Worried about a recession? Here are 7 ASX companies with sustainable profits – Sarah Allen

Whether you’ve seen revenue decline or experienced difficulty at the checkout, we’re facing a tougher situation. How hard or soft Australia’s landing will be is anyone’s guess.

Australian GDP grew just 0.2% in the June quarter – and only 1% in 2023, according to the Reserve Bank of Australia. Excluding COVID, this is the slowest growth since the early 1990s. This is hardly good news.

Given this, it’s not surprising that Franklin Templeton’s October CIO Pulse survey found that two of the top four concerns for chief investment officers were disappointing earnings and the recession.

So, with all that said, now is the time to bolster portfolios, and a key aspect of this will be to use companies that can offer consistent returns regardless of the cycle.

To find out which firms meet this requirement, we examined companies’ EBIT margins over the last economic cycle, using standard deviation to see how much variation there was over that period.

If you look at the All Ordinaries and exclude companies that have huge standard deviations over 300, the mean is 15.57. But we are interested in companies with stable earnings, that is, companies whose earnings are unlikely to change negatively during a downturn. For this exercise, we defined these companies as those having a standard deviation of 0.8 or lower. As the following table shows, 18 companies meet these criteria.

Companies with sustainable profits

This data was compiled by Lonsec's Tom Wegner with assistance from Reuters. — This data was compiled by Lonsec’s Tom Wegner with assistance from Reuters.

The next step was to interview some fans about the issue. Daniel Moore joins us to discuss the concept of income sustainability and pick his favorite sustainable workers. IML and Julian McCormack Merlon Capital company.

How these financiers think about sustainability

Both Moore and McCormack say it’s important to look beyond earnings stability over the past few years.

McCormack is concerned about manipulation of the data behind statutory earnings and is focused on generating free cash flow.

“We value companies based on strong free cash flow, which includes macroeconomic fundamentals and mid-cycle quality (industry structure, competitive advantages, etc.), and the alignment of free cash flow with reported earnings, the ‘quality of earnings’ for us,” he says.

Moore also believes investors should consider quality factors and future earnings potential.

Factors he looks at include:

Essential nature of products and services
Is there ongoing demand for these products or services?
Does the company have many clients or just a few large clients?
Does the company have pricing power?
Does the company have a lot of debt?

In both cases, part of the future assessment must include revenue growth as a measure of sustainability.

“We look at the history of companies delivering earnings growth and try to capture long-term growth expectations in the high and low ratings we give to the companies we review.

What we’re really looking for are ‘expectation gaps’ where the market can succumb to short-termism and unduly penalize quality, high-growth businesses,” says McCormack.

Moore gives an example of the importance of income growth in times of inflation.

“At a very simple level, if the inflation rate is 5% and a business’s profits remain unchanged, its profits will also grow by 5% (all other things being equal). Businesses whose earnings grow less than inflation are unattractive over the long term,” Moore says.

5 companies that fit the bill, based on the data we collected

While Moore and McCormack believe it’s important to look beyond earnings stability, they still nominated five companies they’re bullish on based on the list we provided.

Moore’s Choice

Brambles (ASX: BXB)

Moore says Brambles is a high-quality business and pooled pallets are not only critical to global supply chains, but demand has shown continued growth over time. It is also an industry with high barriers to entry.

“There is a good chance of significant upside to free cash flow (FCF) generation (a historical weakness of the company) and share P/E ratio if Brambles’ ongoing efforts to digitize its pallet fleet are successful,” says Moore.

Lottery Corporation (ASX: TLC)

With numerous long-term, high-quality government lottery licenses, The Lottery Corporation has a virtual monopoly on lotteries. It can also raise prices above inflation and sell digitally to drive revenue growth by increasing margins.

“TLC’s revenues tend to be resilient over the economic cycle because lottery tickets are typically a small purchase and consumers tend to view them as even more valuable during tough economic times,” Moore says.

Merger of Sigma (ASX: SIG) and Chemist Warehouse

“Drugstore sales tend to be resilient throughout the economic cycle, and Chemist Warehouse, as a discounter, tends to gain market share at low points in the cycle, providing a growing and sustainable revenue stream,” Moore says.

The merger will create the largest consolidated pharmacy wholesaler and retailer in Australia, with significant growth opportunities overseas. Moore adds that the management approach to overseas expansion has been primarily focused on markets like Australia, where the company can compete with smaller pharmacy competitors rather than large corporations.

McCormack’s Choice

It is interesting to note that both of these manufacturers are currently in litigation with the ACCC over allegations of misleading consumers through price reduction claims. McCormack acknowledges this, as well as the significant price correction in September, saying: “It’s worth remembering the resilience of Australia’s big retailers.”

Coles (ASX: COL)

Merlon Capital bought Coles at the end of 2023, expecting inflation to remain persistent and interest rates high. In a recent meeting with management, Coles noted that Amazon is increasingly competing in non-food categories.

“(This) reinforces our view that a dominant grocery market share is an important moat for both Coles and Woolworths,” McCormack says.

Although Coles lags slightly behind Woolworths in terms of profitability, it is optimistic about the prospects for its narrowing through logistics and supply chain.

“Coles has a significant capital investment program to build large distribution centers in Sydney and Melbourne, and recent full-year results showed improved profitability in supermarkets and sales growth outpacing inflation,” he said.

Woolworths (ASX: WOW)

“We also hold Woolworths shares because we believe the market is too pessimistic about the long-term impact of increased government price controls in supermarkets, overestimates the short-term impact of high wage inflation on earnings and overestimates the challenges Woolworths faces. New Zealand and Big W in the context of their contribution to the group’s assessment.”

His recent meeting with management was encouraging in terms of prospects. Woolworths has a different online strategy than Coles, focusing on its network of stores rather than individual distribution centres.

“Both Australian retailers are relatively well positioned in a persistent inflationary environment, given their strong non-discretionary offerings and demonstrated ability to pass on prices to their customers,” McCormack says.

Other ASX names to watch

Moore also suggests two other names off the list that he is optimistic about.

Telstra (ASX: TLS)

This isn’t the first time the fund manager has mentioned Telstra – communications are the new recession hedge and no one is going to live without phones and the internet. Moore points to Telstra’s valuable infrastructure, superior mobile network coverage and strong brand as driving superior pricing and profitability.

“Telstra is well positioned for sequential earnings growth throughout the cycle as its earnings are driven by its mobile and infrastructure businesses. We expect the mobile industry to achieve robust growth in the coming years as industry consolidation has led to smarter pricing and improved profitability from a still low base,” he says.

Charter Hall Retail REIT (ASX: CQR)

Problems in the property sector could lead investors to avoid investments, but Moore says the assets in these investments are resilient and consist mainly of neighborhood retail assets, as well as some petrol stations and pubs. The valuation metrics also look attractive.

“This portfolio of assets provides a stable, growing rental flow, supported by large and/or non-discretionary tenants, with 46% of rents directly or indirectly (turnover) linked to the consumer price index. This, combined with a flat 4% per annum increase for a further 43% of tenants, results in property income growth of 3%+ per annum over the cycle,” he says.