Tide turning for this troubled sector and three names to ride the recovery

Last week I published the first in the three-part series with Nikko AM’s Iain Fulton, focusing on how he is viewing markets presently and the capital cycle theory he employs when looking for opportunities. You can view that wire here. 

In part two of the series, we dive into the increasing importance of earnings in the current environment, how they could change over the next 12 months, and what this means for investors.

Fulton also provides clear views on the areas of the market he is focusing on for buying opportunities and highlights a previously troubled sector as a fertile hunting ground. 

It must be said, Fulton is a realist. He’s not blind to the challenges that economies and markets are facing right now. 

Previously the team have been on record saying that “the weather is currently poor, and visibility is not great”. When asked if the view has changed at all since that assessment, Fulton was firm;

“No, I think that's fairly a good assessment of the situation and that's why valuations matter. When the skies are blue, money's easy, people can see a long way ahead, and they look a long way into the future. Valuations get very stretched and obviously, that's no longer the case.”

Rather than being dire about the earnings outlook, however, Fulton characterises periods like these in markets as "healthy", noting that the time horizon (for investors) gets much shorter, valuations are lowered, and those are “good things”.

“This uncertainty is quite healthy, and we've talked (in the previous wire) about how sectors go from leadership positions to something else, and I think this is part of that process.”

As for where we are along the market reset continuum, Fulton assesses that “we're a good way through the process of tighter monetary policy being a brake on activity. And as things deteriorate fundamentally at a macroeconomic level, we'll begin to see a little bit more support perhaps coming from central banks. We're not there yet by any means, but I guess that's what the market will eventually start to anticipate".

Therefore prices tend to bottom ahead of earnings, adds Fulton, which 

“Undoubtedly leads to some opportunities, and we're trying to uncover those as we go along.”

It’s all about earnings

With the global economy slowing amid rising interest rates, there has been a significant focus on earnings and their potential deterioration over the foreseeable future.

Putting it into context, Fulton notes that “last year we saw a cost of capital bear market, which was all valuations reverting to the mean and the tighter cost of money. From here it's more about earnings growth and how that pans out.”

Fulton also notes that markets tend to move ahead of earnings, which typically means that prices will form a bottom ahead of the earnings picture. Ultimately, however, Fulton sees the picture for earnings as "challenged".

That doesn’t mean that we need to throw the baby out with the bathwater. Far from it. Fulton contends it depends upon "which sector in which industry you're looking at, and I think there are differing pictures going on across the different sectors".

As for the areas that he likes and does not like, Fulton cites some consumer-related areas (like travel) in the former, and media communications/tech in the latter.

“You're seeing a retrenchment in some of those media communication services technology areas, where the top line pressure is still quite significant, and we think that probably continues. There's a bit more cost-cutting and a bit more CapEx retrenchment probably needed within those areas, which makes that pretty challenging.”

As for travel, Fulton notes “we've got a bit of pent-up demand, we're seeing an alleviation of input costs and the moderation of commodity prices.” 

Summarising his view, Fulton comments that companies that have just been reliant on pricing power might start to be a little bit more challenged; "You're starting to see a bit more that needs to be done in terms of cost-cutting to offset pressures that are out there”.

Where are you hunting?

In terms of where Fulton and his team are looking for investment, as noted above travel is an area of interest. This is an industry that was heavily disrupted by the pandemic and still has quite a long way to go before it is back to pre-pandemic levels.

“If we look at total air traffic volumes and the amount of travel that's going on, we're about 75% of a normal level still, so we're way down". 

"Why is that? Well, that's because China has been closed and is only just reopening, and Japan has been slow to recover as well. All that recovery is still to come through in terms of increasing activity levels, both in Asia and outside of Asia.”

Fulton also notes that business travel has recovered only 80% of pre-pandemic volumes and that, likely, will recover in the long term. 

“Face-to-face communication is still a huge way of building relationships and getting business done”.

This means, according to Fulton, that we’re likely to see an increase in demand and a relative tightening of supply, which will support prices and margins for travel-related businesses.

As for a specific name to focus on, Amadeus (BME: AMS) is currently in the global share portfolio and Fulton also likes Booking.com (NYSE: BKNG) and Samsonite (HKG: 1910).

Amadeus is a Spanish company that "provide the engine for bookings on airlines and then hotel systems around the world. They also outsource IT for some of these companies so as volumes recover”.

As well as the recovery in travel, Fulton talks to the operational efficiencies these businesses were forced to deliver during the pandemic in order to survive, which will hold them in good stead.

“These businesses have had to take a lot of costs out during the pandemic, and they've had to streamline supply chains in many cases and really survive with a much smaller market for a considerable period of time now”.

Fulton adds that there is the potential to see an increase in volumes on a fixed cost base, which is usually quite an attractive scenario for margins. Meanwhile, valuations aren't excessive, because these aren't the hugely exciting parts of the market that everyone's focused on. 

"There probably are some opportunities in these types of areas and we've certainly been increasing our exposure".

Learn more

Iain and his team seek to uncover Future Quality investments – businesses that can attain and sustain high returns on invested capital to deliver better performance for shareholders over the long term. To find out more, visit the Nikko AM Global Share Fund profile below.

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The Nikko AM Global Share Fund is distributed in Australia by Yarra Capital Management.