Which are the safest cyclicals as the recovery trundles on?

Casting a critical eye over the Value stock universe, our four fund managers reveal which sectors they’re most bullish on as the vaccine-led reopening and recovery ramps up. But first, let’s be clear exactly what we’re talking about here. Because as we saw in part one of this series, some of the terminology in the perennial growth-versus-value debate is itself open to dispute.

One reason some industry insiders have a problem with the terms “value” and “growth” in the context of financial markets is that stocks that fall into the value bucket may also be a bit “growth-y”. 

In a similar vein, most value stocks are “cyclical” - which means their performance is linked closely to the economic cycle. But some value stocks may also be “secular”, which means they’re tied to longer-term trends.

In the following wire, I’m asking our contributors to reveal which of the four cyclical sectors they regard as the safest pick for investors over the next couple of years:

• Materials
• Consumer
• Financials
• Real estate.

Without giving away the punchline, they’re pretty evenly divided. Two of them like specific parts of the financial sector; but the others prefer materials. A couple of them also take issue with the oversimplification inherent in some of the terms defined above, and also with the juxtaposition of “safety” and “investing”.

Banks a safe bet, says Bruce

Stephen Bruce, director of portfolio management, Perennial Value Management

I think financials in general and banks, in particular, are pretty safe places to be. They’ve had a good recovery from their lows. But importantly, if you look at their balance sheets at the moment, if things continue to go the way they are with the economic outcomes being upgraded all the time and far better than what people expected a few months ago let alone a year ago when they were taking their massive loss provisions. Credit growth is starting to pick up again, net interest margins are starting to stabilise and bad debt charges are dropping significantly. It’s all going to support payout ratios and when you’re starting with a 12% capital ratio, there’s reasonable scope to supplement that. 

Banks look attractive and relatively low risk from here, with undemanding valuations in a market environment where yields are ultimately low versus most asset classes.

Our second cab off the rank here would be resources. Through COVID, demand from the rest of the world for things like iron ore has been subdued, but China’s demand has been very strong. As the rest of the world reopens, that demand will pick up again and China’s will also continue, if not grow. And also, commodities tend to do well in an inflationary environment, and the consensus view is that’s where we’re headed.

Finding the gaps in investor expectations

Daniel Moore, co-portfolio manager, Investors Mutual

To begin with, raw sector descriptions probably oversimplify a number of the businesses within them. There are individual categories, then there are individual stocks within them that have very different individual drivers of demand.

Within the sectors you mentioned, we see a number of opportunities and some areas of caution, too. One sector that stands out to us is insurance, more specifically general insurance, and the reason for this is the idea of being “safe”. The word safe is an interesting one and you must consider two factors within this idea:

1. How the business performs from here
2. What is priced in

Within cyclicals right now, a lot of good news or a strong recovery are both priced in. Even if the business performance is pretty good, there is some risk to the share price if the company doesn’t meet high expectations.

Insurance stands out for us as a sector that has been pretty badly hit by COVID-19, and share prices here are down significantly. There doesn’t appear to be a real expectation within the market for any significant improvement in those businesses.

We like general insurers – both IAG and Suncorp are in our portfolio – because they have all had big claims from business interruption and some big weather events recently. But they have now provisioned for those claims and raised significant equity to bolster their balance sheets.

The outlook for this environment looks quite good, but share prices still aren’t far off their lows, unlike many other cyclicals. We are currently seeing high premium rises across the board. In the case of IAG and Suncorp, their balance sheets are very strong after capital raisings and their provisions look even a little bit excessive. We think they are quite safe. Recovery does not appear to be priced in, but we see good reasons to be optimistic about the insurance cycle over the next couple of years.

Is anything ever “safe”?

Michael Goldberg, executive director, portfolio manager, Collins St Asset Management

In the investing world, nothing is ever safe. And in this environment, your portfolio can’t be put in the bottom draw like Auntie Ethel’s inherited BHP shares were back in the day. Active management is the name of the game.

But selected materials exposures have some very strong tailwinds behind them. One theme in the materials sector, in particular, metallurgical coal, is definitely one to watch.

Our preferred exposure in this space is Coronado Global Resources, for a few reasons:

• its dual operations in Australia and the US
• the clear linkage between metallurgical coal (a key ingredient in iron ore production, not to be confused with thermal coal is used in power plants)
• the global infrastructure boom, which is tipped to run into the hundreds of billions over the next five to 10 years.

Put simply, unless you want your ports and railways built out of paper mache poles, steel and, along with it, metallurgical coal, are going to be really important.

Philosophically, this statement is, for us, something of an anomaly though. We tend to steer away from materials stocks as a general rule as they are mostly “price takers” and have little scope for differentiating themselves from competitors beyond where they sit on the production cost curve (a graph of the costs of production as a function of total quantity produced). For that reason, selected industrials are usually where we find value for our investors.

Three sector laggards with big upside potential

Robert Miller, portfolio manager, NAOS Asset Management

We don’t like to use the word “safe” in the same sentence as “investing”. Levels of risk is a more appropriate way to think. Our view in trying to pick which sector will be the safest place to invest is a guess at best. There are too many variables.

What will happen to commodity prices? Will inflation creep into the economy and interest rates rise? Will the political instability get far worse? Will the logistics issues experienced globally continue to create widespread concerns?

All of the sectors mentioned above – materials, consumer, financials and real estate – have experienced some level of benefit during the post-COVID economic recovery. But some have experienced greater tailwinds than others.

In our view, another way to identify what sectors may provide adequate risk-adjusted returns over time is to look at those industries or sectors that have not recovered as quickly. These may prove to be lagging indicators in a cyclical upswing and still set to benefit from long-term structural tailwinds.

We believe these areas may potentially have a larger degree of downside protection versus other sectors that have experienced a substantial benefit so far. Downside protection can be achieved through dividend/distribution yields and the quality of the individual balance sheets in question, especially in the current interest rate environment.

In our view, the sector/industry candidates that may fit the above characteristics and have long term tailwinds include:

• commercial and industrial property,
• building materials
• tourism and travel.

In conclusion

The split between financials (and I include insurance here) and materials in the sector selections made by the four PMs above was interesting. And in the case of NAOS's Miller, who named his three preferred cyclical categories, financials didn't rate a mention. 

One thing they all agree on is the importance of an active investing approach for value investors. This is magnified further for Australian shareholders, given that financials and resources companies comprise at least half the local index's market capitalisation.

Stay up to date with this series

Make sure you "FOLLOW" my profile to be notified of the upcoming entries in this series. In part one, our four fundies discussed how they parse the equity universe for stocks that are both cheap and good. And in part three, they will each reveal a favourite value stock from their portfolios.