Has this latest inflation print greenlit an ASX Santa Rally?

Last week, the Australian Bureau of Statistics gifted the RBA (and investors) an early Christmas present. It revealed that the monthly consumer price index (CPI) indicator rose 4.9% in the 12 months to October 2023, down from 5.6% in September. 

This came in below economists' estimates, who had projected a 5.2% rise over the period. Hallelujah! 

It caps off what was already a good month for equity investors, with the All Ordinaries and its miniature elf helper, the Small Ordinaries, rising 4.2% and 6.6% respectively since the beginning of November. 

So can investors expect a fabled Santa Rally into the New Year? And if so, which stocks should they be stuffing into their Christmas stockings (and which should they be crossing off their lists?)

To find out, Livewire's Ally Selby was joined by IML's Simon Conn and Firetrail's Eleanor Swanson - who answered these questions and more.

Note: This episode was filmed on Wednesday 29 November 2023. You can watch the video, listen to a podcast or read an edited transcript below.

Edited Transcript 

Ally Selby: Hello, and welcome to Livewire's Buy Hold Sell. I'm Ally Selby, and today we're on a mission to find out if small-cap investors are in for an early Christmas present this year in the form of a Santa rally. And to do that, we're joined by Simon Conn from IML and Eleanor Swanson from Firetrail.

We've just seen a lower-than-expected inflation print from the Australian Bureau of Statistics. What does that mean for small-cap investors? Could we see a Santa rally into the new year? Simon, starting with you.

Will we see a Santa Rally in 2024? 

Simon Conn: Possibly. We've had a couple of good months, to be fair. A couple of months ago it was inflation and interest rates leading the day. US bond rates peaked at 5%, and as those bond rates have come back, we've seen a bit more strength in the market. But I think to see a sustained rally, we probably need to see more sustained lower inflation. And I think the trouble with the domestic inflation numbers is that domestically, non-traded inflation is still quite high. So we're cautious that interest rates may have to go up more.

Ally Selby: Okay. Over to you, Eleanor. What's your outlook on small caps over the next 12 to 24 months?

Eleanor Swanson: We're very positive on the small-cap market, looking out over the next 12 months. The way we're thinking about it, is if you look at the last two years, the ASX 100 has outperformed the Small Ords Index by 20%. And what we tend to see when economies trough is the small-cap market does rebound harder than the large-cap market. So we think the soft inflation print is a good sign that the worst is behind us. And so we think it is time to start allocating to small caps. They look pretty attractive on a PE relative basis to the large-cap index, and they look like they've got more growth, at a 13% EPS CAGR versus the large-cap index at about a 2% CAGR over the next three years.

One reason why small caps could rally, and one reason why they won't 

Ally Selby: Okay. I want to know one reason why small caps could rally into the New Year and one reason why they couldn't.

Eleanor Swanson: What we're focused on at the moment, just given Black Friday and Cyber Monday have recently finished, is we're looking at some of the consumer trading updates. We are hearing that Black Friday did do particularly well, but we do caution that what we've seen over the last five years is that retail sales do continue to get pulled forward into November. And what that means is you do see a bigger dip into December. So potentially, if what we've seen in November is sustained into December, it'll be a really good end of year for consumer cyclical-style stocks. However, we are just a little bit cautious that perhaps that is a little bit of a furphy, given that pull forward we're seen as a trend over the last five years.

Ally Selby: Over to you, Simon. What's your reason why small caps could rally into the new year, and what's one reason why they won't?

Simon Conn: I think it really gets back to interest rates and the outlook for inflation. We think the RBA is a bit behind the curve, and I'm cautious in terms of the margins that retailers are making. So I think that's one sector to be cautious of. I think it's really about being stockpickers. We've had a reasonable bounce in our funds and I think it's really about positioning yourself in businesses that can sustain or build their margins in an environment where costs are still creeping up. But I agree with Eleanor, there's good valuation support in the small caps. We just need confidence to improve on the domestic economy and the ability to continue to grow earnings.

Where are you seeing the most attractive opportunities 

Ally Selby: Where are you seeing businesses that can sustain their margins? Which sectors are you finding the most attractive?

Simon Conn: Well, one sector that's been really beaten up is the healthcare sector. So companies like Integral Diagnostics (ASX: IDX) and ACL (ASX: ACL) are two companies that we own. And we think in the healthcare sector as things normalise post-COVID, they're getting good revenue growth. If they can manage their costs well, we think they can see good earnings growth from here. And companies like Kelsian (ASX: KLS), which have more inflation-indexed earnings are quite well-positioned.

Ally Selby: What sectors are you liking, if we see a rally situation from here?

Eleanor Swanson: Yeah. If we see a rally, I think you'll see beaten-up cyclicals do pretty well. So something like housing building products, CSR (ASX: CSR) for example, or some of the retailers like a Premier Investments (ASX: PMV) or a Nick Scali (ASX: NCK) should do really well. Also, some of the banks have been pretty beaten up, so that's kind of where we see the potential for outperformance, hopefully if the economy has stabilised.

Which sectors could suffer?

Ally Selby: How about on the other side of that, which sectors could really suffer?

Eleanor Swanson: I guess some of the more defensive names. Something like the supermarkets, something that's a little bit more on the healthcare side. Although, in the small-cap index, healthcare names have been beaten up. However, typically they should be more defensive. So just on a relative basis, those sectors should underperform in a strong market.

Ally Selby: Okay. What about you? What would you be avoiding in a rebound situation?

Simon Conn: I think we're just quite cautious on the consumer. So, some of the retailers. I mean, their margins have really stepped up over this COVID period and we're very cautious in terms of them being able to sustain those margins, particularly with the cost pressures we're seeing in the domestic economy. So, wages are growing quite strongly. Electricity was a big surprise in that CPI print today. So a lot of domestic inflation and the ability to maintain margins is going to be tough, I think, particularly for the cyclically exposed sectors.

6 stocks for your Christmas stockings 

Ally Selby: Okay. This is meant to be a Christmas special. So we've asked you to bring along three stocks that you would be adding to your Christmas stocking as we head into the new year. What have you brought for us today?

Simon Conn: Yeah, I touched on one before. Australian Clinical Labs (ASX: ACL). We think it is really well-positioned. Pathology is a pretty robust repeatable business. The stock's on 13 times, it's got a good balance sheet, and they've proved through COVID their ability with their technology platform to flex costs as volumes have moved. So we quite like that one. 

SG Fleet (ASX: SGF). It's a fleet leasing business, and it also plays in the novated lease space. It's on about 9-10 times. It looks very cheap, and I think it's a business sector that has reasonable contracted revenue. And I think with the lease plan synergies coming through, it can continue to grow earnings. 

And Kelsian (ASX: KLS) is the third, which we really like. They recently did an investor day. They've got their bus business, which is effectively an inflation-protected or linked business. And the US acquisition's going very well. So on 15-16 times, it looks reasonably priced.

Ally Selby: Okay. Over to you, Eleanor. What stocks are you adding to your Christmas stocking at the end of 2023?

Eleanor Swanson: All right, Ally, I'm going to give you one defensive name and I'm going to give you two cyclical names. So the defensive one is Regis Healthcare (ASX: REG), which is an aged care player. They've got 70 homes across Australia. The reason we like this one heading into next year is we're expecting an update from the aged care task force around putting some proposals to government about how to improve industry profitability. That's not factored into consensus earnings. So we think there could be some significant upside if those proposals are positive.

The second one is Premier Investments (ASX: PMV). So whilst yes, the consumer backdrop is tough at the moment, there are lots of things to like about Premier. So firstly, it's got $400 million of cash on the balance sheet, which they can either deploy into buybacks, special dividends, or even some M&A. And then in addition, they're undertaking a strategic review at the moment, we are hoping to get an update at their first half result, but certainly by the middle of next year. And they're looking to unlock some value in some of those more growthy brands, like Peter Alexander and Smiggle, which potentially could accelerate the offshore rollout of those stores.

The final one that I've got for you is Life360 (ASX: 360). So, it's a technology company, it's a B2C business. It does family safety and tracking, so they've also got some add-on insurance products in the application. The reason we like that one is, heading into next year, what we're seeing is that the international subscriber ads are really starting to accelerate, and they're pushing very hard into Canada and the UK. At the same time, they're very much controlling the cost base. So we're expecting that at their March update next year, they should deliver another earnings beat, and it's just a really nice setup moving into next year. So they're our three favourites heading into Christmas.

2 stocks for your naughty list in 2024

Ally Selby: What stock would you be adding to your naughty list?

Eleanor Swanson: We think Healius (ASX: HLS) is still going to be on the naughty list heading into next year. So, Healius is a pathology player. They recently raised about $200 million of equity, and they've also updated their earnings guidance. Now, what we're seeing in terms of their earnings guidance for FY24 is a very large second-half skew. So they're assuming 85% skew at the second half, much larger than normal. So we don't think they've given themselves terribly much headroom in terms of potentially missing on the earnings front. And what that means is that they could be pushing up against some of their debt covenants, which are set at about four times net debt to EBITDA. So we still see some balance sheet risk in Healius, despite that very large dilutive capital raise. So, we're avoiding that one into next year.

Ally Selby: Okay. What would you be adding to your naughty list in 2024, Simon?

Simon Conn: Yeah. I've got to disagree with Eleanor. Premier Investments (ASX: PMV) is one that we're really quite cautious of. You mentioned all the consumer stocks. If you look at their EBIT margins, they've really stepped up from 2019 through 2023. And a lot of these companies look like they're still over-earning - particularly Premier. I just don't think the brands Just Jeans, Dotti, and Jay Jays are great businesses. And if you look at the sales per store, it's actually really stepped up and they've been able to get good cost leverage. But I think as the consumer faces more headwinds, that could unwind and it could potentially look quite expensive.

Ally Selby: Well, that episode certainly proves that someone's trash could be someone else's treasure. I hope you enjoyed that episode as much as I did. If you did, why not give it a like? And remember to subscribe to our YouTube channel. We're adding so much great content just like this every single week.