3 undervalued stocks to consider

Financial Journalist
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Finding value in Australian equities is hard work after this year’s rally. The ASX 200 index is pricey after delivering a 21% total return so far in 2019.

On Morningstar’s numbers, the Australian share market is 20% overvalued on a capitalisation-weighted basis. I also think the market has run too far, and in the past two months have suggested readers lower equities exposure and increase cash and fixed interest in portfolios.

Bull markets do not last forever. With the US bull market now the longest in history, investors should make portfolios more defensive, to preserve capital during the next financial shock. And have cash available to buy equities at bargain prices when the downturn arrives.

Several European countries this month joined Germany and Japan in the negative interest yield club. Effectively, investors are paying these governments to hold their money for years, via 10-year bonds with negative yields. Don’t rule out Australia joining them in the next few years.

The global economy is becoming gloomier, judging by the recent downturn in the Global Purchasing Managers Index (PMI), a barometer of manufacturing activity. And the United States is expected to cut interest rates as US/China trade tensions affect economic activity.

In Australia, the upcoming earnings season will probably show lacklustre profit growth in industrial companies, banks and other sectors exposed to property. Resources should do well given gains in spot commodity prices and interest-rate-sensitive stocks should go okay because of the fall in rates. But the market has already priced in that scenario.

Ultimately, share prices are a function of earnings and it is hard to see better-than-expected earnings growth (outside of resources) in a slowing Australian economy. The sustainability of the equity rally depends on higher earnings growth justifying higher valuation multiples.

Clearly, this is no time to chase high-flying stocks or load up on Australian equities. Negative bond yields overseas signal economic distress and the global economy is slowing. Yet commodity and equity prices are rallying. It could end badly.

In that context, investors must be even more stock-selective to pinpoint value. I’ve nominated three undervalued stocks: Western Areas, Nufarm and Domino’s Pizza Enterprises. Each is a contrarian idea that suits experienced investors comfortable with risk.

Other stocks I considered were: Reliance Worldwide Corporation, Link Administration Holdings, laboratory group ALS, CSR, Worleyparsons, Woodside Petroleum and Charter Hall Group in the Australian Real Estate Investment Trust (A-REIT) sector.

1. Western Areas (WSA)

Nickel’s sharp price rally this month had the bulls proclaiming the base metal’s long overdue rally – based on its exposure to the electric-vehicle (EV) boom – had arrived.

I am not so sure. Reports suggested technical buying, some large Chinese orders and reiterations from Indonesian officials about looming ore export bans, drove up the price. Also, there was some catch-up given base metals had lagged the rally in the bulks: iron-ore and coal.

As this column was written, the nickel price looked overbought and poised for a pullback. But the medium-term outlook for nickel is improving as the metal is increasingly used in second-generation lithium-ion batteries for EVs.

Underinvestment in new nickel production this decade and nickel stockpiles at a seven-year low should coincide with rising demand in the next few years as more nickel is used in batteries. That should drive the nickel price higher and with it nickel producer earnings and valuations.

One of Australia’s larger nickel producers, Western Areas, looks well placed. Its flagship asset is the fully owned Forrestania Nickel Project, 500 kilometres east of Perth.  Its operating mines, Flying Fox and Spotted Quoll, produced just over 23,000 tonnes of nickel ore in FY19.

Western Areas this month announced an offtake sale-and-purchase agreement with Japan’s Sumitomo Metal Mining Co – and expects to achieve other agreements at favourable terms as offshore demand for nickel rises, amid growth in EVs.

Western Areas’ share price had a small jump on the news but the 12-month total return is negative 26%. Over five years, Western Areas has an annualised negative 13% return, in what has been a tough time for nickel producers given the base metal’s price slide.

I suspect the market is underestimating nickel’s rapid gains in market share in EV batteries – a potential boom market if ever there was one. For now, the focus is on Chinese demand for stainless steel, which accounts for the bulk of nickel use. On that score, nickel could remain subdued this year given China’s easing economy.

Any price weakness could be an opportunity for contrarians who are comfortable with small-cap mining stocks to add Western Areas to their portfolio. If you believe in nickel’s long-term prospects in EV batteries, Western Areas is worth considering.

From a charting perspective, Western Areas has held price support around $2 a few times since 2016, forming a solid base to launch its next uptrend.

Chart 1: Western Areas

Source: ASX

2. Nufarm (NUF)

I covered the crop-protection company for the Switzer Report in June 2019 when it was at $3.76. Nufarm has rallied to $4.71 since that report and has further to go.

To recap, Nufarm was belted this year after the company updated the market on the implication of three jury verdicts in United States courts against chemicals giant Monsanto, which produces controversial glyphosate-based products.

Nufarm said corporate risks relating to glyphosate have increased and as a supplier of such herbicides it was exposed to potential litigation risks after the US court cases.

Compounding Nufarm’s problems was the Australian drought and its effect on crop-protection projects and seeds. Supply interruption at Nufarm’s European operations, wet conditions and a late planting season in the US, and a balance sheet that has high debt added to the “perfect storm” of risks facing the company.

Even after recent gains, Nufarm’s one-year total return is minus 33%. The price fell from a 52-week high of $7.69 to as low as $3.60 as the market fretted about the company’s  cash flow and the potential for another profit downgrade and dilutive equity capital raising.

As I wrote in June, there is latent upside to Nufarm when weather conditions normalise and the company has better control of its European supply chain.

Also, negative sentiment towards Nufarm as a result of Monsanto’s issues looks overdone, given the Australian company is a supplier rather than a manufacturer of glyphosate and has said it believes glyphosate-based herbicides are safe when used in accordance with the label.

At $4.71, Nufarm is on a forward PE of about 10 times FY20 earnings, on consensus analysis. The stock still looks undervalued, but gains might be slower from here.

Chart 2: Nufarm

Source: ASX

3. Domino’s Pizza Enterprises (DMP)

I nominated the pizza giant as a contrarian idea for this report in May 2019 at $38.66. The stock  had a brief rally in late June but is back to $38.15.

Domino’s has a long list of challenges: the fallout from its wages-underpayment problem; a class action that alleges Domino’s misled franchisees with some wages-payment advice; and rising competition from online food-ordering platforms such as Uber Eats, to name a few.

Domino’s deserved to halve from its share-price peak in late 2016. The stock was badly overvalued at the time and there was too much hype about its international growth prospects. The market also underestimated the uptake on food-ordering platforms and delivery services.

But every stock has its price. At $38.15, Domino’s is on a forecast PE of about 19 times FY20 earnings. The stock traded on a PE at or well above 25 times for the past six financial years. A PE de-rating was warranted, but it has gone too far given Domino’s medium-term outlook.

Beneath all the gloom, Domino’s remains a major player in digitally ordered food deliveries, a result of its massive investment in ordering and delivery technology. Domino’s control of food production and quality are advantages over ordering platforms that pick up food from restaurants and are under growing attack about food quality and driver conditions.

Domino’s has upside in three areas. The first is pricing power: my hunch is Domino’s could lift the price of its pizzas – some of which are half the price of competitors – without significant consumer pushback. The value in Domino’s pizza for price-conscious consumers is compelling.

The second potential upside is expanding the product range. Adding items such as fried chicken, chips, shakes and even burgers to its menus (without slowing cooking times) could help Domino’s compete with online food-ordering services that deliver a wider range of items.

The third upside is store growth here and overseas. Domino’s still has plenty of scope to open stores in Australia and slowly increase same-store sales growth. The likelihood is Domino’s having a smaller share of a larger fast-food market over time.

An average share-price target of $51, based on the consensus of 11 broking firms, suggests Domino’s is materially undervalued at the current price. I’m not as bullish as the consensus, but see emerging value in Domino’s that could take time to be unlocked.

From a charting perspective, Domino’s needs to hold above $38-39, a point of previous price support.

Chart 3: Domino’s

Source: ASX  

Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 24 July 2019.

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