On Tuesday, the S&P/ASX 200 suffered its biggest one-day loss in five months. On Tuesday, the US dollar also suffered its biggest loss in five months.
While it’s very easy to backsolve narratives to suit a story, in my mind the S&P/ASX 200 fall on Tuesday had absolutely nothing to do with machinations in Canberra, and everything to do with the fall in the world’s reserve currency.
To link Malcolm Turnbull’s leadership troubles to a fall in the S&P/ASX 200 would make the assumption the S&P/ASX 200 has rallied because of Malcolm Turnbull. I don’t think that has been the case at all.
What has been the case has been the ASX200 has benefitted from an unprecedented rotation from emerging markets to developed markets. This rotation has been driven by US dollar strength.
On Tuesday, the overbought US dollar started correcting, after it became clear President Trump wasn’t a fan of the strong dollar or its cause (Federal Reserve Rate hikes). This led to strong bounces in emerging markets, led by China. As China bounced, the S&P/ ASX200 was sold off. It’s as simple as that.
ASX200 and HSCEI Index in Hong Kong: 20% performance divergence in six months in favour of the ASX200
S&P/ASX 200 and US Dollar Index (DXY); joined at the hip
My point is that the S&P/ASX200 has risen to 11-year highs for unjustified reasons and it’s time to be careful. Earnings growth hasn’t driven the rally, P/E expansion driven by global funds trying to park money in a large cap developed market stocks has driven the rally. That is an unsustainable rally and one likely to be reversed if the US dollar continues to pullback or the Australian dollar continues to rally.
What will benefit?
To my eyes, the biggest beneficiaries of this rotation have been the big four Australian banks, Wesfarmers, Woolworths BHP Billiton, Woodside Petroleum, Telstra, property trusts and infrastructure names. It’s worth noting that the sell off on Tuesday was indiscriminate and saw all stocks and sectors above knocked back a few steps. That tells me there is plenty of “tourist” money in large cap Australian equities right at a time when value is very hard to find.
So while there’s a lot of commentary about what drove the S&P/ASX 200 to 11-year highs, I don’t buy any of it, other than the strong US dollar/weak Australian dollar was the key factor. It’s been the key factor globally and the key factor locally.
At the same time, the US dollar appears to be peaking, we are also seeing trade war tensions ease half a notch. This is driving investors back to large cap beaten up Chinese equities in Hong Kong, such as Tencent and Ping An Insurance, to name a couple. It’s also driving bottom fishing in US listed global cyclicals, such as Caterpillar. I can find far greater value and growth outside of Australian equities right now and have been actively reducing my Australian weightings to reallocate globally to China and US facing cyclicals.
Pockets of growth and Aristocrat (ALL)
While I am broadly cautious on Australia’s top 20 stocks by market cap, because I just can’t see further near-term upside, there do remain pockets of growth at a reasonable price in larger mid-caps with global leverage.
Today I thought, after making the points above, I’d keep going with the series of high conviction stocks I have in Australia. HUB24 had a nice bounce on fundamentals, Kidman is trying to bottom after a 50% fall, CYB looks great value versus domestic growthless banks, and Aristocrat (ALL) remains my largest Australian holding.
Aristocrat has done nothing for a while but, in my view, this is just a consolidation of recent gains before the next leg up. This remains the world leader of its industry and is due further re-rating.
Aristocrat has broadly traded sideways since the end of May. This is somewhat surprising considering it delivered a tremendous result that triggered earnings upgrades. Those upgrades are reflected in the chart below.
The Aristocrat share price capital rewards have matched the structural earnings per share growth. Below is an overall of FY18 EPS forecasts (RED LINE) from Aristocrat analysts and the Aristocrat share price over the last five years. You can see the close correlation as EPS estimates were consistently upgraded as management delivered on their growth strategy.
Earnings per share growth (OR NOT). That is the key to successful stock picking. EPS growth drives DPS growth. Never look at yield first. Never: dividend yield is an output, not an input.
Three more strong years
Back to Aristocrat and I see three more strong years of earnings per share growth and a pathway to a $40.00 plus share price.
Aristocrat’s transformation from a straight gaming/slots play, contingent on the replacement cycle, to a content/social gaming provider continues. With the company still in the early stages of the build out of a digital game business of scale, earnings risk lies to the upside, given the greater exposure to this fast-growing market and ‘learning synergies’ the company already appears to be extracting from recent acquisitions. Amazingly, or as a result of the consistent earnings growth, the stock’s PE has barely moved over the last two years, despite the near vertical share price delivering 27% 3YR EPS compound annual growth rate (CAGR) on a 20 times PE, Aristocrat occupies a unique niche in the Australian market, where you generally see domestics pay a much higher multiple for this quantum of earnings growth.
Analysts generally upgraded Aristocrat forecasts by 7% to 10% after the first half earnings beat. The stock price responded in line with the consensus earnings upgrades, but to me, the next leg of this for Aristocrat is P/E expansion, as the world starts to price the company as a software as a service/ platform business, with 70% recurring earnings, and not as poker machine cabinet maker. I think Aristocrat’s P/E can rise to 25 times to reflect the change in its business and its position as the world leader in its sector.
$40.00 plus stock
Let’s assume Aristocrat generates EPS of $1.35 in FY19 and $1.75 in FY20. Put both those EPS estimates on 25 times and we set a price target range of $33.75 to $43.75 over the next two years. I absolutely believe, and am positioned for, Aristocrat being a $40.00 plus stock. If we are right about our EPS forecasts, which I actually think will prove conservative and be upgraded, and right about our view on P/E expanding over the next two years, then I see Aristocrat continuing to be one of the handful of global structural growth stocks that lead the ASX, while domestic exposures struggle.
The AS&P/ASX 200 is 2.5% of the world equity market and Australia has just 24 million of the world’s 7.2 billion people. It’s very hard to drive earnings growth from an addressable market of just 24 million people. I think you want to be investing in stocks with the biggest addressable marketplace. That either means they face Asia or the USA, or preferably both.
I invest in stocks that sell their product or service to the world, not just to 24 million people. I believe all of you need more global exposure in your portfolio and one of my key high conviction ASX-listed global earning ideas remains Aristocrat Leisure (ALL).
Aristocrat passed the earnings and outlook test and has all the characteristics we seek in a high conviction investment. As I said, we’ve increased our investment in Aristocrat post the result and consensus earnings upgrades.
In summary, I think it’s time to be cautious on large-cap, growthless, S&P/ASX 200 leading stocks that have driven up on non-fundamental reasons, such as US dollar strength.
Remember, in the short term, the market is a voting machine. In the long-term it’s a weighing machine. My view is to take profits in S&P/ASX 200 stocks that have risen because of a short-term popular trade, and rotate to those that have structural earnings growth and valuation upside.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.
