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4 stocks to buy on a correction

Bargain hunters who hold their nerve, watching and waiting for value rather than rushing into the sell-off, will be better off.

As I write this column, the Australian sharemarket had fallen almost 5% in two trading days, before some much-needed mid-week respite.

A correction in US shares was long overdue. As the US economy strengthens, markets are factoring in higher wages growth, inflation and interest-rate rises. The Goldilocks scenario of “neither too hot nor too cold” is fading – the US economy looks hotter than expected.

Recent wages-growth data in the US and rising bond yields suggest the pullback has further to run. We might see further losses in the next few weeks, but I expect markets to recover the losses this half, albeit with higher volatility.

The US is a long way from a recession and US market corrections that are not associated with recessions tend to be shallower and shorter, as AMP Capital Investors chief economist Dr Shane Oliver noted this week. The excesses that normally precede recessions – massive debt growth, over-investment and high inflation – are not there in the US.

Meanwhile, the Australian economy is strengthening amid a synchronised resource- and infrastructure-sector rally. The labour market continues to improve, commodity prices are up, property prices are mostly holding firm and inflation is low. Challenges abound, but improving economic fundamentals have supported our sharemarket gains in the past six months.

Investors should wait for better value in Australian shares in the next few weeks. This sell off could take weeks to play out, such is the uncertainty around the pace of US interest-rate rises. Global equity markets are in for a bout of higher volatility and lower prices as investor expectations adjust to the prospect of more US interest-rate rises than the US Federal Reserve has signalled.

These stocks should have a prime spot on portfolio watchlists if the Australian sharemarket falls 7-10% this quarter. Bargain hunters who hold their nerve, watching and waiting for value rather rushing into the sell-off, will find plenty of opportunity.

 

1. Contractors

The resource and infrastructure pick-up is good news for large service contractors. WorleyParsons, Monadelphous, Downer and CIMIC rallied last year in anticipation of greater construction work and were belted this week during the selloff.

Downer fell 5% on Monday, Monadelphous dropped almost 4% and CIMIC and WorleyParsons each shed a bit over 2%, each falling more than the broader market. Investors were itching to take profit, even though the medium-term outlook for contractors is improving.

I wrote favourably on the infrastructure contractors for The Super Switzer Report in May 2016, singling out Downer (at $3.55, now $6.54) and UGL (taken over by CIMIC). Energy-services contractor WorleyParsons has been a long-term inclusion in this report’s takeover portfolio.

It’s tempting to go cold on this sector after such strong gains and it’s no surprise these four fell sharply during the selloff. But improving industry fundamentals for the big contractors as government spend on infrastructure projects increases, and as resource-sector activity improves, suggests earnings and company valuations can go higher.

Former market darling Monadelphous might be the pick. It is benefiting from higher oil and gas maintenance activity and has more leverage to the mining sector.

Chart 1: Monadelphous (MND:ASX)

Source: nabtrade

 

2. Diversified miners

If the bears are right, US wages growth will drive inflation and interest rates higher, stymieing what is a rare period of synchronised economic growth.

In January, the International Monetary Fund upgraded its global economic-growth forecast for 2018 to 3.9%, from 3.7%. The World Bank last month also predicted stronger global growth, following other prominent forecasters that have lifted predictions.

Their predictions are far from infallible. But an uptick in growth across all major regions in the world is underway for the first time since the 2008-09 Global Financial Crisis. The US economy looks well supported in the next 12 months by tax cuts and other spending measures.

BHP Billiton rallied from a 52-week low of $22.06 to a high of $32.16, before giving back some of those gains. BHP shed about 5% on Monday and Tuesday as investors dumped growth stocks and will surely fall further if iron-ore prices suffer larger declines. That’s an opportunity.

Improving global economic growth in 2018 should underpin iron-ore, coking-coal and oil prices, and earnings upgrades from BHP. An average price target of $25.51, based on the consensus of 17 broking firms, suggests BHP is overvalued at the current $29.33.

BHP will look a lot more interesting if it heads towards the consensus price target ($25.51), providing global growth holds up. The potential for earnings upgrades, as analysts factor in higher spot commodity prices, suggests BHP’s rally has further to run, after an inevitable pullback during this market sell-off.

Chart 2: BHP Billiton (BHP:ASX)

Source: nabtrade

 

3. Internet portals

Buying the dominant online advertising stocks, such as Seek, REA Group or Carsales.com, on market sell off has been one of my preferred strategies for years.

These stocks almost always trade at a hefty valuation premium because of their growth prospects, so it pays to buy them a little cheaper during corrections.

REA Group, owner of realestate.com.au, could struggle if local interest rates rise faster than expected, dampening property activity and advertising volumes. But REA has shown it can weather property slowdowns by exerting its pricing power.

Also, never-ending predictions of property crashes are fanciful. My base case is for no growth or modest property-price falls in houses in the main capital cities this year.

The surprise exit of Domain Holdings Australia CEO Antony Catalano is a positive for REA. Sudden management changes can create uncertainty among staff, customers and investors – or lead to operational turmoil or lethargy for a few months. Arch-rival Domain looks weakened.

An average share-price target of $76.94, based on the consensus of 13 broking firms, suggests REA is undervalued at the current $73.54. REA will look interesting below $70 and might get there in a hurry if the market sell off intensifies later this week or next. The stock was down almost 6% in the first two trading sessions this week.

Job-advertiser Seek is another for portfolio watch lists. The rise in the latest ANZ job-advertisement series and expectations of a tighter labour market are good news for Seek. But it looks a touch overvalued around $19 – the consensus share-price target is $17.24.

I’ll stick with REA Group as the pick of the big portals, on valuation grounds.

Chart 3: REA Group (REA:ASX)

Source: nabtrade

 

4. US housing cycle

Buying Australian companies exposed to the US housing cycle looks like jumping into the eye of the hurricane if the bears are right. Faster-than-expected interest-rate rises would be bad news for housing activity and suppliers of building products, such as James Hardie Industries.

As mentioned earlier, the US economy has reasonable prospects in the next 12-24 months as tax cuts kick in and business investment rises. Much-needed infrastructure spending, led by the US government, would be a positive in the medium term.

James Hardie continues to beat expectations. Its third-quarter FY18 result, recently released, was better than analysts expected, thanks to good growth in its US profit margins. The company noted the strong US economy and the prospect of further operational efficiencies.

James Hardie has fared better than most blue chips this week. The consensus price target ($19.22) suggests it is overvalued at the current $22.96. The market is bearish; as analysts upgrade forecasts, target valuations for James Hardie will rise.

Macquarie’s price target of $26.25 for James Hardie looks reasonable. If the US economy continues to strengthen in 2018, without an inflation outbreak, double-digit capital growth in James Hardie in 2018 is a fair bet.

Investors seeking mid-cap exposure to the US housing market could consider plumbing manufacturer Reliance Worldwide Corporation, a stock I have written favourably on several times for this report in the past 12 months.

Chart 4: James Hardie Industries (JHX:ASX)

Source: nabtrade


About the Author
Tony Featherstone , Switzer Group

Tony is a former managing editor of BRW, Shares, Personal Investor, Asset and CFO magazines and currently an author at Switzer Report. He specialises in small listed companies, IPOs, entrepreneurship and innovation and writes a weekly blog for The Sydney Morning Herald/The Age on small companies and entrepreneurs.