Two stocks making their way into the ASX 20 (and one on its way out)

We investors are constantly searching for the next CSL. After all, if you invested in this growth darling a decade ago, your cash would have increased by almost 616%. If you had invested two decades ago, that figure would skyrocket to 3097%. 

But not all stocks that climb their way up into the ASX 20 stay there. In the past year, we've seen the Afterpay/Block acquisition and Brambles drop from the list. And then, of course, there are names like Pasminco, ERG Group, Centro Properties and Babcock & Brown, which over the past few decades stung investors on their way down. 

So are we spending too much time trying to uncover the next CSL and not enough time thinking about whether there's a Babcock & Brown or a Pasminco lurking in our portfolios? 

In this episode, Livewire's Ally Selby was joined by Atlas Funds Management's Hugh Dive and IML's Hugh Giddy for their analysis of the current market environment, where they think is safe, as well as one stock making its way up into the top 20 - and one on its way out. 

Note: This video was filmed on Wednesday 20th July, 2022. You can watch the video, listen to the podcast, or read an edited transcript below.

Edited Transcript  

Ally Selby: Hey, how are you doing? And welcome to Livewire's Buy Hold Sell. I'm Ally Selby and today we're going to take a look at large caps to see if they can keep your portfolio afloat over the next financial year. Plus, we're also asking our guests to name one stock on its way up into the ASX 20 and one on its way out. To do that, we're joined by Hugh Dive from Atlas Funds Management and Hugh Giddy from IML. It's obviously been a really volatile time for investors. A lot of stocks have been heavily sold off. 

Hugh, I might start with you. How are you feeling about markets right now? Are you holding onto your cash or are you buying?

Hugh Dive: Well, I mean, asking an equity fund manager is now the time to invest is similar to asking a barber, do you need a haircut? They're always going to say yes, but being in a range of difficult markets, I think you don't want to indiscriminately invest in everything. You don't want to be indiscriminately invested in a unit trust, for example, because a range of companies are going to struggle. Look at the concept stocks, the buy now, pay later stocks and also perhaps some of the resource companies, and tech stocks with no earnings. They're going to struggle. Companies with solid earnings that are growing in profits. They're going to do well over the next year, but not everything.

Ally Selby: So you're being selective right now. Okay. Over to you, Hugh. Are you holding onto your cash? Or are you diving on in?

Hugh Giddy: Thanks Ally. I agree with Hugh. I mean it's definitely a time to be selective. We always are. I think you've got to invest in quality. You got to invest in companies that have reliable earnings and so forth because it is going to be a tougher time in Australia and globally as interest rates go up. Should you dive headlong into the equity market? To be honest, a lot of people have quite big stock holdings already compared to history. So should they put the rest into the stock market? I don't know. That's a personal decision.

Is bigger better? 

Ally Selby: There's actually not been that much change in the ASX 20 over the past few decades. Is investing in this kind of benchmark, the top 20 stocks, the biggest stocks on the market, the safer option in this environment?

Hugh Giddy: Well, if you buy a big stock, of course, it's safer in terms of they're probably not going to go bust. But is just buying a big stock safe? Is it better than buying a mid or small stock? Safety really comes from the franchise of the business, the balance sheet and so on. And if you look back to one of the recent departures from the ASX 20 and that departed with the takeover, which is Afterpay - now Block (ASX: SQ2). But I think now - if you look at Zip Co (ASX: Z1P) and Sezzle (ASX: SZL) and so forth, it would no longer be anywhere near the top 20 because the franchise is not that strong. It's a competitive market. They didn't have the best balance sheet. They certainly didn't have much in the way of earnings. So top 20 doesn't mean safe.

Ally Selby: Over to you, Hugh. Is bigger better?

Hugh Dive: Totally agree with Hugh, if you look at the top 20 from 20 years ago, most of them underperformed. AMP (ASX: AMP) is down 90%, NAB (ASX: NAB) is off 10-15%, Lendlease (ASX: LLC) is similar. I think only three or four companies in that top 20 from 20 years ago have actually outperformed the ASX. A lot of these companies are still around, but they are shadows of their former selves. So simply buying an ASX top 20 stock doesn't mean safety. However, on Hugh's comment on larger companies during times of market dislocation, like we're seeing right now, they tend to work a bit better in that they have sympathetic bankers and equity holders that can raise money. Smaller companies, like Hugh mentioned, say Zip (ASX: Z1P) are fighting for their corporate lives at the moment.

Large caps that benefit from rising rates and inflation

Ally Selby: Okay. We know that buy now, pay later is not doing well. We also know inflation and interest rates are on the rise. Are there any large caps that you think can really benefit in this environment?

Hugh Dive: Well, rising interest rates don't impact all companies. So for example, we talked a lot about the banks benefiting from rising interest rates. At the moment, all the banks are raising their rates. And I think the bad debt cycle will be below what people expect. Given they are predominantly geared towards mortgages, which have low bad debts. 

I think the insurance companies will do well particularly, for example, QBE Insurance (ASX: QBE). It's got a US$29 billion float, which has earned close to zero for the last 10 years. It's earned about 1%. In a market of hardening rates or rising rates, that's good news because they can start to earn some money out of that. 

Thirdly, and I am probably pinching from Hugh here because I'm sure this is one of your stocks - Transurban (ASX: TCL). With the utilities, you wouldn't think that they would normally do well in a rising rate environment and their biggest cost is interest. But given that the debt is termed out on an average of about eight years, it's not really moving. And every year with inflation, the tolls go up. For the next four years, Transurban has said that every 1% increase in inflation equals another US$50 million in profit. So there are companies that do quite well in this environment.

Ally Selby: Okay. Hugh has given us three. Can you name the types of companies? Or actually name some companies that you think can do well in this rising rate, rising inflation environment? 

Hugh Giddy: Sure. I think it's about your franchise, your ability to raise prices. 

Ally Selby: Pricing power.

Hugh Giddy: It comes down to pricing power. And also what your input costs are like. So if you have a very high margin business, for example, CSL (ASX: CSL), where a lot of their cost is in the R&D that's already been done, it's been expensed and so forth. Then they've got the plasma donation cost, but that actually could come down because we are heading into harder times. People need to supplement their incomes. So here we are, two value style managers and I'm talking about CSL. But they actually also have a very strong position in the market in terms of their products and so on, so they might do really well. I'd generally be worried about companies where they rely on a price that they have no control over. So that tends to speak to most commodity, resource exposures and also companies that are very small players in their market because they don't really have pricing power. It's set by other people.

The company on its way out 

Ally Selby: I want to stick with that commodities comment there. There are a lot of old-world energy companies in the ASX 20. Obviously, everyone's talking about ESG and decarbonisation now. Do you feel like we could see a real shake-up in the top stocks in the ASX over the coming few years?

Hugh Giddy: Not specifically because of decarbonisation and climate change, personally. Because you're seeing how the war in Ukraine has really brought into focus the idealistic response to climate change - which has, in all honesty, been a disaster for some countries. You've got Germany, desperately trying to source coal for their coal-fired power stations. And now, it's not an emissions thing, but they want to reopen their nuclear power stations. 

And you're seeing that the world is realising that although lots of young people are saying, "Climate's going to ruin my future" - the Greta Thunbergs of the world. The fact is, most of our power still comes from fossil fuels. Not just like a little bit more than half - most of our power comes from fossil fuels. So we can't migrate away from those. And even if people don't like the bad ESG of those old-world energy companies, they'll still make lots of money while fossil fuels are in demand. Although, it does depend on the price. Now, I certainly don't have a forecast in particular about the oil price, but I don't personally think it's going to stay over a hundred.

Ally Selby: I hope not. It's costing a lot of money to fill up the car at the moment. Over to you, Hugh. We've talked a little bit about decarbonisation. Maybe let's touch on Afterpay/Block, it's fallen out of the ASX 20. Are there any other examples or do you think there will be companies in the next decade or so that will drop out in a similar fashion?

Hugh Dive: Almost certainly. If you look at every point in history, going back every 10 years, there are a couple that have fallen out and gone into insignificance. Looking through that, I'd probably look at Fortescue Metals Group (ASX: FMG) as probably the one that's going to fall out. In 10 years' time, in a situation where commodity price is falling down, they have a lower quality of iron, it will fall down. And also structurally, as economies mature, they start to produce their own scrap steel, which goes into electric arc furnaces. In the US, about 70% of their steel is made through electric arc furnaces. I think China is about 10-15%. Ultimately the Chinese want to do that. So it's tough to believe that the current level of steel demand for direct shipping hematite or magnetite ore is going to be the same in 10 years' time. And we took a view that Fortescue is going to be the one that'll fall out.

Ally Selby: Over to you, Hugh. Is there a stock that you think could fall out of the ASX 20 over the next decade?

Hugh Giddy: It's unfortunate, but I would have to agree with Hugh. Not unfortunate to agree, but I can't come up with something else as my top pick. My reasoning is not just the scrap. I think that when you look at where the majority of where the demand comes from, it's China. And China's property market is an absolute house of cards. They've overbuilt property. They always stimulate their economy by trying to stimulate property development. And you look at the share prices of all the property developers in China and look at their bonds, it's a very weak sector.

Two stocks on their way up

Ally Selby: Okay. Let's end on a positive note. Is there a stock that you think can climb its way up into the ASX 20 over the next year?

Hugh Giddy: I'd pick Brambles (ASX: BXB). I'm impressed with Brambles. The management is focused on generating good cash flow. They've been able to raise prices to their customers to cover the costs, like the very high costs of lumber going to building pallets and high transport costs. They have a very, very strong position versus their competitors. They are usually number one in the countries in which they operate. And there is a natural advantage of being the number one. It's on the cusp of the top 20. And it could rise into the top 20.

Ally Selby: Okay. Over to Hugh. Is there a company that you think can climb its way up into the ASX 20 over the next 12 months?

Hugh Dive: Using the same mathematics as Hugh. I looked at the ones in the early 20s and I think it'll be Sonic Healthcare (ASX: SHL). So we'll see. Ramsay (ASX: RHC) will probably be taken out. Some of the miners will come down. Sonic's been a great beneficiary of COVID, but it'll benefit in the long term from an older, sicker population, as well as increases in medical technology, allowing for more tests and doctors wanting to prescribe more tests to avoid malpractice. It is a well-run company. Number one in pathology in Australia. Number one in Germany, number one in Switzerland, number two in the UK, and number three in the US. I think it is a great beneficiary in the future.

Ally Selby: Well, that's all we have time for today. We hope you enjoyed that episode of Buy Hold Sell. If you did, why not give it a like remember to subscribe to our YouTube channel, we're adding so much great content every week.

Let us know what you think

Both the Hughs chose Fortescue Metals Group as the stock that is on its way out of the ASX 20. But we would love to know what you think? Let us know what stock you think could fall out of the benchmark over the coming decade in the comments below. 

Plus, they named Brambles and Sonic Healthcare as the stocks climbing into the index over the next 10 years. Do you agree? If not, let us know what stock you think could make the ASX 20 in the next decade.  

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