How to find value on the ASX

Chris Conway: Hello and welcome to Buy Hold Sell, brought to you by Livewire Markets. My name is Chris Conway, and today we're coming to you from my hometown, magnificent Melbourne, for a rare special with some local guests. We're going to take a deep dive into value, and to do that, we're joined by Reece Birtles from Martin Currie and Hamish Tadgell from SG Hiscock. Reece Birtles: For us, valuation is really all about understanding the mid-cycle earnings or long-term earnings power of a company, but that considers things like the quality of the business, the governance, the management, sustainability, the return on capital, and we really look for an edge, something that our analysts have an insight in that's different to what the market knows.

Chris Conway: Hamish, what about you? What does value mean to you?

Hamish Tadgell: We are big believers in price being what you pay, and value is what you get. We focus on a margin of safety and we're really looking for some insurance or a buffer when we buy stocks. So we don't think of it in terms of cigar butts like Benjamin Graham. It's very much focused on the earnings power of the business, its competitive position and the quality of the business that we're buying relative to the price that we're paying for that.

Chris Conway: Hamish, I'll stay with you. What's the biggest mistake that you think investors make when it comes to picking stocks on valuation grounds?

Hamish Tadgell: I think it's probably focusing too much on the valuation and not enough on the quality of the business or how the environment or competitive positioning in that business has changed. During my career in markets, I've seen a number of instances where the industry structure has changed and people have bought, including ourselves, businesses on the basis that we think that the status quo is going to remain the same. Chris Conway: Reece, what about you? What's a mistake that you see investors making?

Reece Birtles: I think a lot of the time these days it's about not looking at valuation. Everyone's so focused on things like factors, exposure to bond yields, and sentiment on stocks that they really lose sight of where the long-term value is in particular companies. And then of course, if you get into the deeper value names, sometimes the price does matter. It is telling you something about the change in the business and being aware of that. So not being overconfident in your views too much.

How much value is there on the ASX today? 

Chris Conway: Reece, I'll stay with you. Let's talk about the current market conditions. On a scale from one to five, where one is cheap, and five is expensive, how much value are you seeing on the ASX right now?

Reece Birtles: I think if I was looking at the index and I'm talking about the index, I'd be giving it a four. I don't think there's great value in the index, but if I think about value stocks in the market, the types of cheaper stocks that we like to buy and how cheap they are compared to that index, I'd be more like a two. There's quite good dispersion in the market at the moment. There are quite good opportunities from an active point of view.

Chris Conway: Hamish, what about you? Score from one to five, five being of course the expensive end and then why?

Hamish Tadgell: I agree with what Reece has said. I probably think about the market being a four or five over the last 12-24 months. I'd probably say it's back at about a three at the moment. I think it's maybe trading a touch over fair value. You look at the market today, it's trading on about 14.5 times, which is basically in line with its 20-year average. But again, I agree that there are pockets in the market which look very attractive and there's value. And so I think this is probably a very good time for active managers at the moment.

Overvalued sectors on the ASX

Chris Conway: Hamish, I'll stay with you. Let's zoom in on the sectors a little bit. Which sectors are looking overvalued to you at the moment?

Hamish Tadgell: I think we would say consumer staples look at the top end of their range. I think there's a reason for that, perhaps that they're defensive, and particularly supermarkets which are seen as inflation beneficiaries. The other area that I'd call out is probably discretionary retail. Now, discretionary retail includes a lot of stocks and different characteristics in those stocks, from gaming to apparel retailers and the like. But our view is that financial conditions are tightening. We do think that there's a bit to play out there with the consumer still. And with that, we would expect to see some earnings pressure there and as a consequence, some of those stocks to us look overvalued at the moment.

Chris Conway: Reece, what about you? Do you have a similar sort of outlook to Hamish or are you looking at some different sectors as overvalued?

Reece Birtles: I'd probably agree on consumer staples - I think they're suffering from inflation and cost trends in terms of their business. But the one that jumps out to me is resources and more specifically iron ore within resources. I just think the iron ore price looks unsustainably high given the demand characteristics for steel in China are so weak and the Chinese steel makers are making so little money. So those stocks really look overvalued to us.

Undervalued sectors on the ASX

Chris Conway: Reece, I'll stay with you. On the other side of the coin, what's undervalued at the moment? Where are you hunting?

Reece Birtles: Non-bank financials. The insurance names for us, the domestic P&C insurance companies, as well as health insurance. We think they've got very good revenue trends and doing very well on margins in this environment.

Chris Conway: Hamish, what about you? What's undervalued in your eyes?

Hamish Tadgell: We'd probably call out REITs. It's interesting, if you look at REITs at the headline level, they're trading at about a 28% premium to NTA, but once you strip out the fund managers, so the Charter Halls (ASX: CHC) and the Goodmans (ASX: GMG), they're trading at a 26% discount to NTA. And if we look more deeply, the yield they're trading on is about 6%. But the average cap rate across the property or the rent collectors as we call them, is about 5.4%. The implied cap rate in the market today is about 7%. So it's implying about a 20% discount if you like to underlying value. And to us, that looks interesting and we see some opportunities there.

High-conviction stock picks 

Chris Conway: It wouldn't be Buy Hol, Sell if we didn't talk about some stock picks. So we've asked the gents to bring along a high-conviction pick that they think is underappreciated by the market right now. Hamish, I'll stay with you. What's your stock pick?

Hamish Tadgell: I'd call out Chorus (ASX: CNU). Chorus is effectively the NBN in New Zealand. It's an infrastructure, telecommunication stock, but very much leveraged to the data thematic of fibre consumption, which we see continuing to grow very strongly. Over the last decade, Chorus has been building out the fibre network in New Zealand, and it's currently really shifting from investment in the network to operating the network. We're going to see a big decline in CapEx, a big uptick in free cash flow, and with that, a pick up in the dividend and growth in the dividend. The stock's trading at the moment on about a 7% yield with a growing dividend, we think it's very attractive.

Chris Conway: Reece, can you top that? What have you got for us?

Reece Birtles: It's probably a similar space, hard assets. So for us, it's Aurizon Holdings (ASX: AZJ). In recent years, it's really suffered from the weather dynamics - with the wet weather conditions - and that's impacted their volumes. And then this year, they've really benefited on their regulatory asset business from higher interest rates, giving them a higher return on capital. Inflation has been driving their asset base higher, and then their volumes are really locked in with long-term contracts. We think the company's doing well with its transition - with the one rail business. And its bulk transition, to move away from the traditional coal businesses. It has a PE of 13 times, near 6% yield and [it has a] growing income stream as those weather recovery and then inflation protection in their contracts really comes through.

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