It’s amazing how fast market narratives change these days. A week ago, the talk was about easing inflation and a ‘Goldilocks’ economy where growth was neither too hot nor too cold. Markets earlier this week tumbled amid recession fears.
Poor US economic data, weak tech earnings and the plunge in Japanese equities pummelled global share markets The bears argued that emergency rate cuts were needed to stop the US economy sliding into recession, given deteriorating manufacturing and unemployment data.
Investors should respond in a few ways. First, by ignoring market noise and commentators opining about short-term market moves. Who knows what markets will do today, tomorrow or next week?
Second, focus on what matters most: company valuations in the context of a long-term investment framework. Aim to buy quality companies when they trade too far below their fair value – not speculate on top-down trends or macro-economic forecasts that are usually wrong.
Third, capitalise on volatility by buying into market corrections and pullbacks. Taking advantage of irrational market sentiment in the short term – like we’ve experienced this week – is the key to building long-term wealth.
None of this is easy. Adding to portfolio equity allocations when markets are tumbling can terrify some investors. The key is recognising that valuations could still fall further and being prepared to wait out heightened volatility.
As I have written before this year, markets will be more volatile in the next few years due to higher inflation than investors have been accustomed to in the past decade. Heightened geopolitical uncertainty will amplify volatility.
Then there’s the boom in passive investing and its distorting effect on valuations, as more capital piles into stocks with large market weightings, regardless of price. And less into stocks that have fallen and look seriously undervalued.
As persistently higher inflation this decade erodes purchasing power, investors will require a high total return (including dividends). One way to achieve that return is by capitalising on short-term volatility through active investing.
I still believe the US and Australia will avoid recession, although the odds of economic contraction were shortening. The market was primed to sell off given the extent of gains in recent weeks. That’s the bad news. The good news is that valuations in parts of the Australian equities market are compelling.
Here are three mid- and small-cap stocks to consider during market volatility. Each has been belted this week. Each has slumped this year due to market sentiment rather than any change in the company’s fundamentals.
- IDP Education (ASX: IDP)
IDP was one of my favourite mid-cap stocks for years, given soaring demand for English-language testing and growth in international students. The stock almost quadrupled between 2019 and late 2021, to peak above $38.
But a draft government bill to limit international student enrolments in Australia – and take pressure off immigration and population growth – rocked IDP and our international education sector. Rising competition for English-language training and fears of less globalisation affecting student numbers also weighed on IDP.
IDP has slumped to $13.49. The company’s valuation had to fall, but a plunge of more than 40% in one year is excessive.
Through its part-ownership of IELTS, IDP has a big stake in one of the world’s most widely accepted English-language tests. Demand to learn English (and be tested for it) will continue to rise this decade. So, too, will global growth in international student numbers and student mobility.
Let’s hope common sense prevails and the Australian government realises its proposal to limit international student numbers is dangerously short-sighted and will have unintended consequences on the sector and broader economy.
An average share-price target of $18.52, based on the consensus of eight broking firms, suggests IDP is materially undervalued at the current $13.49.
There might be further losses yet, such is current market negativity towards IDP. Any recovery will take time and not be in a straight line. But if, like me, you believe in buying quality businesses when they are trashed by the market and have a long-term view that can ride out short-term weakness, IDP appeals.
Chart 1: IDP Education
- IGO (ASX: IGO)
I missed the boom in lithium stocks and avoided the sector when prices got too frothy. After savage price falls, some lithium producers appeal.
IGO’s key asset is a 25% non-controlling stake in the Greenbushes Lithium Mine in Western Australia. Talison Lithium, a joint venture between IGO, Albemarle and Tianqi Lithium (the effective controller) operates the mine. IGO also owns a 49% interest in the Kwinana lithium hydroxide refinery, which is primarily used to produce cathode materials for lithium-ion batteries.
IGO has plunged from a 52-week high of $14.90 to $4.98. Lithium prices tumbled as China’s economy slowed and sales of Electric Vehicles (EVs) stalled. After stunning gains, share prices of key lithium producers nosedived.
The sell-off has gone too far. At current prices, lithium is trading below its marginal cost of production, encouraging downstream producers to reduce brownfields expansion and upstream producers to cut back production.
These conditions won’t last forever given expected medium- and long-term demand for lithium, amid growth in EVs worldwide.
Lithium prices might not be as strong as expected in the medium term if EV sales are slower than expected. But IGO’s exposure to the Greenbushes mine, among the world’s lowest-cost operators in its field, should support its profitability.
Morningstar’s valuation of $7.50 for IGO suggests the stock is undervalued at the current $4.98. I’m not quite as bullish because I think EV sales will slightly disappoint in the medium term, weighing on the lithium price. Even so, IGO looks undervalued after horrendous falls this year.
Chart 2: IGO
Source Google Finance
- Megaport (ASX: MP1)
I’ll have more to say on Megaport in this column in the next few weeks. The emerging tech company has been hammered this year, partly on slower-than-expected growth in the US as the company builds its sales team there.
Megaport’s services enable enterprises to connect to Amazon Web Services, Microsoft Azure, Google Cloud and other cloud service providers – a long-term growth market if ever there is one. The business says it helps more than 2,800 enterprise customers connect to hundreds of data centres worldwide.
Megaport has an early-mover advantage in a structurally attractive growth industry. More data centres worldwide and more companies seeking fast, secure and reliable connections to multiple centres, across multiple locations, is good business. Megaport has a valuable foothold in a market that will eventually boil down to a few large providers that offer these connectivity services.
An average share-price target of $15.26, based on a handful of broking firms, suggests Megaport is undervalued at the current $10.07.
The small-cap stock suits experienced investors who can withstand short-term losses, and who have an eye on the long-term outlook for data centres, cloud services and global network connectivity.
Megaport looks like another example of a company with solid long-term growth prospects that has been caught up in general, short-term market negativity. It’s conditions like these that create opportunity for contrarians.
Chart 3: Megaport
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 6 August 2024.
