Why Yarra is underweight banks and miners (but bullish on these 5 ASX names)

There’s a near-consensus view among Australian economists that this will be the year that the RBA drops interest rates – but Yarra’s Dion Hershan isn’t holding his breath.

“I don’t think rates are going to get cut any time soon. That might be one of the mistakes that are embedded in financial markets, this view that there’ll be a loosening cycle within the next six to 12 months,” Hershan told Livewire’s James Marlay last month.

He referred to the movement in the 10-year bond yield, which has dipped by 33 points in the last month, as further vindication of Yarra’s view.

“The fall has been significant…but we don’t think we’re going back to a 2% 10-year bond any time soon. And if we are, it’s for bad reasons not good reasons, there would have to be an almighty economic crash,” Hershan said.

What this means for Aussie consumers

On average, Hershan believes we will slide through – but stresses there will be wild variations between different demographic segments. As he explained it, the period ahead will bring the “best of times” for some people and the “worst of times” for others.

To illustrate this point, Hershan referred to some surprising statistics: only around one-third of Australians have a mortgage, with the remainder roughly evenly split between those who rent and those who own their home outright.

“The bottom 40% of the Australian economy, in income terms, account for about 26% of expenditure. And unfortunately, that bottom 40% are probably going to do it tough for the next few years,” Hershan said.

“In contrast, the top 20% account for 34% of expenditure…the people that are typically long physical assets, that hold the $1.5 to $2 trillion of deposits, have benefited from higher rates. Our contention is that the strength at the top will probably be enough to offset the weakness at the bottom.”

How investors should respond

“Buy quality stocks” is a familiar refrain of the last couple of years but Hershan emphasised this doesn’t mean scooping up the same old so-called blue chips of the ASX. He doesn’t believe the notion that blue chips last forever.

“We’re long-term investors, but we’re paranoid long-term investors…we’re always testing and re-testing what we own and why,” Hershan said.

He emphasised the narrow, mature attributes that apply to much of the Australian economy – which further explain the presence of so many local oligopolies and duopolies.

“But many of them tend to decay over time. The most obvious example is probably the Australian banking sector,” Hershan said.

“There’s a view that there’s an oligopoly, with no competition, and they earn excess returns – which is a convenient narrative, but it’s challenged by the facts.”

What’s wrong with Aussie banks

Hershan noted three of the big four banks had higher share prices back in 2007 than they do now, with no capital appreciation for more than 15 years, and that their return on equity has been declining for about a decade.

He stopped short of suggesting Aussie banks will slide into insignificance, given four of them are among the eight largest ASX companies.

“A lot would have to go wrong for all of them to fall out of the top 20. But have we seen their peak returns? In my opinion, we probably did five or six years ago.”

His team holds a similar view on that other stalwart of the Australian economy, the materials sector. This thesis hinges on a belief that China has reached peak urbanisation, which means steel production has also peaked.

So, with both commodities and financials out of favour in Yarra portfolios – they’re underweight both sectors – where are they finding opportunity?

Hershan points to technology and new media as prime areas of interest. He singles out the following three companies as examples of those with the attributes of strong pricing power, good organic growth, and high incremental profit margins that his team covets above all.

• Xero (ASX: XRO),
• Car Group (ASX: CAR), and
• Seek (ASX: SEK).

A good industry structure is one of the overarching attributes his team looks for, Hershan noting that this positions firms well to respond to economic downturns or management missteps: “Quality is one of the best forms of defence”.

“You won’t always get everything you’re looking for…we’re in an environment where inflation could be persistent and labour markets are really tight, if you haven’t got good pricing power it could be a challenging three to five years, so that’s something we’re emphasising currently.”

Five-year stock picks

On the final question of the interview, where Hershan was challenged to name a single company he would buy and hold for five years if markets shut tomorrow, he fudged (but only slightly) by naming two.

Resmed (ASX: RMD) and Worley (ASX: WOR) were his five-year picks. The biopharma firm was selected because of Hershan's view that this period is enough for the lingering questions over competing drug treatments to be settled.

His thesis on Worley focuses on the firm’s box-seat position for the energy transition and as a beneficiary of what Hershan regards as a long-running underinvestment in oil and gas production.