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Top picks from the Morningstar conference
Focusing on three sectors of Australian shares for direct purchases, sectors favoured by SMSF trustees and other individual investors, Morningstar offered its top picks at the annual Morningstar Investment Conference last week (October 8-9).
Cognisant of market volatility, valuations, dividend policies and the importance of fundamentals in uncertain times, three Morningstar researchers – Johannes Faul, Nathan Zaia and Mark Taylor – dissected their favourite listed companies in consumer retail, the banks and energy. The winners were: Woolworths, Westpac and Santos.
Adam Fleck, director of equity research for Morningstar Australia, who introduced the session, said the research house saw about one-third of its stock coverage trading at four or five-star territory. This compared with about 15 per cent at the start of the year and 75 per cent at the height of the sell-off at the end of March. “As we said in late March, the COVID sell-off was a panic. It was likely to be overdone,” he said.
Banks and Financials – buy Westpac
Nathan Zaia said the researchers saw value in the banks, notwithstanding the pressure they were under for credit growth, on loan losses and for revenue growth. Credit card accounts were down 4 per cent and balances were down 25 per cent. But this makes up a small part of their overall business.
Loan deferrals represent the major uncertainty but each of the banks has adequate provisioning. Westpac has the lowest deferrals but the highest provisioning as a proportion of its loan book. NAB and ANZ have the lowest deferrals but also the lowest provisioning. Across the banks, provisioning is at about 10 per cent.
Zaia said: “We’re expecting over the next three years for bad debts to be about $35 billion, which is three times what it was for the past three years… Banks have actually grown their customer deposits, which is a major competitive advantage, helped by an acceleration of the trend to online banking. They can close branches and ATMs but still keep deposits. They are in a strong position.”
Morningstar believes Westpac is the most likely to raise capital, but this is unlikely to be material. The researchers have assumed $1.5 billion in their forecasts. Zaia said the banks were no longer shackled to shareholders’ expectations around dividends. “We’re assuming dividends will be cut about 50 per cent in the short term. Choosing Westpac as the best buy, Zaia said that risks with its investor loans had been exaggerated.
Energy – buy Woodside
Mark Taylor said that the market seemed to be saying that the low price for oil – the standard Brent oil at US$40 a barrel – “but we think that’s a mistake”. Morningstar expects oil to go to US$60 a barrel about mid-cycle, about 2022.
Australian energy stocks are extremely cheap at the moment, as COVID has put a huge dent in demand for crude, he said. “But for companies to benefit from the higher oil price in the future they obviously have to be around. They have to survive the current status, which is not so bright,” he said. “They need a sound balance sheet and low operating costs. Fortunately, we think Australian companies, by and large, fit this bill.”
In a close-run race, Morningstar believes Woodside represents the best value, in terms of price-to-fair–value discount, balance sheet strength and operating costs. For a company to have a five-star rating in the energy sector it needed a price to fair-value discount of about 40 per cent. Woodside, Santos and Oil Search had discounts of between 50-60 per cent.
In terms of balance-sheet strength, Beach Energy was probably the best-placed company in the list, closely followed by Woodside, then Santos, and then, lastly, the laggard Oil Search. In terms of EBITDA margins, all companies were very high, with Woodside the highest. In terms of life expectancy of production, the researchers put Woodside on 35 years, followed by Oil Search on 32, Santos on 28 and Beach on just 13. Woodside also has the highest prospective dividend of the four, of 4%.
Consumer retail – buy Woolworths
There are two overlapping themes that Morningstar is following in consumer retailing: strong sales in some categories, especially food; and strong growth in online sales.
Morningstar analyst Johannes Faul said some categories, such as food, had done very well during lockdown, but other categories, such as restaurants, had performed very poorly. “We think the disruptions with consumers are fleeting,” Faul said. “Conditions will revert over the next 6-12 months. But the ongoing sales boom leaves the retailing sector overvalued. Most of the buying opportunities have come and gone in a heartbeat.” As an example, the researchers believe that sales for Super Retail Group (SUL) will remain strong until the end of the year, but then will turn into negative sales growth heading into early 2021.
The growth in online sales was a structural change which had been seen for more than a decade. “Now, we’re seeing an acceleration of the trend. It will have a lasting impact,” Faul said.
“Woolworths’ online food sales are outpacing those of Coles, but both are eating to their in-store sales. We expect to see material shifts unwinding but the online sector will continue to grow,” he said. A number of investors were using ‘pair trades’ – often used by arbitrage and other hedge fund managers – with ‘switching’ trades, such as favouring Woolworths over Coles, and Harvey Norman over JB Hi-Fi.
