Covid-19 raised turmoil through the global financial markets, and for more Australian shares, they have only partially recovered their pre-Covid levels. The bull market, which started after the GFC is over and the seeds for the next cycle begin to take shape as Covid-19 vaccines become available in 2021 and a return towards normalcy. We have updated our investment thesis for our portfolio in preparation for the Covid-19 recovery and the next leg of the market cycle.
Investment Portfolio Highlights
Previously we constructed our own portfolio focusing on a mix of strong dividend shares and growth shares where there is a clear path to growth in revenues, earnings, and finally dividends.
During the earlier periods of volatility, we rebalanced our focus towards more income and capital protection strategies to ride out the volatile market and even considering some offshore as a means of diversifying the portfolio.
How does ASX compare with other global markets?
During the bull market, returns across markets correlate strongly. After the end and in bear markets, the spread between the companies with strong fundamentals and the pretenders opens up. As always, in the good times, the risks of subpar shares are overlooked or underpriced as investor’s optimism extrapolate the past into the future. Bear markets show the markets do not always go up in the future.
The table below shows the return of the ASX 200 against a suite of global benchmarks. The standout performer has been the Nasdaq, which is dominated by technology companies; the one sector the Australia market has always been short of until recently.
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This divergent market performance shows that it pays to have offshore exposure since the local market is heavily weighted towards the mining and financial sectors. We originally expected Australian equities to underperform as the banks shares will be the local market’s performance.
The overhang of the poor unemployment outlook and the resulting residential market impact was just too obvious. Nevertheless, the government stimulus has kept the music going, and it hasn’t played out as we expected. Sometimes in investing, it still pays to be wrong.
We have scoured the ASX for ideas that can best withstand expected volatility going forward, at least until at least a vaccine is widely available to return to some sense of normality of the pre-Coivd world.
This is also an opportunity to pick up some companies where we have kept an eye on, and while the short term performance has been affected by Covid, it is only temporary. We are willing to look through the short term hiccup as an opportunity to buy into the long term thesis.
Key disclosure: stocks and ETFs listed below do not consider individuals’ own risk parameters and are not recommendations. The list below is just a sample of our investment portfolio ideas and can change as the market condition changes.
Top Australian Shares to Buy
The list below is our top 5 best share ideas.
BHP / Rio Tinto – both mining companies provide diversified global commodity exposure. Instead of trying to pick pure commodity plays (copper, nickel or zinc, etc.). We always considered diversified approach always pays off on a risk adjusted basis.
The trophy in these two has always been the iron ore mines in the Pilbara as they are some of the lowest cost producers in the world. These mines have a low operating cost but also the quality is markedly good and trades at a premium to the other producers’ output. It also has a large degree of Copper exposure, which we see favorable fundamentals in the medium term. Overall the balance sheet looking good with strong cash flow.
As always, the key risks in owning these shares is China. The market overlooks the current trade spat as iron ore is not a simple commodity that can be easily replaced so we should be good. The real risk from China for the thesis is a real estate market slowdown.
Finally, the management needs to remember the last cycle and maintain cost discipline as commodity prices bounce back.
Woolworths – Consumer staples is one of the most defensive businesses in the current uncertain economic environment. Woolworths was a laggard in our portfolio for a long time as the business struggled after being under invested for several years. The new CEO implemented much needed changes in turning around comparable same store sales.
A2 Milk – A2 Milk came onto our radar when the shares were trading below $1. Unfortunately, we took our eye off the ball, and it traded up to nearly $20. It is a 20 bagger we missed, and we kick ourselves every time we see it.
Since late 2020, the A2 milk share price sold off by almost 50% due to earning downgrades caused by the international travel restrictions and Melbourne Covid shutdown. We are a holder now and look past the temporary slowdown. A2M recently made an NZ acquisition and it is a joint venture with the partner in China. This shows there is a low risk of them getting dragged into the trade spat, for now.
The overall story is intact in which the current market share is a fraction of their potential total addressable market in China. This shows there is still a runway for growth for A2M, but like many Australian shares, it is reliant on China and the perception of the Australian-China political stability.
Santos – We always have a soft spot for having some oil exposure in our portfolio. The global economic slowdown is putting a decent dent in global oil demand; however, the secular transition from coal to gas and LNG’s importance in the energy mix is still intact.
Santos post the 2016/2017 slowdown, repaired its balance sheet and has multiple avenues to expand its production. Previously we leaned towards Origin Energy; however, the most recent cycle collapse and material setback of shale production meant means that at this stage, we prefer direct LNG exposure through Santos.
Wesfarmers – Wesfarmers is Australia’s largest listed conglomerate and owns some of the most recognizable household brands such as Bunnings, Kmart, and Officeworks. Aside from retail exposure, it has a strong industrials business focusing on chemicals, energy, and fertilizers.
We like Wesfarmers predominantly due to Bunnings, which is the jewel in the crown and a cash cow for the foreseeable future. In addition to an organic source of growth from its stable businesses, Wesfarmers is not shy to enter into new markets by acquiring Coles, albeit at bad timing just before the GFC.
After successfully exiting its Coles investment, the group balance sheet is cash up and derisked, making it a perfect candidate to be aggressively taking advantage of falls value from their shopping list. The management has a strong history of delivering shareholder returns and stewart of capital and therefore, is trusted to deploy capital in this market.
As we wrote in detail in our Covid-19 risk to real estate post, we think the Australian economy’s greatest risk will be the rise in unemployment and the subsequent impact on the property sector. The ideas above are what we consider the core portfolio, and we will keep an eye on the stocks on our watchlist further below and enter at a better price.
ETFs Can Help Reduce Risks In the Portfolio
We think having some Exchange Traded Funds can be beneficial as each fund typically tracks a market by itself. So on a look through basis, an ETF in your portfolio is an automatic increase in portfolio diversification.
When we are looking at the ETF, a thematic play is looking for exposure to markets where Covid has been contained to a degree, which means directly allocating more exposure to Asia/Australia versus Europe/US.
Market index funds are some of the largest ETFs in Australia. The largest ETF is Vanguard Australia Shares, which replicates the ASX 300. The low cost ETF is ideal for those that want a set and forget long term investment.
Asia ETFs (China and Japan ETFs)
China has avoided the worst impact of the first wave of Covid-19. Two interesting ideas are owning a China index fund representing large cap Chinese stocks listed in Hong Kong. We think China will do relatively well in the medium term, even as the US market has recovered the fastest. We expect the economic numbers to reflect the US poor handling of Covid once the stimulus tapers off.
The US economy’s recovery will be long and slow under a Biden presidency as the expedited reopening in 2020 has done material damage to its long-term health.
Similarly, we are more bullish on Japan and will include some of the exposure down the road. The Japanese economy took a less than severe hit in contrast to the other major economies. The Japanese economy’s strength will provide a high level of buffer for companies in the Nikkei.
We feel strongly economic and financial uncertainty will remain until the vaccine is widely distributed.
Australia Share Watchlist
In addition to our top 5 ideas, we have a watchlist of ideas we are keeping an eye on.
NextDC – Benefit from shift to cloud computing and move IT spending to capital light structure but increasingly look like we missed the boat.
NAB/WBC/CBA/ANZ – We are cautious on the banking sector until the loan losses have shown up and the market capitulates on the selling.
Australian Real Estate – We like real estate in general, either commercial or residential but just not at this point. We feel it is too early as the sector performance lags the rest of the economy. The market has been effectively frozen and will take time until price discovery comes back. We will be keeping an eye on the Australian REITs in the meantime.
Origin – We still like Origin as it provides exposure to the long term secular trend of China moving towards cleaner gas energy. China’s demand for clean gas and shift away from coal has led to it being the world’s largest Gas importer even post-Covid. The stock trades off changes in the oil price in the short term but in the long run, the key driver of value will be LNG production growth.
LNG plays into our income and capital preservation theme as the other half of the business is Origin Energy, one of Australia’s largest utilities. Utilities is a regulated industry where the regulator sets the returns on invested capital. Therefore, the utility business provides stability that differentiates Origin from a pure exploration and production company like Santos.