The rotation to an economic recovery favouring value stocks continues but risks loom on the horizon. Perpetual’s Head of Equities, Paul Skamvougeras, looks at the lessons learnt from reporting season and the trends he expects to see as NSW and Victoria reopen.

A strong August reporting season for our portfolios vindicated many of our positions. We expect to see a continued economic rebound underpinned by high consumer savings rates and a clear path emerging from the recent east coast lockdowns. There will be some pockets of weakness, but the impact on the broader listed environment is likely to be seen as ‘one-off’ in nature as we can see plenty of pent-up demand for reopening trade – travel, hotels, restaurants − heading into the festive season. On costs, however – and as we have previously written – we suspect the current inflationary environment will be more than just transitionary and likely an ongoing theme. We will need to continue to assess companies to ascertain whether they are likely beneficiaries or victims of this environment.

The major highlights of reporting season were the banks and some retailers delivering strong updates along with the dividends paid out by some of the big resources companies. Specifically, the sustainability of the sales line surprised a lot of people with some of the retail stocks. The major banks are still very well capitalised, but we generally prefer the general insurers as we start to see price rises in motor and home insurance. Suncorp delivered a strong result and while there were some concerns about IAG, they were bullish on the commercial insurance business. We have been big beneficiaries of Suncorp’s performance whilst IAG continues to offer strong relative value.

Another stock that has done well for us − and which shows why we like to take different positions from many in the market − has been Medibank Private (ASX: MPL). Pleasingly, the momentum in the core MPL brand has continued through the year, with annual growth reported in policyholders for the first time since listing. The main driver of this is the significant reduction in churn. We would expect this to normalise somewhat going forward, but the company is still expecting policyholder growth in the core brand in FY22. The company continues to be conservatively provisioned for the expected uplift in hospital utilisation once we are through lockdowns. This is despite returning some of these excess provisions to customers during FY22, which should also assist with retention. It should be noted that the market is a little bit skeptical of whether this is a new trend or whether it’s just a response to COVID-19 as people think more about their health and consider protecting themselves.

Looking forward, Qantas is a stock we also like. Not only is the company well positioned for post lockdown travel, but we feel that Qantas has the ability to increase its market dominance and market share in Australia, which is a very big profit driver for the national carrier. Key competitor Virgin is now owned by private equity and air travel will be characterised by more rational and profitable competition within the duopoly they enjoy. However, we acknowledge that lots of things can change around domestic and international travel. We were pleasantly surprised at how well Qantas performed during lockdown. We’ve seen some of the reopening trades actually retrace but Qantas continues trading at very high levels. We used the second lockdown in NSW as an opportunity to top up as we anticipate a lot of pent-up demand.

Post reporting season, expectations are for growth to continue, and this will only be strengthened as the uncertainty around lockdowns is removed. Discretionary retailers have seen sales hold up far better than expected but the jury is out on to what extent COVID-19 lockdowns pulled forward future sales. Our view is mixed on the discretionary retail sector leading into Christmas as online retailers must again content with brick-and-mortar shop fronts. It also seems likely that lockdown-wary consumers will start directing their spending away from buying more electronics or furniture to experiences and services. Coming out of reporting season, it is clear that investors have repositioned themselves for the reopening of the economy by buying stocks like Flight Centre, Event and the casino names and we are positioned for this.

Finally, our view is that whilst there is a lot of pent-up demand in the system, and we feel that the economy is rebounding quite well, there are risks in the form of rising costs and the potential for interest rates to rise sooner than expected. Companies we speak to are seeing inflation in various parts of their businesses, for example, in the supply chain because of disruptions, freight and other inflationary pressures on input costs. We continue to be mindful of higher interest rates and how these will likely impact on various companies and sectors moving forward, especially those companies and consumers who have levered up during a long period of record low rates. Inflation is actually positive for many stocks, especially resources, and we have selected a range of these for our investors especially where demand/supply imbalance is highly supportive of the business longer term. This includes nickel and copper markets where structural demand will be high for years due to high usage in electric vehicles, which will increasingly replace petrol cars. Nevertheless, we expect a bumpy ride as a range of shocks, disruptions and policy decisions rumble through global markets. Our focus will remain on screening out balance-sheet, management, earnings, and business risks to ensure our clients are invested in high-quality businesses at reasonable prices.

Originally published by Paul Skamvougeras, Head of Equities, Portfolio Manager, Perpetual