Lincoln’s eight ‘star stocks’ for 2019

Photo of Elio D’Amato, Lincoln Indicators By Elio D’Amato, Lincoln Indicators

min read

Market fundamentals still strong, but risks and volatility are rising.

What started as a placid investing year turned on its head at the completion of the reporting season in August. Since the recent high on 30 August the market has pulled back more than 7 per cent and in the calendar year to date the market is negative.

A defining measure of the latter half of 2018 has been the return of volatility to our markets. Keeping things in perspective, 2017 saw the market experience its lowest volatility this century. However, the change recently has been rapid as investors became increasingly spooked by events here and overseas.

The incessant noise surrounding rising global interest rates, looming trade wars, Brexit, Italy’s debt concerns, an impending property market implosion, tighter government controls, rising energy prices, and elevated personal, corporate and government debt levels, are all seen as reasons for an imminent correction.

The market is a resilient beast, however, over the long run, proactive investors who have the means and a disciplined bottom-up stock research process, should do well.

But it would be remiss not to acknowledge that we are currently in a late-stage bull market, which means “buyer beware” when it comes to share investing.

For most investors focused on the larger end of town, they will find comfort in the much-improved results shown in the overall health of the ASX 200. Eighty per cent are exposed to manageable levels of financial risk as diverse revenue streams and stable cashflow generation support operations and provide a robust foundation.

Earnings better than expected
From an earnings perspective, most companies are performing well. After the past reporting season, looking at the ASX 300, an impressive 77.8 per cent of companies either met or exceeded expectations, which was an improvement on the 75 per cent 12 months ago.

This exceptional historical growth does create a problem in that some are asking whether this is as good as it gets. The early indication from this latest AGM season is that it will be challenging to exceed the earnings growth rate of the past year. This is reflected in the consensus for earnings growth expectations in FY19 sitting around 12 per cent, down 1.5 per cent.

Source: Lincoln Indicators

This easing in growth expectations has seen several quality growth companies sold off, as the market gets jittery about a possible pullback and looks to lock in profits. We believe this has created a unique opportunity for those investors who have sat on the sidelines watching the meteoric rise of these dynamic businesses, to now take a position, as many are some way off their recent highs.

In an environment where the pace of growth is slowing, there is likely to be a return to favour in these businesses once the quality of their fundamentals and the strength of their long-term story comes back into focus.

Looking ahead
Although crystal ballgazing is always a challenge, there is enough to give confidence for the year ahead. Notwithstanding the risk of a trade war that has caused the IMF to pull back its expectations slightly, global growth estimates remain solid with emerging regions still expected to shine.

Domestically, Australians remain employed, businesses are confident and inflation remains non-existent. Notwithstanding political gyrations, the economy is running well on its own steam and there is yet no suggestion of overheating.

We are, therefore, comfortable about the pullback in the market. Our view is that corrections are healthy as they avoid overheating. This can be seen in the latest read of forward Price Earnings (PE) ratios, where following the recent sell-off the ASX 200 sees PE returning to the 10-year average.

Source: Lincoln Indicators/Bloomberg

Of course, this does not mean it will not fall further. The most significant risk to the market in 2019 will be the direction of global interest rates, as rates are a crucial input into many stock valuations and should they rise, the re-rate may result in a sell-off.

A rise in rates can mean the economy is doing well and therefore businesses should perform well. What has been of concern is the rapid rise; US 10-year Treasury yields started the year at 2.4 per cent and currently are 3.2 per cent.

Should this rapid rise continue, pressure will come to bear. Although to keep things in perspective, in the four-year bull market before the GFC, Treasury yields consistently stayed well above 4 per cent and were falling at the peak of November 1, 2007.

Source: CNBC / Lincoln Indicators

Is increased merger and acquisition activity a sign that things are ‘frothy’?
We have also seen a spike in the number of private equity firms and companies buying out others. Recent bids for APA, Westconnex, Life Healthcare, Healthscope, Scottish Pacific, MYOB, Navitas, Asia Pacific Data Centres and Greencross, show that deals are being prepared.

A recent report from Dealogic shows that AUD124 billion worth of contracts have already been negotiated this year. This excludes the recent $3.3-billion WorleyParsons bid for Jacobs Engineering’s resources and energy business.

Globally for the first three quarters of this year, deals announced are tracking at USD3.1 trillion, the highest level since the same time in 2007. Spikes also occurred in 2000 and 2015, followed by corrections. Only time will tell whether this bodes as a warning.

When cash is cheap and projections are high, it is not unusual to see this type of “bubbly” behaviour as a sign of overheating and a risk to the future direction of the market.

Source: Dealogic

So could 2019 be the start of something more sinister? No one knows what will happen. The fact is that every week brings us closer to an eventual correction.

While we expect a mild correction rather than a significant crash, we do not get the right to choose when and why a pullback occurs. Therefore, here are five key tips for investing in a market that is close to the top of the cycle.

1. Looking in the rear-view mirror is not an investment strategy
Irrespective of where the current price has come from, investors have a decision to allocate their capital today. So, the only question that matters is, will an allocation in this stock today represent the best chance to maximise my returns in the future?

2. Have a clearly defined investment strategy
In our view, it is the only way to stay focused on the future opportunity while keeping emotions at bay. If a stock meets your rules, include it, and when it doesn’t, sell it. By taking the buy-and-sell decision out of your hands (and head) you have clear rules to follow and act on.

3. Have a good spread of stocks to help absorb a shock
If you equally weight your investments into, say, 15 to 20 stocks, the importance of the performance of one stock is reduced. This will help deal with an occasional 20 per cent pullback in one stock, which only actually represents a 1 per cent decline in the overall portfolio.

4. Drip feed your investment to avoid buying at the wrong time
Known as “averaging in”, this involves buying smaller parcels of a stock at periodic intervals until you gain your desired full exposure. This spreads the buying process and makes the timing of the purchase less relevant.

5. You need cash to seize opportunities
Should you have the cash, price pullbacks can prove to be great opportunities to acquire great businesses at lower prices. In markets where gains have been strong, it is prudent to take profits off the table, to build a cash war chest for these opportunities without allocating extra capital.

Eight stocks for the year ahead
This year’s collection of stocks has big shoes to fill. Our focus on quality stocks saw a strong return including dividends, with a collective rise of +10.73 per cent versus the market, which rose +2.71 per cent. Breaking down the performance, they reflect the current strong growth cycle we have been in, whereas income stocks lagged over the year.

As we always stress, the fundamentals can change quickly, as can opinions. You need to conduct your research into these businesses and consider their appropriateness for you and your risk profile before acting on an idea, as nobody can guarantee future performance.

(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article).

Eight Star Stocks to watch this reporting season

Star Growth and Borderline Star Growth Stocks ASX Code Stock Doctor Star Stock status Financial Health Forecast return on assets Forecast revenue growth Forecast earnings per share growth
Altium Limited ALU Star Growth Strong 23.87% 26.65% 34.92%
Themes: developer and seller of printed circuit boards with the aim of being the global leader
Appen Limited APX Borderline Strong 25.53% 68.11% 54.91%
Themes: AI company with many large clients. Demand for services likely to increase.
IDP Education Limited IEL Star Growth Strong 32.99% 15.00% 11.91%
Themes: Language proficiency test provider to universities, soon to also be delivered online
Saracen Minerals Holdings Ltd SAR Star Growth Strong 32.77% 13.51% 54.17%
Themes: Gold producer with rising production profile. Handy in uncertain times.
Star Income Stocks ASX Code Stock Doctor Star Stock status Financial Health Forecast EPS Forecast ann DPS growths Forecast Gross Div Yield ^
Charter Hall Group CHC Star Income Strong Steady 13.21% 5.88%
Themes: Premier property REIT with funds management arm
Insurance Australia Group Limited IAG Star Income Strong Steady 4.41% 7.20%
Themes: Improving premium rate environment with industry-leading insurance margins
Premier Investments Ltd * PMV Star Income Strong Growing 6.45% 5.40%
Themes: Global retailer with strong brand and more store rollouts to come
Rural Funds Group RFF Star Income Strong Growing 4.94% 4.93%
Themes: Agriculture land owner with long agreements with established agricultural names
As at 22/10/2018
* Premier Investments is both a Star Income and Borderline Star Growth Stock
^ Gross dividend yield includes franking credits

About the author

Elio D’Amato is executive director at Lincoln Indicators, a fund manager and creator of the Stock Doctor sharemarket investing platform.

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