I continue to believe the S&P/ASX200 will struggle to hold above 6000 and remain “tactically bearish” Australian equities at the index level. I’m even more confident in my shorter-term cautious stance on the S&P/ASX200 above 6000, now that the negative seasonality of commodity prices has started to kick in. With oil and iron ore under pressure, a classic “sell in May and go away” event in commodities, the ASX resource sector, led by BHP, will come under further profit-taking pressure. Resources have previously been doing the index heavy lifting and that is going to reverse.

More diversification

I am also of the view it is NOT time yet to buy Australian banks, AMP or Telstra. They remain in earnings downgrade cycles. Quite frankly, SMSFs all own way too many of those already and you don’t need more of them! What you need is some diversification in your portfolios, either to global equities or ASX-listed global earners, such as Aristocrat (ALL) or next generation clean energy stocks, such as Kidman Resources (KDR). I’m absolutely not interested in buying Telstra, AMP or Australian banks, but I bought more Aristocrat after they delivered very strong FY18 earnings and bought more Kidman Resources after they signed an offtake agreement with Tesla.

On banks, I warned that offshore hedge funds would short them ex-dividend and that has been correct. We are now seeing bank sector analysts cut earnings estimates based on weak credit growth and tougher mortgage lending standards post the Royal Commission. I think Australian banks have further to fall over the next few months and there’s no rush to buy them. In fact, there’s never a rush to buy ANY stock in an earnings downgrade cycle. Telstra would be the classic example where people have been lured into buying an unsustainable dividend yield and lost 50% of their capital: ditto AMP.

Sustainable share price appreciation is about sustainable earnings growth. Sustainable earnings growth drives sustainable dividend growth (e.g. CSL). Dividend growth is what you want, not unsustainable dividend yield. It may prove to be the case that Australian banks have unsustainable dividend yield as their earnings are going backwards and dividend payout ratios are already very high. This is BEFORE we get any Australian residential house price falls that could lead to a bad debt cycle.

So my advice today is to stop looking at dividend yield first. It’s a sure way to underperform. We are past the low point of interest rates globally and you are going to see equity yield tourists leave the registers of many leading Australian stocks as cash and bond yields become more competitive. Telstra is a classic example.

You need to diversify via geography, sector and currency. The average SMSF is grossly under-exposed to global growth stocks and/or ASX listed global earners. That is and remains a mistake. It’s costing SMSFs relative and absolute performance being underexposed to global equities and ASX listed global earners.

The ASX200 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.

Exposed to the world

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).

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.

And just to show you the opposite, here is Telstra versus FY18 consensus EPS estimates over the last five years.

And here’s Commonwealth Bank of Australia (CBA). This chart suggests to me that CBA shares have further to fall.

And for good measure, AMP vs FY18 consensus EPS over last five years.

Earnings per share growth (OR NOT). That is the key to successful stock picking. The examples above are clear and I hope you understand why I won’t buy CBA and Telstra, and have bought more Aristocrat.

EPS growth drives DPS growth. Never look at yield first. Never: dividend yield is an output, not an input.

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% 3-year 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 service/ platform business, with 70% recurring earnings, and not as poker machine cabinetmaker. 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.

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.

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.

Kidman Resources – transformation story

As for Kidman Resources, this company is transforming from “highly speculative” when I first recommended it at 50c, to potentially the number one lithium stock in Australia.  I was the first East Coast commentator to back Fortescue (FMG) very early, and Kidman has all the attributes that Fortescue had. I think Kidman will be the FMG of Australian lithium. I think this has every chance of tripling from here over the next five years.

Over the next few years, we believe Kidman will become an A$2-3 billion company (vs. its market cap today of A$890 million), as Mt Holland is de-risked and brought into production and as the market begins to price in the assets expansion potential.  While Kidman is still around 2.5 years from production, in our assessment, we believe it is on track to become the preferred ASX lithium exposure, since no other global lithium exposure ticks all of the following boxes:

• First quartile cost lithium hydroxide
• World class scale
  • 189mt @ 1.5% lithium oxide (Li2O) (the third largest hard rock deposit globally by contained lithium)
  • Initial production 44ktpa lithium hydroxide (LiOH) but scalable to 88ktpa or 110ktpa LiOH longer term
• Best-in-class partner in SQM
  • Produces ~25% of global lithium production
  • Has been producing lithium for ~24 years, essentially started the battery-grade lithium market
  • Sells 26 different lithium product
  • Has 300-400 lithium customers around the world
  • KDR will have the option to sell any of its uncommitted share of production into SQM’s customer network
• No Chinese counterparty risk (many hard rock peers sell product to China for conversion)
• No complex brine processing risk
• Australian sovereign risk (no south American sovereign risk)
• KDR is also a pure lithium exposure, with 100% of revenue to come from lithium.  Many of the large existing lithium producers are not pure lithium exposures, including SQM.

Remember, the greatest gains in Fortescue were made in the years leading up to first production. I think this is what happens next for Kidman as its register becomes institutionalised as it de-risks. I also wouldn’t be surprised to see a major car manufacturer take an equity stake in Kidman alongside another offtake agreement. If that proves right, Kidman shareholders will most likely never have to write a cheque to fund the mine and refinery development.

Kidman has moved from highly speculative to a core high conviction investment for AIM. Yes, it’s still going to be volatile, as all mining stocks are, but I see a clear path to further substantial capital gains here and a multi-billion-market cap company.

So there you have it. I am not buying Australian banks, AMP or Telstra. I am also “tactically cautious on the S&P/ASX200 above 6000” as I warned in mid-May. I have bought more Aristocrat and Kidman because I think the potential for medium-term capital gains, driven by earnings growth, far outweighs anything offered by large cap domestic yield stocks.

You’ll never overtake anyone driving in the same lane.

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.