The Australian market is likely to be increasingly intolerant of overvalued companies with weak fundamentals, according to Fidelity’s James Abela, so investors should be focused on quality companies with healthy cashflows and strong balance sheets.
Investors had plenty of concerns on the global macroeconomic stage, including supply-side inflation and the risk of recession or stagflation, especially in Europe. On the home front, investors were facing a cooling Australian housing market and a stockmarket that was becoming “acutely focused” on valuations.
Abela, manager of the $1bn Fidelity Future Leaders fund, said: “An investor’s focus should be shifting towards free cashflows, profitability sustainability, earnings duration and visibility, the market structures companies operate in, the ability to maintain operating margins in the face of higher costs – higher labour wages, commodity prices, energy prices, rising capital and debt costs – and supply chain issues.
“Equity markets have been trending down in the last few months after pricing in a sharp economic recovery over the last two years. Valuations rightfully have taken centre stage after asset prices in Australian housing, equities, bonds and cash all reached territories that were deemed unsustainable. In times like these it is important to stay focused on the long term. Cash flows will continue to drive earnings, and earnings will drive share prices.”
One of Abela’s main concerns was the “significant valuation distortions” that were created by ultra-low interest rates, which brought the cost of capital down to very low levels and led to record loss-making companies in the Australian market.
Now the market was becoming more focused on valuations, the manager expected to see increased pressure on companies that look expensive. Indeed, this had also started to happen in some parts of the market that were performing strongly until this year, such as e-commerce, COVID-19 winners, home meal delivery, online gaming, early stage software and concept stocks, according to Abela.
He also said investors should be cautious when it comes to companies with low quality earnings, weak market structures, competitive market places, high financial leverage and poor sustainability.
“For those quality companies that generate strong cash generation, are in strong market positions to manage through inflation and costs, this current market dislocation is likely to present a buying opportunity,” he added.
“However, exuberant valuations of over 100 times price to earnings ratios are unlikely to return in the short term. Growth at a reasonable price will be the mainstay of a portfolio focused on quality rather than growth at any price.”
Fidelity Future Leaders’ portfolio was currently balanced with a blend of ‘quality at reasonable price’ companies (healthcare and technology), defensives (real estate, airports, petrol stations), industrials (chemicals, engineering services) and resources (lithium, nickel, copper, gold).
