Why the 'forgotten large caps' are back in favour

In our latest reporting season coverage, I discuss how investors have been rotating away from momentum-driven stocks with high valuations towards more defensive stocks with strong fundamentals. I also share my thoughts on the performance of the major banks and iron ore miners as well as some of the key stocks in IML’s portfolios including Brambles (ASX: BXB), Charter Hall Retail REIT (ASX: CQR), CSL (ASX: CSL) and Amcor (ASX: AMC).

Lightly edited transcript – Recorded on 24 February

Jason Guthrie: Hello and welcome to Navigating the Noise, a podcast by Natixis Investment Managers, where we bring you insights from our global collective of experts to help you make better investment decisions. I’m Jason Guthrie, and today I’m joined by Michael O’Neill, portfolio manager on IML’s large cap team. Now, Mike has been with the firm for close to 15 years and co-manages a number of strategies, including the Equity Income Fund and also the Industrial Share Funds.

In this podcast, we’re going to get Mike’s take on reporting season thus far. We’re going to cover some of the key results across the market, as well as the performance of a number of the holdings within IML’s large cap portfolios.

Mike, I know it’s been a little while since we’ve had you on the podcast, so welcome back.

Michael O’Neill: Thanks, Jason.

Jason: Well, it’s great to be in the office there in Sydney last week. Always plenty of action going on during this. You know, I know we’re in the thick of the reporting season here in Australia, so maybe to kick things off, Michael, I know we are most of the way through results for large caps now. How’s it been overall and what are some of the main themes that have really come out over the last few weeks which you think may be important to highlight to clients?

Michael: Well, look, I think there’s definitely been some rotation in the market. We’ve talked about a lot of the stocks where we think the fundamentals really didn’t justify the price, and it feels like this reporting season, the balance has shifted quite sharply. The major banks have underperformed more than 5% month to date.

We’ve also seen a bit of a shake-up in some of the tech companies and the data centre thematic. I did hear recently the CEO of Microsoft (NASDAQ: MSFT) intimated that supply in this space might be currently growing ahead of demand, which obviously doesn’t bode well for profitability on the incremental dollar invested.

So the good thing this reporting season is some of the quality defensive stocks where we’re placed that had been left behind are benefiting from this rotation and a bit of volatility in what were yesterday’s winners. So, you know, we’re starting to see signs of a bit of a changing of the guard. We’re wondering whether 2025 could be the year valuation starts to matter again.

Jason: So maybe just on the banks, you mentioned you’ve been staying in the market for some time, that the Aussie banks are quite overvalued apart from CBA (ASX: CBA), I should say. The results seem to have disappointed investors, a lot of volatility over the last few weeks since some of the big banks. We’ve now seen that sell-off. Do you think that’s going to continue? Have you had any change in your views on the sector based on some of these results?

Michael: We have seen a bit of a correction, but let’s put that in context. The sector had actually gone up 35% last calendar year, and if you look at the results across the banks, the earnings are roughly flat. So the market caps were running well ahead of earnings, and the recent performance of the big banks has only really given back, say, around about 5% on a relative basis.

So there’s still plenty more in terms of valuation exposure for the major banks versus the rest of the market. We did see with CBA a very strong result relative to the others, but really, you know, the outperformance for CBA was driven by its proprietary mortgage franchise — something that the others don’t have. They’re stuck in the competitive brokered market where they’re giving up margin to hold volume. So CBA is differentiated, but really, what did that mean? It meant about 3% earnings growth for what is a very expensive stock.

The other banks are falling a little bit behind in earnings, not just from the mortgage side of things, but also from the deposit side of things. And they’ve all got a bit of a cost issue to manage, particularly Westpac (ASX: WBC).

But if you look back at the sector as a whole, they’re still benefiting from cyclically low impairments. It was only NAB’s (ASX: NAB) result that showed some very minor evidence of non-performing loans in mortgages and businesses ticking up. So there’s no imminent threat of dividend cuts, but really the conclusion is, even though the sector has come off a little bit, there remains significant valuation risk for investors that are concentrated in the banks, given the premium they trade at, not only relative to their global peers but, more importantly, relative to some of the lower-risk industrial stocks that we like to invest in.

Jason: Thanks, Mike. Maybe moving to another sector of the market, we’ve seen some of the big iron ore miners announce cuts to some of their dividends based on the lower iron ore prices and the weakened demand we’re seeing from China that is flowing through to some of their profits. IML is generally quite cautious on resources given their cyclical nature. Given we’ve seen that kind of healthy pullback with some of the big names, I know you hold BHP in a number of portfolios. Are you looking to increase any weights there in those names?

Michael: Yeah, Jase, of the iron ore miners, you’re correct. BHP (ASX: BHP) is the one to own at the right price, and we do hold this across some of our large cap portfolios. The reason is it is the best-in-class, most diversified mining company with the highest quality assets across iron ore, copper and coal. But that being said, even though we saw some correction in iron ore prices, there’s still a degree of earnings risk there.

The falling demand in China has been what’s driven prices down, but we’ve still got excess steel, and under the new US trade tariff policies, we could see that excess remaining, or perhaps growing in China. So there’s still downside risk to iron ore prices here, which, even though they’ve corrected, you know, might have a little bit more to go relative to long-run, marginal cost of supply.

The other thing we’re always cautious of in determining our weighting in the Materials sector is, you know, commodity stocks do ultimately follow commodity prices. So there is a degree of volatility in your capital that you don’t see with industrial companies.

Jason: Speaking of industrials, bread and butter for IML. Looking at some of the other parts of the market, you know, what are some of the key results that have caught your attention, really stood out through this reporting season over the last couple of weeks, Mike?

Michael: The first I’d call out, Jase, is Brambles (ASX: BXB). They’re the largest pallet pooler globally, and pallet pooling is critical to world supply chains. The demand outlook in the past year has been a bit weaker because we have a lower growth environment, but what we’re seeing is Brambles, despite this, delivering on revenue growth through new business wins and price improvement, and they actually grew their net profit in the first half of 2024 by 11%, on the prior period.

The company is in a very strong position to continue to drive their earnings, and the continuation of some of the initiatives that are resulting in higher turns of pallets in the network, repricing opportunities with the customers and growing share, as well as taking more productivity outcomes in their business, have given them the confidence to guide to 8 to 11% earnings growth in the next year on the back of 4 to 6% sales growth.

What we really love about this business is not only are you getting the earnings growth now, you’re also getting the growth in the free cash flows supported by lower losses in their pallet pools and lower capital expenditure. So not only is your earnings growth coming through, but we’re also expecting higher capital returns via higher dividends as well as share buybacks.

I’d probably call out one more if I can, Jase, which is Charter Hall Retail REIT (ASX: CQR). Not because it shot the lights out, but because it stood out as being one of the most predictable of the REITs. The management team has reshaped the portfolio of assets with a focus on higher quality assets and net leases that require low CapEx (capital expenditure) and predictably grow earnings.

It pays a 7.5% yield. The boring nature of Charter Hall’s results is something that we should expect to continue, and not only did they have a strong result, they also announced the accretive acquisition of Hotel Property Investments. This is an asset we know very well and it should just continue their strategy of migrating their portfolio over time to these higher quality assets, with net leases, less CapEx, and predictable earnings growth.

Jason: Fantastic. Thanks, Mike. Now I know we always like to hear about the great positive results. Was there anything that maybe didn’t go the team’s way through the last couple of weeks, and has that created any opportunities to top up any of your high conviction names?

Michael: Yeah. The one that missed for us of note is CSL (ASX: CSL). It missed earnings expectations in the first half.

This was largely driven by performance in their specialty plasma products segments, as well as what we saw as a weaker vaccine uptake in their Seqirus flu business. They are guiding to double-digit earnings growth, and we spent some time with the company on this.

The large driver of this is their Behring plasma business. And what’s going to help this return to double-digit earnings growth is the return in gross margins for plasma products getting back to where they were pre-COVID. There’s a lot of levers to pull in that Behring plasma business to achieve this. The core franchise remains strong, the pathway to pre-COVID margins is fairly clear, and they did demonstrate some progress in the half.

Given how much they’ve underperformed, particularly against other quality growth stocks, if you can get your head around these double-digit earnings increases, the multiple looks pretty attractive, and you know, it’s certainly the risk-reward looks compelling. Again, it is a stock that we’ve added to.

Jason: And Mike, looking a little further out, so I know it’s only early in the new year, February, late Feb, for the remainder of 2025, how is the team there at IML seeing markets? And maybe also touching on the dividends and the income side of these companies you’re investing in. It’s obviously a key component of overall returns, but can sometimes get forgotten by investors in such strong markets. What are the yields on offer today, and how are you really playing this? How’s that feeding through to your portfolios?

Michael: The outlook, I guess from here, given how strong markets have been in the last year, is a little more challenging. If you think about capital growth we’ve seen in 2024 and also yield, resources yields are less than half of what they were three years ago. Bank yields are off around a percent or so because share prices have been strong. So that’s really skewing the capital-weighted yield of the market as a whole.

But that’s not to say we’re not finding plenty of opportunities for high-yielding stocks, where those yields are, in fact, growing or where there’s significant capital upside. So we talked about CQR, but another good example is Amcor. They’re a leading global packaging supplier; they supply fast-moving consumer goods. They’ve got resilient earnings exposed to defensive end markets, and they do pay a 5% dividend yield. They’re going to get steady margin expansion from volume growth and mix. But even beyond that, they’ve just made an all-scrip merger proposal with Berry, which is one of their competitors in the US space, which is expected to complete mid this calendar year, promising earnings accretion of 35% with $650 million of total synergies, most of which is coming from cost-out.

So there’s an example of an industrial stock that is high quality and defensive. You’re being paid a 5% growing yield, and you’ve also got an accretive deal that should drive significant capital upside. These are the sort of companies we’re putting in our portfolios, and these are the companies we think should drive above-market yields and some capital appreciation for our shareholders.

Jason: Makes a lot of sense. Well, thank you, Michael. Thanks for joining us today. There’s always plenty of fresh news and opportunity during reporting season, so it’s really great to get a quick update and breakdown of some of the key themes and companies we should be watching.

Now, Mike will be on the road in March visiting clients across Australia in the major capitals, so please do reach out if you’d like to meet him in person. He’s a smart guy, but he’s also very humble and personable, and I know he does enjoy getting out in front of our clients and investors. So thank you to our listeners today. If you enjoyed the episode, please click follow on your podcast platform or the bell icon to be notified of future episodes and tune in again very soon to hear more from our global collective of experts.

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