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Four quality stocks to consider buying

These high quality ASX 200 businesses offer growth and income prospects at a reasonable valuation.

It was all looking so much more promising at the beginning of the year. Between 29 August and 31 December 2018, the ASX 200 fell 14% and our Buy List was looking longer and healthier, climbing well into double figures. It was lovely to be able to add high quality businesses like Woodside, Westpac, Domain and Carsales to our purchases.

Unfortunately, the pessimism didn’t last. Despite trade wars and a long list of ever-present sources of instability, the ASX 200 has now risen more in the past four months than it fell in the four months to the end of last year. Since the recent low on 21 December, the ASX 200 is up over 21%.

Weirdly, the explanation probably lies in the fact that things are getting worse. US economic growth appears to be slowing and in Australia, where it never really took off, the economy grew by just 1.8% in the year to March, the weakest since the global financial crisis. Household spending and wages growth is especially slack and, were it not for our infrastructure boom and government spending growth in healthcare, we might already be in recession.

Optimism is therefore an unlikely justification for the market’s rise. Instead, recent and extraordinary falls in Australian 10-year bonds, which have more than halved in a year, point the way.

Up until earlier this year, central banks were talking of “normalisation”, a return to rates of around 2%. That worried investors, who have grown used to central bankers changing their nappies at the first sign of a dodgy stomach. They sniffed the wind and rapidly changed course, subtly promising lower rather than higher rates. The result is an unusual rally in shares and bonds and a Buy List back into single digits.

With local rates set to fall, income investors especially are faced with a dilemma; put your money in a term deposit on zero real interest rates or pay up for a better yield and higher risk in stocks. Those investors opting for the latter option might not find much to tempt them given our current Buys.

There is, however, an alternative. Because we set our Sell price around fair value, in environments with record low rates it makes sense to buy some stocks with a Hold recommendation. There may not be as much margin of safety as a Buy but a mildly under-priced stock with a Hold recommendation is more easily justified than either an expensive, high yield stock or a low yield term deposit.

Here then is a 4-stock mini-portfolio of Hold recommendations that we think offer reasonable yields and growth prospects. Their respective prices are closer to our Buy rather than Sell prices and therefore offer a sensible if not devastatingly attractive margin of safety.

Company

Price 1 Jul 19 ($)

Latest Recommendation

Max. Portfolio Weight (%)

Sell Above ($)

Expected FY19 Dividend Yield (%)

ALE Property

4.90

21 Feb 19 (Hold - $4.79)

6

6.50

4.3*

Sonic Healthcare

27.14

21 Feb 19 (Hold - $24.58)

5

36.00

3.1^

Virtus Health

4.50

8 Jun 19 (Hold - $4.29)

4

6.00

5.3

Wesfarmers

35.80

3 May 19 (Hold - $35.65)

8

47.00

4.3#

* 0% franked; ^20% franked; #2020 yield because of Coles demerger

ALE Property

Since joining our Buy list in 2012, ALE’s tenant ALH has invested hundreds of millions of dollars into its pubs – adding hotel rooms, Dan Murphy’s outlets and refurbishing outdated interiors. Until recently, rent reviews were limited to inflation but we expect to see rents across the portfolio rise to the high single digits soon, with management set to consider a special dividend.

Of the 79 properties under rent review, 34 have already received the full 10% uplift, with the remaining 45 being challenged by ALH. This will take a while to play out but shareholders can enjoy a yield of 4.3% in the meantime. Come 2028, we expect rents across the portfolio to increase by at least 60%, on top of any inflationary increases. With a Buy price of $4.50, ALE Property isn’t too far away from getting back on the Buy List.

Sonic Healthcare

Australia’s largest pathology company also operates in New Zealand, the UK, the US, Germany, Switzerland and Belgium. However, the US is where the excitement and biggest opportunity rests. No provider has more than a 5% market share but in Australia Sonic and Healius control 76% of the market. There’s plenty of potential acquisition targets and opportunities to centralise labs and cut costs in this huge market.

The recent result showed the strength of the business. Sonic is now the largest pathology provider in four countries and the third largest in the US, with substantial economies of scale to help maintain that dominance. On a forward price-earnings ratio of 23.7, based on consensus estimates for 2019 earnings, we’d love the opportunity to put it back on the Buy List but are happy to recommend it as a Hold.

Virtus Health

Australia’s largest IVF services provider continues to face volatile IVF cycle growth but enjoys economies of scale and excellent free cash flow. Its budget clinics are now ticking along after a rocky few years while the company’s valuable network of day hospitals adds an interesting property element.

The latest result was disappointing, but on a price-earnings ratio of 13.8 based on consensus estimates for 2019 earnings, a fully-franked dividend yield of 5.1%, this is a highly cash-generative company with a dominant position in a growing industry.

Wesfarmers

Wesfarmers is a highly diversified conglomerate with retail interests that include the Kmart, Officeworks and Bunnings chains. It also has interests in gas, chemicals and fertilisers, and industrial supplies distribution, recently launching bids for Lynas and Kidman.

Based on Rob Scott’s portfolio management so far, we’re more confident about the company’s strategy than previously. How well Wesfarmers buys will be a significant determinant of future returns but the company is now within 15% of our Buy price.

Staff members of InvestSMART may own securities mentioned in this article.

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