Don't worry about the equity market rotation - rotating your portfolio is likely more important

One of the more astute observations of the Australian stockmarket both during and since reporting season is that the market “desperately wants to rotate away from previous winners”, says Alphinity Investment Management’s Bruce Smith.

The problem, however, is that “genuine new leadership is not yet apparent despite an initial swing to the more unloved parts of the market”.

For good measure, Smith adds that for a rotation to be sustained, it needs to be backed up by an earnings leadership change, which “isn’t evident at the moment”.

So, what are investors to do?

Whilst some investors have gone to cash, the Australian equity funds that Smith helps to manage have only seen cash tick up at the margin.

Rather, over the past few months, the portfolios have been undertaking their own modest rotations, by “exiting anything super expensive or with downgrade risk in favour of companies with more appealing upside to valuation and stable or improving earnings”, says Smith.

It just so happens that such companies happen to have been mainly lower-risk companies recently.

In the following Q&A, Smith sheds more light on Alphinity’s approach to the current market conditions and shares a couple of stocks he and the team have been buying and selling.

How are you navigating the current volatility in markets?

We’re not making any big moves across our three Alphinity domestic funds at this point. 

So much is changing on a day-to-day basis that making wholesale portfolio moves based on announcements would be rash. 

We are active, long-term investors, so we’ll keep looking at company fundamentals as always to stay true to our process. We invest in quality companies, trading at reasonable valuations with earnings upgrade prospects. We continue to look for the companies across all sectors and styles showing earnings leadership and watching closely for any changes to those.

Risk in the portfolio has dialed down a bit but not through conscious action, it’s more a function of a shift in the companies that look good on our process. 

Over the last few months, we were trimming or exiting anything super expensive or with downgrade risk in favour of companies with more appealing upside to valuation and stable or improving earnings. These happen to have been mainly lower-risk companies recently.

Cash levels haven’t changed much, we try to keep pretty much fully invested most of the time. Cash has only ticked up at the margin with some chunky dividend receipts after reporting season, and opportunities are starting to present themselves.

What other trends are you paying attention to at the moment?

We are focused on fundamentals: what individual companies’ earnings are doing and how the market is valuing them. We try not to overlay macro views on the portfolio, although we are very much aware of how the macro could impact on fundamentals. 

For instance, we have people travelling a lot at the moment to get insights into how companies and industries are going. Stephane is in China presently working out what is going on there and how it might affect our positions, especially in resources.

We are reasonably unconcerned about the domestic economy, with the caveat that some of the big shifts going on overseas could impact us at some point. 

US trade isn’t big enough to make that much of an impact, although who knows what might happen if the trade war spreads. Absent that, the risk of a domestic recession is probably overstated now that interest rates are edging lower and unemployment remains very low.

It was clear during the most recent reporting season that the market desperately wants to rotate away from previous winners (such as the banks and tech/AI beneficiaries), but convincing, genuine, new leadership is not yet apparent despite an initial swing to the more unloved parts of the market. 

Our focus on valuations, earnings revisions and the quality of those earnings provides us with a good anchor to navigate this volatile market. 

For a rotation to be sustained it needs to be backed up by an earnings leadership change, and that isn’t evident at the moment.

What was the most recent addition to the portfolio?

We added A2 Milk (ASX: A2M) earlier in the year and it had one of the better results of the recent reporting season. Some of the macro drivers are a bit challenging in the long term, particularly the low birth rate in China, but company-specific factors like market share gains more than outweighs that in the short to medium term.

What was the most recent exit from the portfolio and why?

We sold out of a couple of higher-multiple positions late last year, Xero (ASX: XRO) and CAR Group (ASX: CAR), as we could no longer see much upside to the prices they were trading at. Both are really well-managed companies with great products that we would be very happy to own again at the right price and time in their respective earnings cycles. 

The present share price volatility might provide an opportunity at some point, as long as the earnings case isn’t impacted. But given everything that’s going on around the world currently we are holding fire for now.

With volatility comes opportunity – if your view of the world plays out, where are you likely to be placing outsized bets to take advantage?

Volatility certainly will present opportunities but we remain focused on finding companies which have appealing upside to what we think they’re worth and also the prospect of ongoing earnings upgrades, as we’ve found that these are the types of companies that tend to outperform over time. 

That group of companies changes with shifts in market regimes but our insightful analysts and the risk-aware investment process we’ve been applying for more than 20 years has produced a portfolio that’s outperformed in most market environments. It is well placed to keep doing that.

Managed Fund

Alphinity Australian Share Fund

Australian Shares

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