Over the past 6 months we have, on aggregate, shifted the Focus Portfolio to higher quality stocks, with less cyclical earnings, while reducing the portfolio beta in the context of higher uncertainty and an increased likelihood of an earnings downgrade cycle.
A sector that we have not added to is consumer staples. We remain underweight the sector, and believe there are compelling reasons for this positioning.
This sector is (considered) less risky and volatile, offering better downside protection to investors. In recent months, the sector has displayed relatively low volatility, which puts it on par with other defensive sectors such as healthcare, infrastructure, insurance and utilities.
When it comes to investing, downside protection is important, but returns are equally important. We remain underweight consumer staples as the investment case for returns does not stack up.
The rationale for remaining underweight is:
- Consumer staples valuations look too steep – the trade is overcrowded.
- Earnings growth is too low, especially at current valuations.
- We think there is downside risk to expected earnings – costs and price competition are increasing.
- Earning are typically not as defensive as expected.
- Consumer staples provide downside protection but not the future return profiles we look for.
We believe there are better defensives on the market that can provide downside protection but can also offer better over-the-cycle returns than the large consumer staples on the ASX.
Relative Valuations Near All-Time Highs
While the share price performance had been strong prior to reporting season, results were not sufficient to support this rally.
After the share price falls following reporting season, we still believe supermarkets – especially Woolworths Group (WOW), Coles Group (COL), and Endeavour Group (EDV) – are trading on premiums to the market that are unjustifiable.
Current forward PE premiums of the consumer staples sector are near all-time highs – even higher than they were during the GFC.
Growth Too Slow
In our opinion, the lack of expected growth for consumer staples makes the valuation unjustifiable.
The market expects consumer staples to grow by 4% in FY23. Even with the sector's defensive characteristics, we find it difficult to rationalise an FY23 PE multiple of 22x with such a low expected growth rate.
Further downgrades to the sector could lead to a potentially harsh reaction from the market at the current premium.
Downside Risk to Earnings
We also believe consensus earnings have downside risk. While food inflation is a tailwind for the sector, it could be offset by cost and competition headwinds in a low-margin industry.
Higher costs
Supermarkets could come under more margin pressure over the next 12 months. Operating costs could continue to push higher via wages, supply chain and rent. These costs were a downside surprise during reporting season.
We think there is a risk these costs outpace the increase in sales prices that supermarkets can achieve over 1H23. Certainly, labour costs could be a key area where supermarkets may struggle to offset as wage pressure becomes more prevalent. Labour costs were 12.9% for COL and 15.8% for WOW in FY22, and have increased over the past few years.
A small change in costs can have a considerable impact on the bottom line given net income margins for COL and WOW both sit at 2.7% for FY23E.
Premiumisation unwind
Supermarkets have benefitted from the pandemic in terms of households buying higher margin, premium products from supermarkets as other trade was closed. This seems to be now unwinding and households are now trading down to lower margin private labels. This would be negative for margins.
Competition still a risk
The supermarket industry is becoming more competitive. Aldi has been a decade-long headwind for the big 2 supermarkets, Coles (COL) and Woolworths (WOW), increasing competition and leading to downward pressure on prices. Aldi has over doubled its number of stores since 2011. We believe that Aldi can continue to take market share over the next decade and lead to more price competition.
Over the last few years, new disruptors and competitors have emerged, and we believe food delivery apps as well as overseas supermarket chains may continue to disrupt the industry. This could lead to further pricing pressure.
Underwhelms on Analyst Expectations
For the sector, we see notable EPS downgrades post earnings and operational updates to the market (due to more competition, price wars and cost issues). The persistence of downgrades over the last decade is a concern for us. We would expect a defensive sector to have fewer downgrades.
Staples Should Provide Downside Protection but There Are Other Stocks With Better Outlooks
In place of ‘traditional’ consumer staples exposures, the Focus Portfolio holds a selection of high-quality businesses with defensive earnings, superior margins, strong competitive advantages and pricing power, and more attractive long-term growth prospects.
We think these companies are valued more attractively (relative to their growth outlook) than the crowded consumer staples sector. Still, like consumer staples, these companies should also demonstrate resilient earnings through the economic cycle, providing a degree of protection against a slowdown or recession.
In summary, our key Quality Defensive picks:
- All have low market betas.
- Are much higher-margin businesses than the major consumer staples players.
- On average, trade at premium PE multiples relative to the major consumer staples companies. However, this premium is justified by their much higher average EPS growth expectations, and by their arguably stronger economic moats and more favourable industry structures.
- Offer materially better value on the whole, when considering their valuations relative to expected earnings growth by using the PEG ratio (PE ratio / EPS growth).
Therefore, given the Quality Defensives in the Focus Portfolio are expected to generate stronger earnings growth over the medium-term, we believe they are well positioned to outperform the consumer staples sector, while also retaining defensive attributes on the downside.
| Name | Ticker | Beta* | Dividend Yield | EBITDA Margin % (FY23) | 12 mth fwd PE | 12 mth fwd EV/EBITDA | EPS growth (3 yr CAGR) | Comment |
| ASX Large Consumer Staples | ||||||||
| Woolworths | WOW | 0.48 | 3.10% | 8.70% | 24.4 | 10.5 | 9.20% | While we are cautious on the sector as a whole, WOW is our preference among the group given its market share and its superior earnings growth outlook. For COL and EDV, we are more cautious on margins from higher CODB. MTS is expected to deliver only benign growth over the coming years as it will face the headwinds of a slowing housing market (impacting its hardware businesses like Mitre 10 and Trade Tools (40% of EBIT). |
| Coles | COL | 0.36 | 4.00% | 8.80% | 20.3 | 8.7 | 5.60% | |
| Endeavour | EDV | 0.36 | 3.20% | 12.80% | 22.7 | 11.2 | 7.80% | |
| Metcash | MTS | 0.45 | 5.40% | 4.00% | 13.3 | 7.7 | 1.40% | |
| Average | 0.41 | 3.90% | 8.60% | 20.2 | 9.5 | 6.00% | ||
| Wilsons Focus Portfolio Quality Defensives | ||||||||
| Infrastructure-Like | ||||||||
| Telstra | TLS | 0.51 | 4.60% | 34.30% | 21.9 | 7.3 | 11.60% | Infrastructure-like businesses deserve to trade at a premium PE / PEG multiple given the stability of their cash flows, which reflects a contracted or defensive demand profile, and industry structures that have high barriers to entry (e.g. TLC is a monopoly, TLS market leader with ~50% mobile share). They are also typically highly cash generative, high-margin businesses with a degree of inflation protection. |
| Lottery Corp | TLC | 0.17 | 3.30% | 20.00% | 26.6 | 15.7 | 3.60% | |
| Cleanaway | CWY | 0.88 | 2.00% | 21.00% | 31.3 | 11 | 16.80% | |
| Average | 0.52 | 3.30% | 25.10% | 26.6 | 11.3 | 10.70% | ||
| Healthcare | ||||||||
| CSL | CSL | 0.63 | 1.40% | 33.80% | 31.8 | 19.1 | 16.40% | We believe there is upside risk to the EPS forecasts for both of these companies over the medium-tern (particularly RMD given the Philips recall). Plus, both CSL and RMD deserve to trade at premium PE / PEG multiples given their dominant market positions, their high degree of pricing power, and due to the highly defensive demand profile for their products. |
| ResMed | RMD | 0.62 | 0.90% | 34.20% | 31.8 | 22.6 | 9.60% | |
| Average | 0.62 | 1.10% | 34.00% | 31.8 | 20.8 | 13.00% | ||
| Insurance | ||||||||
| IAG | IAG | 0.39 | 5.90% | NA | 13.4 | 9 | 67.10% | EPS is cycling a low base, which was impacted by Covid-19 and elevated natural peril costs. The insurance cycle is agnostic to broader economic trends generally and we expect strong EPS growth in the coming years to be driven by higher written premiums which should outpace claims inflation, notwithstanding the risk of adverse weather events. Investment returns are also expected to benefit from higher interest rates. |
*180 day beta. 90 day for TLC given its limited trading history.
Source: Refinitiv, Wilsons.
Wilsons Focus Portfolio – Summary of Quality Defensives
CSL (CSL) (8.5% weight)
- CSL is the dominant and lowest cost player within the global blood plasma industry. The business develops a range of biotherapies and vaccines that treat people with serious diseases and chronic medical conditions.
- The market for Immunoglobulin (IG) products is supply constrained, while underlying demand is highly defensive given IG is used to treat patients with a range of serious immunologic and neurologic diseases.
- CSL was impacted by lower plasma collections during the pandemic, however, collection activity now exceeds pre-pandemic levels and the business has invested significantly into its collection infrastructure which should support higher IG revenues over the medium-term.
ResMed (RMD) (3.5% weight)
- ResMed is the dominant player within the global continuous positive air pressure (CPAP) device market. Wilsons’ analysts estimate RMD will achieve a market share of ~69% and ~56% in the US and in the rest of the world, respectively, in FY22.
- RMD is an inherently defensive business because the treatment of diagnosed breathing conditions is essential. Therapy is also reimbursed by public and private payers in most major markets, making it affordable for most patients. We also view the customer base as sticky.
- RMD’s major competitor, Philips, first announced a recall of its CPAP devices in July 2021, which has presented a significant opportunity for RMD to take material and lasting market share.
Cleanaway Waste Management (CWY) (3.0% weight)
- CWY is a defensive, infrastructure-like business with a market leading position in the high barrier-to-entry waste management industry.
- Revenue is predominately underpinned by long-term contracts across different waste categories with a geographically diverse customer base including municipal councils, hospitals, resources and industrial clients. Multi-year contracts provide predictable and recurring revenue streams.
- CWY is largely insulated from inflationary pressures given its cost pass-through mechanisms. Rise and fall clauses in contracts capture relevant labour fuel and general CPI changes.
The Lottery Corporation (TLC) (3.0% weight)
- The Lottery Corporation is an Australian lottery company which operates various brands including Powerball, Oz Lotto, TattsLotto, Scratch-Its, and Keno.
- Lotteries is a defensive, infrastructure-like business with long-dated, exclusive licenses. Despite being a discretionary purchase, lotteries exhibit annuity-like characteristics, with the key drivers of growth being stable factors such as population growth. Demand for lotteries is typically relatively sticky, irrespective of the macro backdrop.
- The business is highly cash generative and capital light, providing management with funds that can be reinvested into the business or returned to shareholders through buybacks or dividends.
Insurance Australia Group (IAG) (3% weight)
- IAG is the largest general insurer in Australia. The company owns brands such as NRMA Insurance, CGU Insurance, SGIO, SGIC and
Swan Insurance. - Insurance companies such as IAG are exposed to their own industry cycle, which impacts claim costs, written premiums and hence insurer profitability. However, industry conditions are largely agnostic to the broader economic backdrop.
- Insurance is usually a non-discretionary purchase for businesses and households, and dominant industry players like IAG have significant pricing power. This backdrop helps underpin relatively resilient earnings amidst economic slowdowns or downturns.
- We are positive towards IAG at this point of the insurance cycle. Notwithstanding the risk of further adverse weather events, we expect industry premium growth to outpace claims inflation over the medium-term, while investment returns are poised to benefit from higher interest rates.
Telstra (TLS) (3% weight)
- Telstra is a dominant telco with the best network in Australia and ~50% mobile market share.
- Given the largely non-discretionary nature of digital connectivity, telcos such as TLS enjoy fairly inelastic user demand for mobile and fixed plans through the economic cycle. Meanwhile, Telstra’s owned infrastructure provides annuity-like cash flows that are even more predictable.
- The domestic competitive setting has improved with industry pricing becoming more rational, supporting improved margins for TLS.
Quality Defensives Not Held in the Focus Portfolio
Looking beyond the Focus Portfolio, we have conducted both quantitative and qualitative screens of the ASX to uncover other companies with favourable ‘Quality Defensive’ characteristics.
We screened out:
- Companies outside the ASX 100 (except for companies within Wilsons’ research coverage).
- Shares with betas above 0.75.
- Lower quality companies with a Return on Equity lower than 10%.
- By qualitative factors, to exclude highly cyclical businesses (e.g. mining companies), businesses with low quality earnings and companies facing major structural headwinds.
The highlights of our screen were APA Group (APA), Brambles (BXB), Computershare (CPU) and Ridley Corporation (RIC).
Suncorp (SUN)
- Suncorp is an Australia and New Zealand based general insurer. The company owns brands like AAMI, GIO, Bingle, APIA, Shannons.
- The business recently spun-off its banking division, Suncorp Bank, to ANZ for a purchase price of $4.9 billion. Completion of the deal is expected in the second half of calendar year 2023.
- The majority of the net proceeds from the transaction (estimated at $4.1 billion) will be returned to shareholders via a combination of pro-rata capital return, fully franked special dividends and share buybacks.
- We view the simplification of the Suncorp business to focus on its core wheelhouse, and the associated capital returns, favorably.
- Like IAG, we think Suncorp is well placed at this point of the cycle, as we expect premium growth to outpace claims inflation and investment returns are poised to improve given higher interest rates.
APA Group (APA)
- Major energy infrastructure business that owns 7,500km of gas transmission pipelines across Australia, as well as gas storage facilities, power stations and wind farms.
- Highly defensive earnings profile is underpinned by ~85% long-term take-or-pay contracts or regulated earnings.
- The majority of revenue is indexed to CPI, providing a hedge against elevated inflation.
- The transition away from fossil fuels in the Australian energy mix has created uncertainty for APA’s core pipeline business over the long-term.
Brambles (BXB)
- Global leader in the supply-chain logistics space.
- Principally provides reusable pallets and containers to businesses.
- The majority of customers are in consumer staples sectors. ~80% of revenue is derived from the fast-moving consumer goods, fresh produce, beverage and packaging sectors.
- Relatively defensive earnings are supported by this customer mix and BXB’s high degree of pricing power.
Computershare (CPU)
- CPU is a leading share transfer agent and investor service provider.
- The underlying business is relatively stable, which has driven fairly consistent earnings over time through varied market cycles including the GFC.
- Margin income earned on cash balances is positively leveraged to rising short-term interest rates, helping to offset inflationary pressures.
Small Cap Idea
Ridley Corporation (RIC)
- Wilsons Research: Overweight Rated
- Leading Australian agri-business that produces quality animal nutrition solutions across both bulk stock feeds and packaged feeds and ingredients for a wide range of animal species.
- Being a key player in the domestic food supply chain supports relatively consistent customer demand. RIC’s geographical spread, multi-species offering and customer mix also helps to provide earnings resilience through weather, disease and market cycles.
- The need for both increased and improved food production (from reliable and stable jurisdictions like Australia) to meet the needs of a growing global population is expected to drive secular demand growth over the longer-term.
- Valuation upside implied by Wilsons’ target price of $2.21 per share, driven by earnings upgrades and PER multiple expansion.
| Name | Ticker | Beta* | Dividend Yield | EBITDA Margin % (FY23) | ROE | 12 mth fwd EV/EBITDA | 12 mth fwd PE | EPS growth (3 yr CAGR) |
| APA Group | APA | 0.4 | 5.60% | 64.80% | 16.10% | 12.3 | 34.2 | 16.90% |
| Brambles Ltd | BXB | 0.55 | 3.70% | 32.70% | 23.50% | 6.7 | 16.3 | 9.70% |
| COMPUTERSHARE LIMITED | CPU | 0.62 | 3.50% | 32.90% | 24.80% | 10.4 | 16.6 | 27.30% |
| Suncorp Group Ltd | SUN | 0.67 | 7.20% | 15.60% | 9.90% | 19.67 | 10.6 | 25.20% |
| Ridley Corporation Ltd | RIC | 0.51 | 4.20% | 8.10% | 13.00% | 7.6 | 16.1 | 11.20% |
| Average | 0.55 | 4.80% | 31.10% | 17% | 11.3 | 18.7 | 18.10% |
Source: Refinitiv, Wilsons
Written by
Rob Crookston, Equity Strategist
Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.
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