17 April 2024
Elston Quarterly Portfolio Update Q2 2024
In this video, Portfolio Manager David Seager provides his perspective on the key questions discussed in the recent quarterly asset allocation meeting. Read more
This article was originally published on LivewireMarkets.com on July 5th, 2023
Despite all the doom and gloom of recession fears, inflation that remains well above central bank targets, and predictions that interest rates were going to 6%, equity markets rallied and rallied hard in the last 12 months. The ASX 200 finished the 2022/2023 financial year up more than 10% while the NASDAQ 100 soared nearly 40%. What downturn!
But now that investors have finished their tax-loss selling and the slate is (proverbially at least) clean, where can you put some of that dry powder to work?
To answer those questions, we’ll be asking a slew of fundies to take up a hypothetical challenge.
If you were given $10,000 in fresh capital by a new investor, where would you put it to work and why?
In this wire, we’ll hear from the first team to take up the challenge – Leon de Wet from Elston Asset Management.
What’s your opinion on valuations in the Australian equity market?
de Wet: Most major developed markets are still fighting stickier core inflation despite significant rate hikes, and given the resilience to date in economic activity and employment, the risk of major central banks raising rates too aggressively is growing especially given the tightening in lending standards that has occurred too.
And while the fight to tame inflation will not necessarily lead to recessions, it will lead to economic slowdowns including here in Australia with corporate earnings impacted negatively.
Characterising markets as reasonably valued based on averages is misleading – sections of the market are fully priced or even still expensive. Despite being wound back in recent months, aggregate earnings per share (EPS) forecasts for FY24 for the S&P ASX 300 Index are generally still too high. (Note: The ASX 200 P/E ratio is currently around 16.)
Forecasts seem to be underestimating the potential headwinds of slowing revenue (courtesy of demand destruction given higher rates) and cost pressures amid high inflation that are likely to crimp historically high profit margins.
The upcoming August reporting season is a likely catalyst for a reassessment of expectations.
How did you pick the assets you did for this experiment?
de Wet: For anybody uncertain as to whether they may need that $10,000 in the next 12 months, the old adage “cash is king” probably applies. That’s because we are cautious about the market outlook for many of the same reasons expressed by others in recent weeks on Livewire.
Notwithstanding downside vulnerabilities, for those willing to tolerate possible volatility we’d suggest investing that spare $10,000 across the three companies as set out below – we think they provide some of the better earnings certainty into FY24.
As a firm, we are believers in sensible diversification since the future is ultimately uncertain and as investors, we will inevitably get things wrong.
Elston’s $10,000 ideas
| Company | Stock code | Allocation (%) |
|---|---|---|
| Aurizon | ASX: AZJ | 30 |
| CSL | ASX: CSL | 40 |
| Worley | ASX: WOR | 30 |
As part of the piece, de Wet shared with us Elston’s reasons for why they picked the companies that they did.
The case for Aurizon (ASX: AZJ)
In the absence of ESG objections, we believe Aurizon offers earnings growth in the year ahead notwithstanding the weakening economic outlook with a >5% fully franked dividend to boot.
The reason for this is twofold – a recovery in the volume of coal hauled across NSW and QLD and an increase in the maximum revenue it can charge for access to the Central Queensland Coal Network (CQCN).
In FY23 Aurizon has been impacted by the lingering effects of unusually wet weather (can negatively impact a coal system for 12 months or more), and a track derailment in the Blackwater system in February this year, the latter accounting for around 35% of total tonnes hauled on the CQCN in FY22.
The other positive is increased revenue the company will earn over the next few years starting in FY24 for granting access to the 2,670km CQCN it operates, the largest open access coal rail network in Australia that connects customers from more than 40 mines to five export terminals located at three ports.
A regulatory framework permits Aurizon to earn an approved return on its Regulatory Asset Base (RAB) and recover its capital expenditure. Under the 10-year agreement with miners for the period 2018-2028, commencing in FY24 certain external inputs used to calculate the allowable return are reset – these include CPI, a discount rate and debt spreads.
In essence, with higher inflation and bond yields plus wider credit spreads, the maximum revenue that it can charge to access the CQCN is being increased.
The case for Aurizon (ASX: AZJ)
In the absence of ESG objections, we believe Aurizon offers earnings growth in the year ahead notwithstanding the weakening economic outlook with a >5% fully franked dividend to boot.
The reason for this is twofold – a recovery in the volume of coal hauled across NSW and QLD and an increase in the maximum revenue it can charge for access to the Central Queensland Coal Network (CQCN).
In FY23 Aurizon has been impacted by the lingering effects of unusually wet weather (can negatively impact a coal system for 12 months or more), and a track derailment in the Blackwater system in February this year, the latter accounting for around 35% of total tonnes hauled on the CQCN in FY22.
The other positive is increased revenue the company will earn over the next few years starting in FY24 for granting access to the 2,670km CQCN it operates, the largest open access coal rail network in Australia that connects customers from more than 40 mines to five export terminals located at three ports.
A regulatory framework permits Aurizon to earn an approved return on its Regulatory Asset Base (RAB) and recover its capital expenditure. Under the 10-year agreement with miners for the period 2018-2028, commencing in FY24 certain external inputs used to calculate the allowable return are reset – these include CPI, a discount rate and debt spreads.
In essence, with higher inflation and bond yields plus wider credit spreads, the maximum revenue that it can charge to access the CQCN is being increased.
The case for CSL Limited (ASX: CSL)
Admittedly not a novel idea, but as a non-cyclical business it should perform regardless of economic conditions with CSL Behring still a COVID recovery play in the years ahead.
In our view the recent downgrade was an isolated incident, and the subsequent share price weakness offers a good opportunity to buy Australia’s largest biopharmaceutical company and one of the largest and most efficient plasma treatment developers globally.
While disappointing, focusing only on the slower-than-expected gross margin recovery in CSL Behring (this business is the largest contributor to total profit), in our view misses the big picture. Behring’s focus on the development and distribution of plasma products to treat immune deficiencies and chronic illnesses sets it up well for growth driven by higher disease awareness & diagnostic rates, alongside an ageing population.
Substantial unmet demand for the plasma industry’s base and specialty products combined with improving plasma supply dynamics – increased collections aided by an expanding plasma collection centre network and expected efficiency gains from a new plasma collection platform – provide a long runway for growth.
Valuation is reasonable given the quality of the business and still solid growth prospects – management have guided to NPATA growth of 13-18% for FY24 in constant currency. In our view, the company will continue to deliver low-to-mid double-digit earnings growth over the next few years beyond that.
The case for Worley (ASX: WOR)
This professional services firm provides engineering, consulting and construction services to companies operating across three key end markets – Energy, Chemicals and Resources.
The crux of the thesis is that the unstoppable decarbonisation of economies will offer attractive investment opportunities via companies focused on the multi-decade, potentially multi-trillion dollar energy transition towards net-zero.
Whatever the final cost, the annual spend needed to achieve net zero targets will need to increase by multiples of what is currently being spent. Also, with roughly 80% of revenue from reimbursable contracts, it has pricing power in the current inflationary environment.
Given a strategic refocus in recent years to energy transition and circular economy opportunities, we believe Worley is well placed to benefit from decarbonisation with segments like offshore wind, hydrogen, and carbon capture & storage complimentary to the company’s ‘legacy’ core competencies.
Recent updates show an 8%+ backlog growth in the 9-months to 31 March to $16.7 billion. This not only infers that solid revenue growth is coming, but also provides confidence in Worley’s competitive position. Importantly, with a growing proportion of revenue being driven by more complex sustainability projects, EBITDA margins are also improving and, in our view, may surprise positively going forward versus consensus expectations.
Admittedly, given current forward PE multiples, something to watch in the event of a severe recession is whether customers cut back spending and the current rational bidding environment holds.
If you would like more information, please call 1300 ELSTON or contact us.
