Why the glass is half full and 5 ASX stocks to participate in the ongoing recovery

Last year was a tough one for investors and a lot of commentary of late has been anchored to lower earnings as we approach reporting season, amid a more challenging economic environment.

Markets are forward-looking beasts, however, and Michael Carmody from Centennial Asset Management prefers to look at the glass as being half full.

While Carmody is mindful that the upcoming earnings season will very likely deliver some clangers, he remains confident there are better times ahead.

We expect the Australian market to continue its recovery in the next 12 months. We remain focused on the interest rate cycle which is nearing a peak both in Australia and in the US.

While it would be surprising if the upcoming profit reporting season didn’t deliver some disappointing results, we believe markets have broadly priced the downside risks and the Australian market is unlikely to re-test the recent cyclical low.

Carmody goes on to add that whilst declining, backward-looking macroeconomic data such as GDP and employment will likely dominate the newspaper headlines, in contrast to the economy, the market is likely to price an improving outlook for earnings growth.

It is important to remember that markets, as a forward pricing instrument, are likely to lead any improvement in underlying macroeconomic data.

In this wire, we further unpack Carmody’s outlook, discuss where he is hunting for opportunity, and run the ruler over a handful of stocks.

Carmody and Matthew Kidman run the Level 18 Fund, the portfolio for which is skewed to companies with above-market earnings growth, strong balance sheets, predictable free cash flow, and strong management teams. 

Which companies make the cut?

There are a handful of stocks that Carmody highlights as examples that fulfill the above criteria, three of which were major contributors to the performance of the Fund over the past 12 months, and two that are major positions within the Fund currently that Carmody expects to perform well.

The performers

Lindsay Australia (ASX: LAU) – Lindsay Australia is an integrated transport, logistics and rural supply company. During the year the company delivered several upgrades to forecast earnings following ongoing consolidation within the road transport sector.

SRG Global (ASX: SRG) - SRG Global is a diversified industrial services company that provides asset maintenance, mining services, and engineering and construction services in local and international markets. The company delivered consistent contract wins during the last 12 months.

Helloworld Travel (ASX: HLO) - Helloworld Travel operates as a travel product and services distribution business in Australia, and internationally. In FY23 the company benefitted from a post-Covid recovery in travel and delivered a strong earning performance in the year.

Two for the future

Lycopodium (ASX: LYL) – "We believe Lycopodium is inexpensive compared to the market and well-positioned to win additional contractual work with major global mining groups. The company has a strong net cash balance sheet and a globally diversified business model. We believe the business is likely to consistently exceed market earnings expectations over the medium term," Carmody said.

MMA Offshore (ASX: MRM) - “We expect the recovery in oil and gas activity and the forecast growth in new offshore wind infrastructure to deliver strong demand for MRM’s unique portfolio of marine vessel assets over the next year. Improving vessel utilisation and structurally higher day rates are expected to contribute to growing earnings and a higher return on invested capital. If we are right, the share price should continue to outperform the market in the next year,” Carmody said.

And a couple that didn’t go to plan

Of course, not every investment follows the thesis and Carmody kindly shared a couple of stocks that haven’t panned out and whether or not the Fund still owns them.

Monash IVF (ASX: MVF) - "We owned Monash IVF early in the year because it was inexpensive compared to the sector and we forecast a rapid post-Covid volume recovery. We also expected the company to exceed consensus earnings expectations this year. We overestimated the pace of the demand recovery and underestimated the wage cost base inflation associated with the business. We no longer own the business," he noted.

Ardent Leisure (ASX: ALG) – "We have owned Ardent Leisure for most of the last year. Post the sale of Ardent Leisure’s US business, Main Event, the Australian theme parks business (Dreamworld), property portfolio and balance sheet have underpinned the group’s valuation. The share price has underperformed as the market adjusted the company’s valuation to the smaller portfolio of assets. We believe the stock is oversold. We expect a recent announcement confirming the performance of the operating business, development plans for the surplus land and the potential for capital management should close the current valuation gap."

Looking ahead

As noted above, Carmody is optimistic about the coming 12 months and he’s very clear about where he and the team will be hunting if the base case plays out.

He notes that a consistent theme in the last year has been the outperformance of large-cap stocks vs small-cap stocks, highlighting that over the past 12 months, the All Ordinaries Accumulation Index outperformed the S&P/ASX Small Ordinaries Accumulation Index by +6.3%.

We believe that as the market recovers and risk appetites increase, investors will move capital from lower growth large cap exposures into higher growth small caps.

We expect the recent underperformance of small caps to reverse over the next year and so expect the Fund will continue to increase its exposure to small cap stocks.

The biggest challenge over the next 12 months

Of course, markets don’t move in straight lines and even if the scenario Carmody envisages plays out, he adds that investors need to be mindful of key risks – one of which he sees as the difficulty in predicting commodity prices.

Carmody notes that predicting macro events, currency forecasts, and commodity prices are all incredibly difficult, but that commodity prices are “probably the most difficult to forecast because they are largely linked to the performance of the Chinese economy”.

He adds that changes in Chinese economic policy are generally unpredictable however most commentators expect the Chinese government to support the local economy with fiscal and monetary stimulus this year.

The wrinkle, as he sees it however, is that in contrast to most international markets, the Chinese economy does not have an inflation problem and the country has failed to recover its pre-COVID economic growth.

As a result, determining a market price in the next year for iron ore, copper, nickel, lithium, rare earths, gold, and coal remains a significant challenge, as does the extent to which the Chinese economy will have an impact on global growth.

This article was first published for Livewire Markets on Monday, 24 July 2023.

Want to know more?

Michael Carmody and Matthew Kidman are Portfolio Managers for the Level 18 Fund. If you would like more information, it is available via the Centennial Asset Management website.