Insights

• We see a strong chance of FY19 results beating low expectations, but market estimates for FY20 look too heroic, leaving scope for some disappointment versus very stretched valuations. Be vigilant with high growth stocks in this context.
• We think upside surprise to capital management may again feature in August. Investors have sought returns in defensively oriented names since the February reporting season.

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FY20 forecasts vs stretched valuations leave little room for error

Stocks enter the August reporting season with very low expectations for FY19 on aggregate. Consensus expectations for FY19 EPS growth (excluding Resources stocks) have eroded from around 4.7% post February results to only 1% heading into August. This has been a persistent theme for 3-4 years now.

So while we think that results can clear this low hurdle for FY19, we do worry about:

1. current consensus FY20 EPS growth expectations looking look too heroic at ~8%; and
2. aggregate industrials valuations at a decade high 17.5x (12-month forward PE multiple) leaving very little room for error in FY20 outlook commentary versus consensus expectations.

Capital management once again in focus

Lower rates have again fueled the 'yield' trade. A mix of slowing economic growth, interest rate cuts and companies dialling back expansion capex have created an ideal environment for yield investors.

We think upside surprise to capital management may again feature in August. Investors have sought returns in defensively oriented names since the February reporting season.

However, we're uneasy about this dynamic in the context that EPS expectations, which support DPS expectations, have continued to erode.

Pay close attention to the sustainability of future capital returns.

Growth names have defined 2019

Our basket of Growth bellwethers has outpaced Value by 41% YTD (page 10), and this highlights the ongoing trend of high PE stocks re-rating further against the pool of lower valued stocks. The spread is now 18 PE points vs the 10-year average of 10.

A slowdown in the economic climate and falling interest rates have contributed to the appeal of growth, extending valuations further.

However, as the focus turns to domestic earnings and given expectations are higher than ever, we could be nearing the eventual cyclical turning point.

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.

Woolworths (WOW) has unveiled plans to consolidate its drinks and hospitality businesses into a single entity, Endeavour Group. This strategic move precedes a potential demerger in CY20, aiming to streamline operations and enhance focus within Woolworths' core Food business.

Endeavour Group Restructure

Overview

Endeavour Group will integrate Woolworths' drinks division, comprising retail brands like Dan Murphy’s and BWS, with its hospitality arm, ALH Group, which manages a portfolio of pubs, bars, and hotels. Following consolidation, Woolworths intends to pursue a demerger or explore other value-enhancing alternatives.

Timeline

The restructuring is slated for the second half of CY19, with the demerger or sale anticipated in CY20.

Ownership Structure

Upon consolidation, Woolworths will hold an 85.4% stake in Endeavour Group, while the Bruce Mathieson Group (BMG) will own the remaining 14.6%. Woolworths plans to retain a minority shareholding in Endeavour Group post-demerger.

Focusing on Food Business

Strategic Rationale

The separation of Endeavour Group will enable Woolworths to sharpen its focus on its core Food business. This move is strategic amid rising competition, escalating costs, and evolving consumer preferences, with digital platforms gaining prominence.

Growth Opportunities

With a more streamlined structure, Endeavour Group can pursue growth initiatives such as accelerating store renovations and expanding its store footprint. Capital investment in Endeavour Group was previously limited due to higher returns in the Food business.

Potential Gambling Exit

While Woolworths maintains it isn't distancing itself from the gambling industry, the Endeavour Group separation could facilitate a potential exit from gambling activities in the future.

Valuation and Investment Outlook

Endeavour Group Valuation

As a standalone entity, Endeavour Group is valued at an enterprise value of A$10.5-11.5 billion, based on a 14-15x FY20F EV/EBIT multiple. This valuation aligns with industry peers such as Coles Group (COL) and Wesfarmers (WES).

Investment Insights

No changes are made to earnings forecasts, but adjustments are made for recent off-market buybacks. Despite a robust balance sheet and positive sales momentum, Woolworths' fully valued status, trading at 23.3x FY20F PE ratio and 3.2% yield, prompts a hold rating.

In conclusion, Woolworths' strategic restructure underscores its commitment to optimizing its business portfolio and enhancing shareholder value amidst a dynamic market landscape.

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.

Investing in abnormal markets

Australian banks and high yielders enjoyed a relief rally post the surprise Australian Federal election result, but Australian long bond rates plummeting to record lows (below 1.3%) has been the major driver of Australian equities to near record highs. This is a pure yield arbitrage story. With Australian equity yields (ex-Resources) at decade lows (4.3%), their premium over long bond rates (roughly 3%) is currently at decade highs, supporting the share push to extreme valuations (currently >17.5x 12-month forward).

What worries us is the ongoing erosion in profit growth expectations. This was a difficult 'Confession season' this year with several larger stocks downgrading earnings guidance. That said, with the removal of Federal Election uncertainty, and with forecast FY19 earnings growth now at zero, the market has set itself a very low hurdle to clear heading toward August results.

Highlighting four standout opportunities over a 12 month period

Our Sector Analysts have provided an update on key dynamics, the outlook and have nominated their preferred picks per ASX sector.

We highlight four standout opportunities below, including our forecast 12-month return:

• Westpac Banking Corporation (WBC) – 27% forecast 12-month return
• Orora Limited (ORA) – 13%
• Treasury Wine Estates Limited (TWE) – 26%
• Oil Search Limited (OSH) – 48%

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.

With the election out of the way and Labor's more disruptive reforms defeated, market sentiment has clearly taken a turn for the better. Looking ahead, the most likely scenario is that the domestic and global economy will find ways to grind higher, although the likely pace of business activity now looks slower than previously expected.

Political certainty provides some relief but more will be needed

The Coalition victory is undoubtedly positive for the equity market and particularly domestic cyclicals. We note that the market had already priced in the risks that a Labor Government and their 'controversial' policies posed. Banks had their best week in over three years, up 8.1% the week following the election. While investor sentiment has improved and will continue to buoy the market over the short term, we think a clear agenda for stimulating economic growth, other than solely relying on tax cuts and monetary policy, will be necessary to sustain further gains.

Watch

Two changes to our High Conviction picks this month

We have removed Reliance Worldwide (RWC) from our list due to the weaker-than-expected downgrade in May and our subsequent change in recommendation to Hold. While the absence of a freeze event in the US was in line with our expectations, we are concerned about the downturn in multi-res in Australia and the increase on US tariffs on imports from China that could negatively impact FY20 earnings.

We have added OZ Minerals (OZL) given the near 20% correction from its early April peak. In our view this looks far too overdone versus a less dramatic adjustment in A$ copper fundamentals.

Five high conviction ASX100 stocks in June

Our high conviction stocks 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 typically our preferred sector exposures.

Five high conviction ASX100 stocks in June:

1. OZ Minerals (OZL)
2. Oil Search (OSH)
3. ResMed (RMD)
4. Sonic Healthcare (SHL)
5. Westpac Bank (WBC)

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.

Disclosure of interest: Morgans may from time to time hold an interest in any security referred to in this report and may, as principal or agent, sell such interests. Morgans may previously have acted as manager or co-manager of a public offering of any such securities. Morgans affiliates may provide or have provided banking services or corporate finance to the companies referred to in the report. The knowledge of affiliates concerning such services may not be reflected in this report. Morgans advises that it may earn brokerage, commissions, fees or other benefits and advantages, direct or indirect, in connection with the making of a recommendation or a dealing by a client in these securities. Some or all of Morgans Authorised Representatives may be remunerated wholly or partly by way of commission.

In its statement on 20 March 2019, the Open Market Committee of the Federal Reserve noted "on a 12 month basis, overall inflation has declined, largely as a result of lower energy prices; inflation for items other than food and energy, remains near 2 percent". This means that the Fed now believes it has hit its inflation target. In the following two paragraphs, the Fed twice made reference to their "symmetric 2 percent objective".

The first time was in the sentence "the committee continues to view sustained expansion of economic activity, strong labour market conditions, and inflation near the committee's symmetric 2 percent objective as the most likely outcomes". This means that the Fed believes it is also achieving its full employment objectives at the same time as hitting its inflation target.

Since the Fed is now hitting both of its targets, the right thing to do should be to do absolutely nothing. This is what they decided to do by leaving the Fed Funds rate unchanged. In the third paragraph of the statement, the Open Market Committee of the Fed said that it would continue to assess "expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective".

Symmetric Inflation Objectives

I was not aware that the Fed had changed its statement of inflation targeting to that of a symmetric inflation target until I attended a presentation by Jay Powell, Chairman of the Federal Reserve, in Atlanta in January 2019. What does the Fed mean by "symmetric"?

In October 2017, former chairman Ben Bernanke published a paper showing that because the Fed had been underachieving its 2 percent inflation target for some years, the increase in the price index for the personal consumption deflator was now around 5% lower than it would be, had the target been achieved. This suggested that the Fed could allow inflation to run above the 2 percent target for a number of years, in order to increase the personal consumption deflator to the level that it would be, if the 2 percent target had been hit each year. Other economists had achieved this same position by suggesting that the price level, rather than just the inflation rate, should be part of the target.

The idea of the symmetric target then came into the Fed statements. It means that over the coming years, the Fed may allow the personal consumption deflator to run higher than its 2 percent annual target, in order to allow the price level to rise towards a long term target.

The Benefit of Symmetrical Inflation Targeting

The Fed believes, and we believe, that the US economy will go into a soft landing or growth recession between the middle of 2020 and the beginning of 2021. As the US economy slows into that growth recession, it is important that the growth remains still positive, even though unemployment goes up. The increase in unemployment that the Fed is seeking to achieve by this slowdown would only raise US unemployment from 3.7% to 4.3%.

The difficult thing in the slowdown is stopping it from being a full blown recession. A smart way to prevent a sharper than desired deceleration of growth in 2020 and 2021 is to be reducing the real Fed Funds rate as we enter 2020. Interestingly, this is exactly what will happen if the Fed keeps the Fed Funds rate exactly where it is and allows the inflation rate to rise for a small period above its inflation target. The decline in the real Fed Funds rate in 2020 and 2021, will provide the support that the US economy will need to prevent further deceleration.

The Fed Outlook

The mid points of the economic projections of the Federal Reserve Board members and Federal Reserve presidents in March 2019, is shown in Figure 1 below:

The median expectation is for US growth to slow to 2.1% in 2019 from the 3.1% growth that was achieved in 2018. They believe that growth will continue to decline to 1.9% in 2020 and 1.8% in 2021.

As this gradual slowdown occurs, they believe that unemployment will rise from 3.7% in 2019 to 3.8% in 2020 and 3.9% in 2021. In the long term, they think that unemployment will stabilise at 4.3%. We point out that if the Fed achieves this low level of unemployment in 2019, 2020 and 2021, they will achieve the lowest level of sustained unemployment the US economy has seen since 1968 and 1969.

The Fed believes the core personal consumption deflator will hit its 2% target in 2019, 2020 and 2021. We believe it will overshoot in 2020 and 2021 and the Fed in response, will do nothing. By doing nothing at that time, they reduce the real Fed Funds rate to put a floor under growth in 2021.

The median expectation, is that the Fed thinks there will be no increases in the Fed Funds rate in 2019, there will be one increase in the Fed Funds rate in 2020, but in the long term, beyond 2021, the Fed Funds rate will settle at a long term equilibrium point around 50 basis points higher than the current level.

Conclusion

The Open Market Committee of the Federal Reserve now believes that they have achieved their objective of a 2% inflation target and full employment. Not wishing to mess up a good thing, they have decided that the best thing to do is nothing.

Interestingly, their inflation target is now stated as "symmetric'. By allowing inflation to run above its objective for a short time, they might be reducing the real Fed Funds rate ahead of an anticipated slowdown in 2020 and 2021. This means that inflation might help the Fed in providing support for a softer US economy in 2021.

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.

Reporting season in a nutshell

In our reporting season preview we noted that the spread in consensus forecasts was very narrow and the potential for beats and misses versus market expectations was lower than normal. It is this dynamic that foreshadowed many of the results across our coverage universe, where results were mostly in line with expectations.

Earnings momentum was mixed with no clear directional trend and it is clear market rotation rather than breakout has defined the FY18 reporting season – we are still waiting for the circuit breaker.

Pleasingly, results mostly shrugged off the systemic risks that posed a threat to earnings heading into August (e.g. housing slowdown, weak consumer confidence, intensifying regulatory concerns and political risk). No bad news was welcome news and investors put cash to work by backing solid inline results.

Investors have to be more tactical given the current market settings of elevated valuations and cautious sentiment.

Watch

Three changes to our list this month

We add Australian Finance Group (AFG) and Noni B (NBL) to our list in September.

For AFG, we believe concerns about regulatory risk regarding broker remuneration models as well as consternation about the cooling housing market are overdone. Such concerns have resulted in this stock offering good value and an attractive dividend yield.

Noni B now commands approximately A$1bn of sales and a material portion of the womenswear market. This should enable NBL to rationalise an industry which has been primarily focused on volumes and discounting, and in doing so increase profitability over time.

We remove Suncorp Group (SUN) this month following the solid result in August and the completion of the Life Business sale. Despite the removal, Suncorp still remains our preferred exposure in the large-cap diversified financials and insurance space.

Nine high conviction stocks in September

Our high conviction stocks 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 typically our preferred sector exposures.

Here are our seven high conviction stock picks this month:

1. Atlas Arteria (ALX)
2. OZ Minerals (OZL)
3. Westpac Bank (WBC)
4. Australian Finance Group (AFG)
5. Noni B (NBL)
6. CML Group (CGR)
7. Kina Securities (KSL)
8. PWR Holdings (PWH)
9. Volpara Health Technologies (VHT)

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.

Disclosure of interest: Morgans may from time to time hold an interest in any security referred to in this report and may, as principal or agent, sell such interests. Morgans may previously have acted as manager or co-manager of a public offering of any such securities. Morgans affiliates may provide or have provided banking services or corporate finance to the companies referred to in the report. The knowledge of affiliates concerning such services may not be reflected in this report. Morgans advises that it may earn brokerage, commissions, fees or other benefits and advantages, direct or indirect, in connection with the making of a recommendation or a dealing by a client in these securities. Some or all of Morgans Authorised Representatives may be remunerated wholly or partly by way of commission.