key insights for Wealth Management, including the key spotlight article ‘Innovative retirement income streams.’

This latest publication will also cover giving an early inheritance to your children, an economic update addressing a slowdown in US economic growth, and SMSF trustee education, emphasising the significance of a written investment strategy.

Download your copy today to receive the latest insights.

Innovative Retirement Income Streams

In February 2022, legislation was enacted which inserted a new covenant into the Superannuation Act that requires trustees of superannuation entities to develop a retirement income strategy for Australians who are retired or are approaching retirement. This covenant is known as the Retirement Income Covenant and requires large (non-SMSF) super fund trustees to have a strategy to assist beneficiaries to achieve and balance the following three objectives:

• maximising expected retirement income;
• managing expected risks to the sustainability and stability of their expected retirement income; and
• having flexible access to expected funds during retirement.

Since then, a number of new innovative products have been developed and introduced to the market.

Morgans has reviewed a number of these innovative products, the details of which are summarised in the latest publication of Your Wealth.

Morgans Chief Economist Michael Knox says that core Australian CPI numbers still suggests another RBA rate hike. However, we may not see rates rise until February 2024.

Watch

Listen

Treasury Wine Estates (TWE)

Pre-COVID, TWE was one of the ASX’s great growth stocks, delivering shareholders strong returns over many years. In recent years, COVID and the China tariffs on Australian imported wine have knocked the stock for six.

Just when its share price was starting to recover given Australia/China’s improving government relationship and the possibility that the absorbent tariffs could be removed, it announced a big acquisition of Paso Robles luxury wine business, DAOU Vineyards (DAOU) for US$900m (A$1.4bn). While the acquisition is in line with TWE’s premiumisation and growth strategy and will strengthen a key gap in Treasury Americas portfolio, it was much larger than the market was expecting.

Consequently, it required a large equity raising to fund it. It will therefore take some time for this raising to be absorbed by the market. Additionally, there have also been mixed views from some camps on the acquisition given TWE’s chequered history in the US under previous management teams. We take some comfort that its last acquisition in the US, Frank Family Vineyards, has gone extremely, well beating its original business case, albeit it was a much smaller acquisition than DAOU.

Post this transaction, TWE will become the largest player in the US luxury wine market. In the future, TWE will have two luxury wine businesses of scale – Penfolds and Treasury Americas Luxury. Both these businesses which are high margin and high growth, will make up the bulk of TWE’s earnings and will command higher trading multiples. Over time, to focus on its luxury wine businesses and to realise shareholder value, TWE may look to demerge or divest its much smaller Treasury Premium Brands business unit. The key near-term catalyst for the stock is China removing the tariffs on Australian wine imports.

TWE’s FY24 guidance and long-term earnings expectations do not assume any benefits from a positive outcome in relation to the review of tariffs on Australian wine into China. If China tariffs are removed, there is upside to its growth expectations over the coming years. While TWE will report a weak 1H24 result, from the 2H24 onwards it has the drivers in place to deliver solid earnings growth over the next few years. We are therefore taking advantage of recent share price weakness to get set for what should hopefully be a strong rerating over coming years.

Lovisa (LOV)

Although the share price of Lovisa has increased nearly 10x since listing at $2 nine years ago, the ride has never been a smooth one. Before the most recent correction, there have been three periods when the shares have fallen by more than 40% (June 2018 to January 2019; October 2019 to March 2020; and November 2021-June 2022) and, on each occasion, the price has bounced back to a new all-time high.

We’re confident the ~30% fall in the share price since April this year will be no different. To appreciate the reasons for our view, it’s important to understand the causes of this most recent period of share price weakness. One is the broader cyclical move away from consumer discretionary stocks due to concerns about household spending in the context of rising borrowing rates and stubbornly high inflation around the world.

Cycles turn, and when interest rates finally show signs of plateauing and inflation begins to normalise, it is likely investor sentiment towards the sector will warm up and Lovisa shares will be much sought-after as a way of playing the recovery.

A second reason for Lovisa’s recent share price underperformance is the recent move into negative like-for-like sales growth. So far this financial year, sales on a comparable store basis have fallen by 6%. Investors don’t like to see this, but it has been experienced against an unusually strong period last year when like-for-like growth was +16% following an uplift in selling prices. On a two-year basis, growth is still very positive. We expect negative like-for-like sales to be a temporary function of cycling strong comparative numbers and we expect a return to positive growth from around March next year.

Furthermore, the key value driver for Lovisa is the expansion of its global network and we think it should be remembered that Lovisa grew total sales by 17% in the first 20 weeks of FY24, demonstrating the benefit of this expansion. Lovisa recently announced that it will shortly be opening its first stores in mainland China (population: 1.4 billion) and Vietnam (population: 99 million), a development that could lock in substantial network expansion for the future.

Lovisa has proven it can successfully build out its unique brand in many diverse territories around the world on its journey to becoming a truly global brand. It’s at times like these that investors should be getting set to reap the rewards of this strategy over the longer term.

ResMed (RMD)

RMD has lost nearly A$7bn in market capitalisation (more than 1/3 of its total value) in a mere quarter, unprecedented in 24 years of listing, due to investor angst around the potential impact of weight loss drugs, namely GLP-1s (Glucagon-Like Peptide-1), in curtailing the core obstructive sleep apnoea (OSA) addressable market. Hype and hope tend to spring eternal in medicine.

We believe talk of an emerging weight loss drug ‘revolution’ should not feared as an existential threat, but instead as a unique opportunity to buy a quality global franchise at a discounted price, especially considering the impact of weight loss drugs is likely to be fairly limited given the following.

First, it is a mere fallacy to simply assume drugs that reduce obesity will ‘cure’ OSA, despite the majority (~65%) of OSA being linked to excess body weight. Unfortunately, nothing in medicine is ever that simple, especially when you are dealing with a complex, chronic disease that is driven by a myriad of underlying factors. Even bariatric surgery, which is and is likely to remain the most effective intervention for obesity treatment and long-term maintenance of body weight, is not a ‘cure’ for OSA. However, bariatric surgery has been shown to reduce OSA severity, but this has had no discernible impact on RMD’s top-line growth.

Second, weight loss drugs have historically suffered from low adherence and high relapse rates, along with a long and chequered safety profile. We have no reason to believe the latest iteration in this class, which is actually more than 15 years old, should not follow suit.

Third, affordability and accessibility should not be underestimated, as the prevalence of obesity is most acute in lower socio-economic demographics. Recent published reports indicate that ~25% of Americans already have difficulty affording their medications, with ~30% not taking their medicines as prescribed at some point in the past year due to the cost. At an annual cost of US$10-15k, GLP-1s are beyond the realms of affordability for most of the population.

Lastly, OSA represents a large (>1bn) and underdiagnosed (<5%) market for RMD’s gold standard continuous positive airway pressure (CPAP) devices. Even if we assume an aggressive 50% uptake of weight loss drugs, the OSA market for CPAP would remain deeply underserved (<10%). As such, it is really OSA diagnosis and not the potential competitive treatment from weight loss drugs, that is the limiting factor for the uptake of CPAP. More realistically, the weight loss drugs are likely to complement rather than compete with CPAP; ultimately, helping to increase awareness about obesity and opening up the market to more patients who seek treatment.

The bottom line, and in the words of ‘The Oracle of Omaha', “be fearful when others are greedy and be greedy only when others are fearful."

Morgans clients receive exclusive insights such as access to the latest stock and sector coverage featured in the Month Ahead. Contact us today to begin your journey with Morgans.

Morgans Chief Economist Michael Knox discusses the key drivers for the lack of a US recession in 2023 and explains why Joe Biden's economic policy isn't more popular.

Watch

Listen