"Consensus earnings still at least 10% too high". So what is this fundie doing about it?

Coming out of the pandemic, as inflation skyrocketed and rates followed like a well-trained dog, many in the market began calling for an earnings nosedive.

Whilst earnings expectations have come down, they haven’t collapsed by any stretch. The February reporting season in Australia demonstrated the resilience of corporate Australia – to that point at least.

The recent US earnings season saw earnings come in slightly weaker than expected but again, it was not calamitous.

That’s why the call that consensus earnings are still overcooked by 10%, is a big one – particularly when we’re only six weeks out from the next local reporting season.

The bold call is made by Ron Sargeant from Touchstone Asset Management.

“Many stocks are also trading at elevated multiples. Recently we’ve been able to add value through avoiding a lot of the earnings downgrades, although we’re still finding some new opportunities. 

They’re just more difficult to find given the outgoing earnings tide”, says Sargeant. 

In this wire, Sargeant shares with me his outlook for the Australian market, how he and the Touchstone team are navigating conditions, and two stocks that he believes are well-placed to weather the oncoming earnings storm.

Strap in, it could get bumpy

When offering his outlook for the next 12-24 months, Sargeant pulls no punches.

“We expect continued volatility into 2HCY23 with a soft reporting season in August and cautious outlook statements. The long-awaited consumer-led slowdown has started with many households facing sharply higher mortgages and cost of living”.

He adds that corporates will likely see lower volumes as an outcome, with “operating deleverage compounded by higher wages, energy and interest costs”.

Sargeant also points to the probability of a US recession and that markets aren’t particularly good at signalling when they will arrive.

“In the US, the market has generally been within 2% of its peak just four months before a recession starts”.

It makes one wonder if the recent surge in US equities is the last peak before the seemingly inevitable recession.

But it's not all bad news, says Sargeant:

“These tougher conditions should create a lot of opportunities in the next 6-12 months, particularly in some of the higher quality cyclicals and resource names”.

The good times and the bad

Tougher conditions aren’t a huge concern for Sargeant and the Touchstone team. Sargeant himself has been covering markets, with a focus on consumer sectors, for 25 years - and he’s seen it all. He readily admits that it is the periods of rampant speculation and excess global liquidity and low-cost capital (like the one pre-covid) that pose the most problems for the fund’s strategy.

“That [period] saw a number of stocks with little or no earnings, unproven business models, minimal competitive moats, and in some cases regulatory risks, trade at extreme valuations. Similarly, the valuations ascribed to long-duration assets left little room for error”.

During that period Sargeant says the team was happy just to keep up with the market.

In the period since, which has seen the macro environment normalise and a lesser focus on momentum, the fund’s focus on bottom-up stock picking and fundamentals has come to the fore.

“That’s given us the opportunity to leverage the team's experience to see our way through the uncertainty”.

The Touchstone process

The Touchstone Index Unaware Fund, as the name suggests, is both index and style unaware. And this is primarily because of the concentration within the Australian market.

As Sargeant explains, “The Australian equity market is unique in that it has a high level of concentration in the top 10 stocks - which comprise almost half of the index. In addition, it has an extremely high weighting towards banks and miners which together are around 45% of the index”.

Sargeant also emphasises that by adopting a passive or benchmark-aware strategy, ultimately investors end up with a very high-risk portfolio due to the high sector and stock concentration.

To avoid such concentration, Sargeant posits that a far better risk/return trade-off can be found by focusing on building a diversified portfolio of quality companies.

“Through time quality companies will find ways to grow earnings and shareholder value. The key is not to overpay and hence our ‘Quality at a Reasonable Price’ approach”.

Whilst lots of fund managers talk about quality, it can mean different things to different people. For Sargeant, the starting point for any discussion around Quality is to focus on why it matters. He adds that numerous studies show that combining Quality factors into a portfolio can deliver superior risk-adjusted returns and greatly reduce volatility.

Perhaps most importantly, however, is that it’s an important criterion for Touchstone clients.

“This is critical as our clients can be confident they can access funds when required. In more volatile return streams, investor returns often underperform their funds due to adverse timing impacts”.

When it comes to Quality, Sargeant contends that much of the industry spends significant time analysing earnings and deriving valuations and that “Quality is often considered in a far less systematic and objective manner”.

The issue with this, he adds, is that an otherwise great company only needs one deficient aspect of quality to have a materially negative impact.

“This occurred recently with IDP Education which had a weaker competitive moat than the market believed”.

Sargeant goes on to explain that Touchstone makes qualitative and quantitative assessments of several financial and non-financial quality factors of every company in its investment universe.

“These are then fed into a quantitative framework. As a result we can objectively and consistently assess quality across the ASX 300”.

As well as quality, Touchstone is concerned with “Reasonable price”, a function that is driven largely by the experience of the team. As well as the 25 years of experience that Sargeant has racked up, across the team the total sits at more than 200. This depth of experience means that the team can cover a great deal of ground when it comes to fundamental research.

“As with quality, it is critical to assess value within an objective, consistent and repeatable framework. A reasonable price is a price that would deliver an attractive return relative to the observed risk (as assessed by the quality) of the stock”.

There is one other factor that is often (but not always) common to the companies that make it into the portfolio, and that is a significant share of expected returns coming from sustainable dividends.

“In Australia, around half of the total return from the market comes from dividends - more when considering franking credits. So they’re important even before you consider the fact that the consistency and growth of dividend payments, and the ability to fund them from free cash flow, are also useful indicators of quality”.

What do you like right now?

Two stocks that have survived the Touchstone process are Goodman Group (ASX: GMG) and  CSL Limited (ASX: CSL).

Of the former, Sargeant says:

“It is very high quality with tier 1 assets, a strong balance sheet and an exceptional management team. We talk to a number of their tenants and are comfortable that even in a global downturn, demand for their properties will remain high."

"In addition, we expect that in a downturn they would find it easier to deploy capital at attractive returns. Such a scenario would eventually lead to lower interest rates and so would benefit long-duration assets such as GMG. Despite a solid growth outlook the stock is only trading on a high teens multiple, so looks reasonably valued”.

With respect to CSL, Sargeant notes the firm is a global biotech leader with exceptional positions in strong markets.

“Management is well-regarded with a proven track record and the company's balance sheet is sound. 

We’re forecasting annual earnings growth in excess of 15% per annum over the next few years. Following the company’s recent pullback, and given the very strong growth profile, the stock is expected to generate strong returns from here”. 

Successful long-term investing is a combination of both ‘art’ and ‘science’

Touchstone Asset Management is a Bennelong Funds Management Australian equities boutique with an index unaware approach to investing in quality companies at reasonable prices.. For more insights, visit Touchstone’s website.

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