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The Market
The rotation away from overvalued large stocks
Financial conditions create environments in which different stocks with different styles of returns perform better than others. For instance, in a rising-rate environment, smaller companies and companies with more debt often underperform.
Relative economic conditions and differences in expectations between countries can also create global capital flows that impact the largest stocks in a domestic market.
Domestic conditions and international flows have impacted the ASX in the past nine months, and often, only after these conditions unwind can we have a clearer view of their impact.
For the past nine months global flows into Australia from China have contributed to the rising share prices of Australian non-mining large capitalisation companies, as global managers avoided a weakening Chinese economy. Domestically the impact of rising rates concerned investors looking to place funds in smaller companies.
Now, four critical features of the global economy and local market conditions have contributed to the beginning of a rotation away from the forces at play. These changes are.
- The promise of Chinese stimulus has seen an improved short-term outlook for Chinese demand and a powerful rebound in the Chinese share market (up 22% in 8 days)
- Rapidly falling global inflation. Lower inflation and the understanding that moderate interest rate levels can control inflation is almost a Goldilocks scenario for equities
- Decision by the Federal Reserve to reduce interest rates on Sept 18th.
- Existing ASX conditions in which historically over-inflated prices for large capitalisation and bank stocks and moderately high prices for growth stocks
This has created four short-term effects that have been critical to the ASX in recent weeks. Each of the effects involves demand rotating away from recent strong performers and the most expensive stocks in favour of other sectors in the market.
- Rotation towards resources stocks
- Rotation towards value stocks, excluding banks
- Rotation away from expensive bank stocks and the 20 largest stocks
- Rotation towards small-cap stocks
For First Samuel clients, each move has been beneficial to both absolute and relative returns. For the market, the degree to which this is a pure “rotation” is exemplified by the relatively benign overall movements on the surface, considering the magnitude of moves underneath.
A series of simple charts show the magnitude of the market impacts.
The market movements for various sectors are shown for the following periods.
- FY24, the financial year ended June 30th 2024
- The period from the end of June 2024 to the Federal Reserve rate cut decision on September 18th and;
- The period since the Federal Reserve decision, including the announcement of Chinese stimulus on the 22nd of September
- The overall financial year to date (FYTD)
Movements by sector – FY24
Source: First Samuel. The top 20 Stocks is XTLAI. Non-top 20 is the implied return of remaining stocks in ASX300. Big 4 Banks is a simple average of returns, including dividends for CBA, ANZ, NAB and WBC. Resources refers to XMKAI (ASX300 Materials Inc. divs)
The scale of the global impacts is evident in the FY24 returns by sector. The Big Four banks dramatically outperformed the rest of the market. The difference between the Top 20 stocks (+14.9 per cent) and the remainder of the ASX300 was vast (non-top 20 return of +7.1 per cent).
The underperformance of small caps was significant, 2.6 percent less than that of ASX300, especially considering the underperformance of previous years.
Movements by sector – June 30th to Fed Reserve decision and Chinese Stimulus
Source: First Samuel. Top 20 Stocks is XTLAI. Non-top 20 is the implied return of remaining stocks in ASX300. Big 4 Banks is a simple average of returns, including dividends for CBA, ANZ, NAB and WBC. Resources refers to XMKAI (ASX300 Materials Inc. divs)
The trends of FY24 continued in part into FY25, especially the market preference for Banks over Resources. The underperformance of Small Caps accelerated as the impact of higher interest rates continued to constrain the domestic and global economy.
This changes on September 18th with a ferocious rotation.
Movements by sector – Since rotation began on September 18th
Source: First Samuel. Top 20 Stocks is XTLAI. Non-top 20 is the implied return of remaining stocks in ASX300. Big 4 Banks is a simple average of returns, including dividends for CBA, ANZ, NAB and WBC. Resources refers to XMKAI (ASX300 Materials inc. divs)
The rotation has so far impacted the largest extremes of underperformance without affecting the market overall, ASX300 +0.9 per cent. In just over a fortnight, the return gap between banks and resources has been more than 17 per cent. First Samuel clients have benefited from our very limited holdings in the Big 4 Banks and our positions in Copper, Gold, and a range of other Resource positions.
Despite the rotation there is a large amount of unwind from FY24 which is still possible. The FY25 YTD results below show that despite the rotation FY25 has so far only marginally recaptured some of the lost ground in Resources versus Banks, some strong progress on the gap between the Top 20 and the remainder of the ASX300, but none of the underperformance of small caps since June 2023.
Movements by sector – Financial year-to-date
Can the rotation continue
While the uncertainty of a continued rotation is clear, several conditions suggest an extended period of rebalancing is likely.
In the medium term, the success of the rotation towards Materials and away from the remaining parts of the market is likely dependent upon the success of the Chinese authoritarian regime in stimulating a structurally constrained economy and its stultified underlying outlook for household demand. We have concerns about the medium-term success of this venture.
We do not believe that the simple model of Chinese growth driven purely by infrastructure can be continued indefinitely. However, we do see the underlying level of growth for a basket of materials, including copper, lithium, and some metals, remaining strong. We are unconvinced of the demand for iron ore at elevated levels.
Rotation certainly has further to go if we consider the valuation mean reversion required in the banking sector to see it trading at historical levels. Look out for part of the upcoming CIO presentations through October and November that touch on this topic.
We have additional confidence in the part of the rotation that relates to the future performance of smaller companies versus larger ones for three core reasons. The first is the relative value of current smaller companies’ share prices, the second is the outlook for ongoing reductions in domestic and global interest rates over the next 2 years, and the third is the underrepresentation of ownership of these stocks by the largest of Australians rapidly consolidating Industry super funds.
On balance, we are excited to see this rotation begin and look forward to further strong returns.
Paragon Care (PGC) – Results presentation and important ACCC decision this week
First Samuel View: Positive
Market reaction since result update: +13% (30th August)
Paragon Care has been in a significant position in client accounts over the past decade.
Following a period in which we right-sized the position, we have been supportive of the company through a set of acquisitions and a significant merger with the listed Quantum Health Group Limited (ASX:QTM) in February 2022.
Paragon Care share price over past 5 years
Source: asx.com.au
We enjoyed the progress Paragon Care made under the leadership of former CEO Mark Hooper.
However, the stock failed to gain much traction with the market, despite operating in the structurally advantaged healthcare sector, which has traditionally been a highly sought-after market sector. In hindsight, the company lacked a clear vision for its role in the complicated landscape of healthcare wholesaling.
The lack of clarity has been significantly reduced since the March 2024 merger (reverse takeover) with CH2 (Clifford Hallam Healthcare), and the market is gaining comfort in the leadership and direction of the new combined vehicle. We have previously written about the strength of the CH2 business and its role in distribution amongst the independent chemist networks.
On August 30th, the company provided its obligatory market update despite it relating to only a small period of joint operations. The numbers were broadly in line with expectations set during the merger. Significant progress has been made on integrating the three main businesses (Quantum, Paragon Care, and CH2) and the many smaller businesses that entailed the original Paragon Care.
The Paragon CH2 merger was not the biggest in the sector, the Sigma Healthcare combination with Chemist Warehouse will see the behemoth retailer become a listed company (ASX:SIG) subject to ACCC approval.
The Sigma Chemist Warehouse deal is likely to be positive for the Paragon CH2 combination. Until this week, uncertainty remained regarding the ACCC’s decision on the merger (due late October) and, hence, the scale of possible benefits to the new Paragon CH2 offering.
As a reminder, one of the issues the ACCC faces with the Sigma Chemist Warehouse merger is that unlike Paragon CH2, the other giant wholesale competitors all own or are aligned with retail brands. Sigma owns Amcal and intends to merge with Chemist Warehouse. API owns Priceline, and Symbion owns Terry White Chemmart. The apparent problem for Amcal Chemists is that its biggest and strongest competitor will own the combined company (Sigma / Chemist Warehouse).
This week the ACCC announced they would be seeking “undertakings” regarding the deal, likely reducing the probability that the ACCC will simply block the Sigma Chemist Warehouse deal. The undertakings that are likely to be finally accepted would allow or even promote the movement of Amcal chemists and others to another likely independent wholesaler away from Sigma.
Considering Paragon CH2 is the only independent distributor, it is well placed to be the wholesaler for a significant number of “non-aligned” pharmacies regardless of where they fall in the current distribution of chemists.
What now for the position – First Samuel view
With the stock rallying to levels not seen for several years, we have been conscious of taking some returns off the table. However, the prize that remains for the business is still substantial.
Over the past decade, it was clear that a merger with Sigma Healthcare would have created significant value, first as an analyst in the sector and second as the manager of a large position in Paragon Care. Mark Hooper, the former CEO of Paragon Care, was previously the CEO of Sigma Healthcare.
Merging with a scale player in wholesale distribution, such as Sigma, made sense; hence, the merger with CH2 provided similar advantages. The impact of Chemist Warehouse and the ACCC will likely turbocharge the benefit by adding additional scale from former Amcal chemists to the Paragon business without paying for it.
In our view, execution has always been this company’s shortcoming. Hardened, experienced leadership in Doug Collins (CFO or Managing Director since 2005) and a founder mentality applied to the Paragon businesses by CH2 will likely generate value above current expectations.
With additional tailwinds from healthcare demand and further movement in the business, we likely see an upside from current levels. The company is also likely to be strongly cash-generative and has low effective gearing, providing the market with various options for value in the coming years.
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.