Cyclical sector stocks successful amid inflationary pressures

Sam Twidale, Portfolio Manager at boutique Australian investment manager DNR Capital, has singled out stocks from the value and cyclical sectors such as Resources and Energy as the most successful for Australian equity investors to position their portfolios for higher inflation.

Twidale, manager of the DNR Capital Australian Emerging Companies fund, said the inflation narrative has shifted from transitory to longer-term pressures, with shifts in equity market leadership also expected to last.

“Greater inflationary pressure has been evident during just about all our recent discussions with various companies’ management teams,” he said.

“This is due to supply chain challenges, higher commodity prices, increased energy costs associated with the transition to renewables, higher property costs and ongoing labour constraints.

“Some normalisation can be expected as the impact of the pandemic recedes, but many of these issues also appear more structural in nature and may not be resolved quickly.”

Twidale also said DNR Capital has reduced exposure to the more expensive areas of the market in the fund, after noticing the shift in favour of cheaper sectors like Resources, Energy and attractively priced defensives.

“We finished 2021 with the forward price/earnings (PE) multiple of the stocks in the portfolio at one of the lowest levels since the inception of the strategy four years ago,” he said.

“The forward PE multiple is 17 times currently, compared with close to 30 times a year ago. Many of the main beneficiaries from the long period of low inflation and low interest rates could find it difficult to repeat this period of outperformance.

“Many growth stocks were simply priced for perfection. This compared with many of the more value and cyclical related sectors, where earnings expectations appear more on the conservative side and offer a margin of safety in their valuation.”

Some top performing stocks monitored by the DNR Capital fund included commodity producer Champion Iron, appliance manufacturer Breville Group, financial services software company Iress, Iluka Resources, IGO, Lynas Rare Earths and Deterra Royalties.

“As we look ahead to the 2022 calendar year, our outlook for the market and the positioning in our DNR Capital Australian Emerging Companies Fund remains unchanged,” Twidale said.

“We continue to look for strong bottom-up investment opportunities, in quality companies trading on attractive valuations.”