The expectations of a “regime change” in which global central banks cut interest rates has encouraged investors to reposition portfolios to include more companies which may benefit from it. This is the view put forward in a recent webinar delivered by Sandstone Insights on September 4 (2024).

A trend towards lower rates is already in play with several central banks reducing rates in recent months, including the US Federal Reserve, European Central Bank, Bank of Canada and Reserve Bank of New Zealand.

“The shift has direct implications for equity investors. But it’s important to note this is not the end of the current cycle, but instead an extension of it. In other words, central banks aren’t cutting rates because economies are heading into recession,” says John Lockton, Head of Investment Strategy at Sandstone Insights.

The upshot, he argues, is that co-ordinated interest rate cuts will not necessarily provide a signal to start de-risking portfolios.

Ultimately, the market outlook depends to a large degree on whether central banks opt for soft rate cuts or more dramatic cuts that would cause more volatility.

“There are already signs the performance of stocks and sectors that did well over the past three or four years is starting to reverse,” says Lockton.

“Globally, the biggest trade over the last three years has been the NASDAQ Index or technology as a bucket. But even with earnings upgrades, multiples are mostly higher now than three years ago.

“Locally, banks are up significantly year to date and resource stocks – which make up a quarter of the market – are down 10-15%. That gap is unusually large, so lower rates could be the catalyst for investors to start thinking about where they allocate capital.”

A key indicator for advisers to watch, Lockton maintains, is “real interest rates” – or headline interest rates adjusted for inflation. 

Real interest rates are a proxy for the real cost of capital and remain positive at this point. But they will fall close to the long-term average of 0-0.5% if official rates fall to the degree anticipated by the market, Lockton says.

Earnings backdrop

The recent local earnings season reinforced the dispersion between financial and material stocks, with both earnings upgrades and dividend increases most common in the former, according to the webinar. Resource companies, by contrast, were among those that disappointed with either earnings downgrades or dividend cuts.

Ten new share buybacks worth a collective $2.8 billion were also announced in August as companies sought to return capital to shareholders, including buybacks from Brambles (ASX: BXB), Qantas (ASX: QAN), Aurizon Holding (ASX: AZJ) and Insurance Australia Group (ASX: IAG).

“There was probably a slightly higher level of downward revisions relative to the last two to three years. But the market appeared to look through it and focus on the impact that ‘regime change’ may have on the longer-term outlook into 2025,” Lockton says.

So, which companies delivered during earnings season?

Ryan McCaugherty, Research Analyst at Sandstone Insights, points to medical technology company ResMed (ASX: RMD) as one standout.

“We've been positive on ResMed for some time, even though it’s had a rocky time. The hype around GLP-1 drugs drove fear that sleep apnea treatments would not be required if people slept better after losing weight,” McCaugherty says.

“But instead GPs are diagnosing sleep apnea in patients who had requested weight loss drugs. In the short term, it’s driving more demand for ResMed products,” he says.

Sandstone Insights expects the company to continue delivering top line growth and cutting costs with manufacturing efficiencies. 

“Despite a good run recently, ResMed is still undervalued and has a massive runway,” McCaugherty suggests.

Seven Group (ASX: SVW) also delivered a strong result, he says, driven by the industrial component of its portfolio. Its WesTrac division, which is a Caterpillar equipment dealer, continues to perform well due to demand from miners.

Seven Group’s recent 100% acquisition of Boral is also critical to its outlook: it believes it can extract significant margins from Boral given its potential synergies with Coates (another Seven-owned company and the largest equipment hire company in Australia).

“Seven Group only trades at around 16 times earnings – that's lower than the industrials benchmark. We think it is very undervalued and likely to grow earnings by around 10% per annum.” McCaugherty says.

High growth play

Block Inc (ASX: SQ2) remains on Sandstone Insight’s radar because it has beaten and upgraded its guidance for each of the last 12 quarters.

“We think the stock is very undervalued. It’s one of the high growth stocks we like, even though it’s been frustrating for investors at times,” McCaugherty says. 

The company has two main divisions – Square (which provides ETFPOS terminals in local cafes) and a cash app that is currently available only in the US.

“The latter is essentially an all-in-one banking services app which allows you to pay, get paid, as well as trade Bitcoin, stocks and investment products. It offers everything you’d expect from a bank and is continuing to meet new customer goals,” McCaugherty says.

“The group as a whole is undergoing a real pivot to profitability, like a lot of other tech companies. But its share price has essentially gone nowhere. It's probably one for clients who can take on more volatility in their portfolios.”

Logistics company Brambles’ (ASX: BXB) heavy investment in technology means it is another company with potential to outperform, according to Sandstone Insights.

“Brambles has historically been a high capex, high cash intensive business. But it’s been able to introduce new contracts and better mechanisms to know its customers,” McCaugherty says. 

“The loss rates from its pallets have significantly reduced over the past two years and the capex-to-sales ratio is structurally lower than it was pre-COVID.

“This all makes it more cash generative. It’s delivering that back to shareholders by upping its payout ratio and announcing a $750 million share buyback. There is still both earnings and valuation upside for the company.”

In the supermarket space, Coles Group (ASX: COL) has recovered from the fallout of increased theft. Its PE (price to earnings) ratio is back to its long-term average and earnings momentum is driven by Coles-specific factors, including same-store sales higher than rival Woolworths, according to Lockton.

“Woolworths has been distracted over the past 12 months by the appointment of a new chief executive officer and taken its eye off execution. So there is still more earnings momentum and therefore share price upside for Coles,” Lockton says.

He added that an ACCC industry review as part of a federal government anti-inflation drive may generate some “showmanship”. But it is unlikely to structurally lower the ability of supermarket operators to generate margins.

Mid cap picks

Mid cap companies to come out well from earnings season included car accessories manufacturer and retailer ARB (ASX: ARB), tracking app company Life360 (ASX: 360), furniture and homewares company Temple and Webster (ASX: TPW) and insurance broker Steadfast (ASX: SDF).

“ARB is a long-term compounding stock and one of the few companies on the Aussie market that since IPO has never raised equity capital – it can self-fund it through growth,” Lockton says.

He says the company’s multiple has expanded partly because of that enduring growth – but argues it has the potential to penetrate the US market further. 

In terms of Life360, Sandstone Insights argues its potential lies not just in its significant growth trajectory, but also in the value of its data. Its ability to earn advertising revenue off the back of that data could be commensurate with companies such as Uber.

Temple and Webster “has the best ecommerce team in the country in terms of capital allocation and being able to follow its customers,” according to Lockton. 

“These guys don't have to destroy the likes of JB Hi-Fi (ASX: JBH), The Good Guys or Harvey Norman (ASX: HVN) to be successful. With $450 million in annualised revenue, there’s meaningful upside on earnings and share price,” he suggests.

Finally, Steadfast has grown its earning since IPO by 300 basis points more than the growth in premiums. Lockton argues it’s well-placed to benefit from the shift away from direct relationships with insurers to indirect contact through intermediaries.

Overall, there was clearly much to digest in earnings season. Advisers should focus on a broad range of factors – from macroeconomics to company fundamentals – when building portfolios for clients.