Forget the white-knuckle ride, there’s plenty of opportunity beyond banks and miners

Hershan is right to point out that there are fundamental and non-fundamental reasons why stocks move, and the reasons above fall into the latter category. He goes on to distinguish that the Yarra equities team chooses to research and invest in a business' fundamentals.

Regardless of the reasons for the rally in the banks, Hershan notes that “the further you pull on a string, the more likely it is to break.

And when it does, it could be a pretty volatile correction.”

We could be starting to see things unravel right now. More recently, the banks have fallen around 10%, with that capital largely flowing to materials plays, much of it the iron ore miners. The sector is up around 13% over the past month.

But is that rotation simply transferring the inefficiency? While an argument could be made that Chinese stimulus has warranted the rally in materials, Hershan seems unconvinced.

“If you're an ASX 200 investor, you've got the two big barbells: banks at 23% and resources, including energy, at 25%. Often, when a lot of people are negative on one, the other is the beneficiary,” says Hershan.

“There's an inverse correlation in Australia between the performance of banks and major mining companies,” notes Hershan, adding that “the last couple of weeks have been really interesting because whilst there's been a period of enthusiasm around China, the banks have very discreetly just given up 10% in the background.”

“There's no doubt in my mind that banks were a parking lot over the last couple of years for people who were worried about the economic uncertainty and status of China. If this China rally gathers momentum, banks are the obvious funding source”, says Hershan.

Short-term versus long-term

While the recent movements between banks and iron ore miners highlight some of the inefficiencies and distortions in the Australian market, Hershan believes both cohorts face long-term structural issues, referring to them collectively as “The Mundane Seven.”

On the banks, Hershan sees them as a microcosm of the Australian economy which is “reasonably mature” and exhibiting sluggish growth— “one-and-a-half percent GDP growth, negative on per capita terms.”

Hershan argues this is hardly a robust backdrop for banks, which manifests as low levels of credit growth. Banks primarily hold mortgages and given high property prices and declining affordability, mortgage credit growth is unlikely to continue at past rates. Consequently, banks' revenue and credit growth prospects are modest.

Furthermore, Hershan points to the ongoing decline in net interest margins, which have steadily fallen over the past 30 years due to increased competition.

“Net interest margins for the Australian banks were double the current levels about 30 years ago and it has been a slow and steady decline as pressure has intensified," says Hershan.

Additionally, banks face rising costs that surpass revenue growth, putting pressure on profitability—an issue referred to as "negative jaws."

Finally, Hershan points out that despite a challenged economy, bad debts remain low. In his view, there are three possible explanations:

• There could be a delay in the appearance of bad debts;
• Private credit funds now hold riskier loans that were previously on banks' books; or
• Banks might be underreporting bad debts.

Whatever the reason, it takes nothing away from the fact that Australian banks face structural issues that limit growth and profitability in a challenging economic environment.

As for the iron ore miners, Hershan believes it is even more important to consider the short-term versus the long-term outlook. He adds that the prospects for iron ore looked weak until recently, but renewed hopes for Chinese stimulus packages have raised expectations for a potential boost in the housing market, which could benefit iron ore demand in the near term.

However, that does not diminish the longer-term issues and the fact that the market will likely become significantly oversupplied. China, which represents half of the seaborne iron ore market and has driven growth for two decades, reached peak steel consumption about four or five years ago, notes Hershan.

“It has plateaued ever since and it's hard to make a case that [demand] will go through that prior peak, but what you can say is that pain in the iron ore market is probably going to come from rapid supply growth,” says Hershan.

Rapid supply growth is mainly due to major projects in Africa, particularly Guinea, well-documented production increases from major mining companies like BHP, Rio Tinto, and Vale, and new projects from mid-tier producers.

Lots of problems, what are the solutions?

It’s one thing to point out inefficiencies and long-term structural problems in a market, but what about the solutions?

Unsurprisingly, Hershan came prepared, and one key stat helps unlock the scope of the opportunity beyond the Mundane Seven.

In FY25, 56 ex-ASX 20 companies are projected to hit over 10% revenue growth. As for the ASX20? Xero. Zip. Zilch. Nada. Not one.

Hershan adds that the ex-20 is “a pretty eclectic and diversified group of companies,” adding to the potential for sizeable growth. He points to tech names, including data centres, software and hardware companies, healthcare names like ResMed (ASX: RMD), and mining companies capable of increasing production.

“Look at the big three resource companies; they've got very modest, if any, volume growth.”

“Now, you can't really influence commodity prices for most markets, but what you can do is grow production.”

“Outside the ASX20, you've got companies like Northern Star (ASX: NST), Evolution (ASX: EVN), and Sandfire (ASX: SFR) that have quite a meaningful volume growth, which supports that revenue growth of 10% plus,” says Hershan.

Exploiting inefficiencies

As discussed above, piling into the top end of the market can lead to inefficiencies and distortions, but it can also create inefficiencies for the rest of the market.

Hershan and the Yarra equities team jokingly refer to the ASX 21-100 as “the Twilight Zone,” given the outsized research focus on the top 20 and sharp drop-off thereafter. Not that he is complaining—the lack of coverage provides opportunity.

“Last time we looked, there were 28 analysts that covered BHP and every time a bank blinks you'll see a dozen notes on it,” says Hershan.

"The small-cap part of the market is also quite well covered because there are many dedicated small-cap brokers, and last time we checked, there were north of a hundred small-cap funds as well."

"Whereas if you look at that middle zone, it probably does suffer from a degree of neglect,” says Hershan.

Yarra exploits that inefficiency by having a team of 14 in Australian equities coupled with a small coverage list and conducting north of 2,500 company meetings per year.

“We can get to know our companies really well,” says Hershan.

Top ex-20 ASX picks

Block (ASX: SQ2)

One of the companies that Yarra knows really well is Block—the company formerly known as Square and the buyer of Afterpay.

According to Hershan, Block has strong growth potential driven by its Cash App and merchant processing businesses. These units demonstrate robust revenue growth, widening margins, and strong cash flow.

Currently undervalued at 15-16x earnings, Block offers a compelling investment opportunity as a cheap tech stock and “is a standout versus 70 other companies we look at,” says Hershan.

The Lottery Corporation (ASX: TLC)

Australia’s primary lottery operator has cash-generative assets underpinned by long-dated licenses in a highly defensive segment.

The business provides an attractive blend of high single-digit EPS growth and yield, benefiting from inelastic demand, margin expansion from digital lottery adoption, and optionality over pricing and game innovation.

Car Group (ASX: CAR)

CAR Group has seen a 14% compound annual growth rate for the past few years, notes Hershan.

It is compelling due to its strong runway to lift yields across key regions and products, is well-positioned to benefit from car dealerships, and has excellent product innovation.

Access companies offering strong growth potential

The Yarra Ex-20 Australian Equities Fund offers exposure to forward-looking companies by investing in a portfolio of stocks that sit outside the S&P/ASX 20, offering greater diversity, superior returns and strong growth potential over the medium to long term. 

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