Five deep-value stocks beckon

First, the bear case for Australian equities in 2022. As our economy roars back to life, consumer and business demand booms. Soaring jobs growth translates into higher wages as competition for labour intensifies. Higher wages eat into profit margins.

On the supply side, Covid-induced production bottlenecks boost input prices. You know it’s bad when alcohol companies report shortages of popular beer brands this Christmas due to pallet shortages. Or when cafes (including my local) tell customers to brace for price rises next year thanks to “massive” food costs.

In turn, rising wages and raw-material prices force companies to lift prices. That means higher inflation and a Reserve Bank under pressure to lift interest rates to cool economic growth. If the RBA moves faster than the market expects, the equity bull market ends abruptly.

The bull case says higher inflation won’t last. It’s a transitory response to the effect of Covid. As production labour bottlenecks are resolved, costs stabilize. Companies will have the best of both worlds: a booming economy and record-low interest rates. Dividend yields remain highly attractive compared to cash and bonds, attracting more capital into equities.

At the same time, there are mountains of capital to be put to work. Many consumers are cashed-up after house-price rises and the share market rally and are being denied their usual spending behaviour (overseas holidays etc.) during Covid. Corporate balance sheets are generally in good shape and debt is cheap. This ‘weight of money’ will underpin further share market gains.

So far, the market is clearly in the bull camp on inflation. US stock made new highs last week despite the highest inflation data in 40 years. A US consumer price index (CPI) print of 6.8% in November means 30-year US treasuries are paying a negative yield of about 5%!

My view on inflation? The bull and bear views are both partly right. I expect a booming Australian economy next year (6%-plus growth) and rising inflation. The big question is how long the RBA lets the party continue. An economy growing at 6% next year and an emergency cash-rate setting of 0.1% is madness. The risk is interest rates rising much faster than expected, hurting asset prices and those heavily indebted.

The market expects higher inflation to spark the first rates hike around the middle of 2022, with two more increases that year. I’m not as hawkish on rates: I believe the RBA will keep rates on hold amid ongoing Covid uncertainty. If I’m right, 2022 should be an okay year for Australian equities, though the big gains are well behind us.

By this time next year (or sooner), we’ll be at the top of the equity-market cycle. The market will look to several rate increases in 2023. House and equity prices will retreat. Whatever happens, we are in the final stages of this bull market in Australian equities.

That doesn’t mean stocks can’t rise or that we won’t have the traditional Christmas/New Year market rally. There are always winners and losers in any share market index. But it does mean investors should avoid chasing expensive growth stocks higher. Rising interest rates in the second half of 2022 (or more likely, the first half of 2023) work against growth stocks.

This thinking informs my stock ideas below. I’ve avoided high-priced growth stocks and focused on companies that offer value. The problem with deep-value investing, of course, is that it takes time to realise value. If I were investing only for 2022, I’d focus on momentum-based growth stocks and popular ideas, but that is a dumb way to invest.

I want stocks that offer a reasonable margin of safety at their current price. Here are five that make the grade.

 

1. Qantas Airways (QAN)

The airline has had a terrible few years thanks to Covid and its effect on international and domestic travel. Qantas’s three-year annualised total return, including dividends, is minus 2.1%. The stock has badly underperformed the market even though it’s an obvious ‘reopening play’.

I’ve been wrong on Qantas over the past few years but am not about to give up now. Qantas is emerging from the pandemic in excellent shape: costs have been trimmed, the balance sheet is strong, and it has a weakened competitor in Virgin Australia Holdings.

Moreover, travel demand will soar next year as borders reopen and consumers become more confident to go overseas. Longer-term, Qantas’s frequent-flier program has untapped value. I’ve long thought this business is worth more than the market realises. Perhaps it’s time for Qantas to revisit the idea of a spin-off of its frequent-flyer operation and unlock value.

A consensus share-price target of about $6 for Qantas (it’s $5.01 now) looks fair.

 

Chart 1: Qantas

Source: ASX

 

2. QBE Insurance (QBE)

Could 2022 be the year of the insurance-sector recovery? Several large-cap insurance stocks have disappointed for more than a decade amid falling interest rates. Low bond yields hurt insurance companies that need to hold a lot of safe debt to back their policies.

As inflation and bond yields rise in 2022, the headwind of interest rates could start to become a tailwind for insurers. But there’s more to the insurance story than rates: for all its faults, insurance is a highly resilient product. Covid or no Covid, we still need home, content and life insurance.

A booming economy lifts insurance demand as more homes and cars are bought, businesses are formed and people maintain health insurance (or buy a policy). Insurance companies should benefit from reasonable premium growth in 2022.

Lower-than-expected claims (e.g., fewer accident claims because cars are used less as people work more from home) could also surprise the market. Either way, it feels like 2022 could be a turning point for the insurance sector, although any recovery will take time.

If I’m right, there’s no better way to play insurance on ASX than QBE Insurance. QBE’s annualised 10-year total return is an appalling 2.5%, Morningstar data shows. The consensus price target of $14.50 for QBE compares to the current $11.96.

 

Chart 2: QBE Insurance

Source: ASX

 

3. Aurizon Holdings (AZJ)

Who would want to own companies heavily exposed to coal, such is the growing reallocation of capital away from fossil-fuel industries? Rail-operator Aurizon still makes most of its money transporting coal in Queensland and New South Wales.

Yes, coal-logistic companies have plenty of long-term challenges, particularly those that do not transition into other forms of freight (Aurizon is quickly growing its bulk-freight business). But every stock has its price and negative market sentiment can drive prices too low.

That is the case with Aurizon. A recovering global economy next year should underpin coal demand and possibly higher coal prices. Aurizon’s coal business might not be popular with Environmental, Social and Governance (ESG) investors, but rail is still vital for coal.

In October, Aurizon announced it will acquire One Rail Australia (ORA) for $2.35 billion as part of its diversification into bulk-rail haulage and freight. Aurizon committed to selling or demerging ORA’s coal-haulage business, amid competition concerns. The acquisition looks like a smart long-term move for Aurizon as it beefs up its bulk-freight business.

A consensus share price target of $3.71 for Aurizon (it’s $3.39 now) is too bearish. Morningstar’s fair value for Aurizon is $4.70. I’m not quite as bullish as Morningstar but see decent upside for Aurizon over the next few years.

 

Chart 3: Aurizon

Source: ASX

 

4. Vicinity Centres (VCX)

Large-cap retail Australian Real Estate Investment Trusts (A-REITs) have lost favour in recent years. Vicinity Centres’ five-year annualised return is minus 5.6%. Scentre Group’s return over this year is minus 2.8%. True believers in retail property have been burned.

Retail A-REITs were under pressure well before Covid. Concerns about the shift towards e-commerce and less demand for bricks-and-mortar outlets spooked investors. Then, Covid crushed shopping-centre owners with outlets shuttered due to lockdown restrictions. Now, there are fears of higher vacancies and lower rental growth in the Covid aftermath.

Beneath the short-term gloom are A-REITs, such as Vicinity Centres, with fabulous property assets – the ‘fortress malls’ that are becoming like mini-CBDs in some instances (Vicinity’s half-owned Chadstone Shopping Centre in Melbourne is an example).

Retail A-REITs should have two tailwinds in 2022. First, a booming economy will drive higher shopping-centre foot traffic and tenancy levels. Second, Covid will provide property-development opportunities at fortress malls as they add more office and/or hotel space and continue to reinvent themselves as owners of multi-purpose, service-driven property, and suburban “enterprises spaces”.

Vicinity or Scentre are worthy ideas at their current price, provided investors have a long-term perspective. I believe the market is too bearish on both A-REITs (each is trading slightly above its consensus price target). It’s hard to separate them but I’ll favour Vicinity on the strength of its fortress malls and the potential of new property developments to drive earnings.

 

Chart 4: Vicinity Centres 

Source: ASX

 

5. Challenger (CGF)

Few stocks are as frustrating as Challenger as a retirement-investments provider. My bullish view on Challenger last year was too early: its one-year total return was 7.1%. Over five years, Challenger’s total annualised return is a dismal minus 7%.

Four factors underpinned my favourable view on Challenger. First, the business has an excellent position in a growth market: retirees and demand for annuity products. Second, the Federal Government’s Retirement Income Review should benefit Challenger by leading to wider adoption of annuities (and stable income streams for retirees).

Third, Challenger should do better in a rising rate environment (it has to hold lower-risk assets, which results in its portfolio being skewed towards fixed-interest investment). Fourth, Challenger looks undervalued at the current price.

A business that dominates annuity sales in Australia – in a retirement market that has decades of growth ahead – shouldn’t be delivering negative shareholder returns over a long period. As I wrote last week in this column, if Challenger can’t lift its performance, a large competitor will surely see untapped value in the company’s annuity platform.

Recent instability in Challenger’s senior management ranks is concerning but might also be a wake-up call to work on the company’s organisation culture.

 

Chart 5: Challenger

Source: ASX

 

 

Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at 16 December 2021. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.