STOCKS

33 Undervalued Australian Stocks For 2023

We share our outlook for different sectors in Australia and highlight opportunities in 2023.

After a turbulent year, 2023 is shaping up to be challenging on many fronts.

Volatility indexes in Australia and the U.S. suggest investors feel comfortable and the outlook is optimistic. We disagree and urge caution at least for the first half of 2023.

Inflation is typically worse overseas and bond yields for most major countries are close to highs. The era of cheap and easy debt appears to be over.

Almost unbridled household spending, which was the main driver of GDP growth in 2022, will be restricted by the delayed impact of eight interest-rate hikes totalling 3.00%.

Household spending growth is expected to decline from 3% in 2022 to between 1% and 1.5% in 2023, as household disposable income comes under increasing pressure from mortgage repayments rises.

The Reserve Bank of Australia’s central forecast is for growth around 1.5% in 2023 and 2024. This represents a 50% decline at least in the growth rate from 2022, with meaningful implications for households and corporate earnings.

Further rate hikes are likely in 2023 as inflation remains elevated through the March quarter. The RBA is likely to then pause and stay on the side lines until 2024, when with economic activity at a low ebb, cuts could be initiated.

As of Dec. 9, Australian and New Zealand stocks covered by Morningstar were trading 7% below fair value on average, compared with a 15% discount at the June and October lows.

About 44% of Australian and New Zealand stocks under coverage are either 4- or 5-star-rated, a historically high proportion. In comparison, the trailing 10-year average is for 22% of our coverage to be 4- or 5-star-rated

Most sectors of the Australian and New Zealand market are now fairly valued or undervalued on average. Large numbers of stocks in the technology, real estate, industrials, and communications sectors are undervalued after major share price falls in 2022, triggered by sharply higher interest rates and growing fears of an economic slowdown. Despite rallying strongly in 2022, many stocks in the energy sector remain attractive, a testament to how cheap they were in 2021.

Here’s a brief summary of how valuations stack up across sectors. Data is as of December 9, 2022.

Currently, we see the best value in energy, real estate, financial services, and telecommunications sectors.

Skip to sector:

• Energy
• Technology
• Financial Services
• Basic Materials
• Communication Services
• Consumer Cyclical
• Consumer Defensive
• Healthcare
• Industrials
• Real Estate
• Utilities

Energy

Energy prices remain above our midcycle predictions. Our mid-cycle Brent crude and LNG price predictions of US$60 per barrel and US$8.40 per mmBtu (one million British Thermal Units – a standard unit of measurement for natural gas) respectively, kicking in from mid-2024, remain unchanged.

While having softened from extreme highs nearer the start of conflict in Ukraine, prices for Brent and contract LNG are still considerably above our mid-cycle estimates at circa US$80 per barrel and US$11.00 per mmBtu. Spot LNG into Asia is higher still at around US$33 per mmBtu.

Share prices still don’t reflect midcycle levels yet. If energy prices remain elevated for longer than expected, their value may be even greater. That is possible given the energy crisis in Europe.

Federal Labor proposed an A$12 per gigajoule cap on the wholesale domestic gas price as part of a multi-pronged strategy to relieve high domestic power prices. Our assessment suggests the policy is likely immaterial to the fair value estimates of Australian exploration and production companies we cover.

Undervalued stocks in the Energy sector

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Technology

The Technology sector index underperformed the broader Australia index in the past year but has outperformed in recent months. We believe the technology sector is now undervalued, especially in fintech.

We expect the key theme in the technology sector to be a renewed focus on fiscal discipline. In a low-interest rate environment, investors were willing to accept technology companies investing heavily into projects whose returns were not immediately obvious. The COVID-pandemic also brought forward demand for technology as companies sought to digitise rapidly for a socially distanced environment.

Consequently, technology companies hired aggressively, increasing headcount, salaries and arguably, bloat. With interest rates up and demand slowing, we expect technology companies to tighten their belts and rein in costs.

We expect the loss-making Fintechs to resolutely work on improving profitability. This is likely to come from cost-outs. We also anticipate more cross-selling to extract a larger share of customer wallets, or simply fee increases. But not all companies will win.

Undervalued stocks in the Technology sector

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Basic Materials

Recent guidance from the Fed that a moderation of interest-rate rises is on the horizon has boosted expectations for economic growth and hence demand for commodities.

Prices have risen in anticipation of the benefit. While China is still officially pursuing a zero-COVID-19 policy, rising opposition to lockdowns within China and increasing vaccination rates sees more investor optimism around China reopening soon.

The ongoing disruption from the Russia-Ukraine war and sanctions on Russia are also supportive.

Our basic materials coverage is now trading at around fair value on average. We still see value among the coal miners with upside from high prices generally not factored in. The rally in iron ore prices again sees those firms as notably overvalued. In housing, the outlook has softened materially given rising interest rates. We expect a steeper housing downturn in 2023, but our long-term outlook remains unchanged.

Undervalued stocks in the Basic Materials sector

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Communication Services

The communication sector has underperformed the broader market and is now trading below fair value on average.

In mobile, pricing is improving while the fixed-line industry is over the worst of the National Broadband Network impact. Operators are increasingly deploying fixed wireless to entice NBN users back on their own wireless networks. While competition is intense in the corporate market, demand for network access and telecom products is strong and there are still cost-efficiency opportunities to partly offset top-line pricing pressure in the corporate market.

In media, advertising markets are cooling with recent data showing monthly declines in the mid- to high-single-digit percentages from a year ago.

In 2023, all eyes will be on the impact of rising rates on consumer confidence and business sentiment, the key drivers of advertising and marketing activities. Furthermore, much of the marketing budgets in Australia are dictated by multinational companies with head offices in the U.S. and Europe. If these countries fall into recession, advertising expenditures in Australia could be cut. Fortunately, balance sheets across the media sector are robust.

Undervalued stocks in the Communication Services sector

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Consumer Cyclical

We forecast Australian retailing sales to weaken significantly in the first half of calendar 2023.

We anticipate consumption to structurally revert to a similar split between goods and services as before lockdowns and restrictions limited consumers’ options.

Consumer cyclical companies are roughly fairly valued on average. We see the greatest risk of softening sales for those discretionary retailing categories still with elevated demand, including recreational goods, household goods, and apparel.

We think there is upside for service-exposed businesses, where the reallocation of spending is still normalising, such as travel agents, casino operators, and restaurants.

Demand for new vehicles is outpacing supply, leading to tremendous pricing conditions for dealerships such as Eagers Automotive. But we expect elevated demand and constrained supply to ease, weighing on dealer profitability.

By contrast, demand for automotive spare parts (required for routine maintenance and repair of vehicles) is linked to the overall size of the vehicle pool, which is much less volatile. We think this defensive quality is underappreciated.

Undervalued stocks in the Consumer Cyclical sector

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Consumer Defensive

The Reserve Bank of Australia’s aggressive rate hikes are a potential catalyst for retail spending to soften near term. Rising cost of living pressures, such as rampant food price inflation and rent increases, are also biting.

In this environment, Australians with increasingly limited budgets are likely to prioritise consumer staples like food and liquor over discretionary goods. However, given concerns about recession risk, an investor flight to safety has left defensive stocks largely overvalued.

In their hunt for yield, investors bid up the price-to-earnings multiples of the most reliable income stocks in the defensive retail sector, such as supermarkets.

Rising bond yields could prompt investors to reconsider what is a reasonable running yield from these stable but relatively mature defensive consumer staples stocks.

Despite rising costs of goods sold for supermarkets, prices have been passed on to shoppers, resulting in gross margin expansion.

Suppliers, however, have been unable to completely offset rising input costs like feed, milk, fertiliser and labour.

Cost inflation has been exacerbated by oversupply in some categories, like poultry and avocados. But we expect input costs and oversupply to normalise in time and supplier profitability to improve.

Undervalued stocks in the Consumer Defensive sector

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Financial Services

The financial sector has closely tracked the broader market in the past year. We see good value in most banks and asset managers.

We expect higher cash rates to support solid earnings growth for Australian banks in 2023. With smaller banks and non-bank lenders having weaker funding positions, we expect the major banks to price loans and term deposits at levels delivering low-double-digit returns on equity.

Credit growth is expected to slow, with higher interest rates and inflation reducing borrower capacity, and falling house prices hurting investor confidence. Higher loan losses are a risk, but we see a return to long-term averages as most likely.

The strength of the economy, household equity buffers, and the banks’ own provisioning levels provide comfort.  The outlook for general insurers is positive despite grappling with severe natural hazard costs. Higher premiums and a focus on operating expenses are helping alleviate the pain. Higher cash rates are expected to provide a material uplift to earnings as investment income on policyholder and shareholder funds improve. 

It is a mixed bag of fortunes in wealth management. Asset managers are likely to see earnings trough in FY23-2024 following the 2022 stock market decline.

Undervalued stocks in the Financial Services sector

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Healthcare

The Healthcare sector underperformed the Morningstar Australia Index in the December quarter. We view the sector as fairly valued on average but still see buying opportunities with just under a third of our coverage trading in 4- or 5-star territory.

We generally view companies in our healthcare coverage as defensive and fairly insulated from rising inflation or a potential Australian recession due to the essential nature of the products and services provided.

This broadly translates to pricing power and being able to pass on rising input costs to customers without a material impact on demand. We also do not expect a material adverse impact on profits from rising interest rates due to a lack of debt within the sector overall.

While the path forward may be volatile, particularly if new coronavirus variants emerge, we still expect continued mean reversion for the temporary winners and losers of the pandemic.

We expect the impact of coronavirus to continue subsiding overall given higher vaccination rates, expanding treatment options, and the general trend for variants to be less severe. As such, we anticipate current challenges including staff absenteeism and supply chain disruption to mostly resolve longer-term.

Undervalued stocks in the Healthcare sector

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Industrials

The Industrials sector underperformed the Morningstar Australia Index in the December quarter. The sector appears fairly valued on average, but we see a variety of buying opportunities in industrial stocks demonstrating relative resilience and an ability to pass though price increases to end customers. 

Roads are benefitting from a recovery in traffic volumes and CPI-linked tolls. Rising interest rates remain a headwind but hedging helps.

Profitability for airlines has recovered strongly as air travel demand outstrips supply. We think elevated profits are sustainable in the medium term, but longer term will be more challenging as supply lifts.

Undervalued stocks in the Industrials sector

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Real Estate

REITs look undervalued, despite a modest recovery in security prices in the December quarter. Market pricing still implies large falls in net tangible assets (NTA) and very little value beyond that.

We have long expected higher interest rates would prompt declines in commercial property prices, but not to the extent implied by listed security/ unit prices. Furthermore, we see considerable value in business ventures that are not included in NTA calculations

While office leasing conditions remain weak, office rent declines have slowed. Vacancies are worst in poor quality assets, typically owned by unlisted players. Market-wide supply and demand should reach equilibrium as new developments slow in the face of higher costs of capital, and low-quality office sites are put to alternative uses such as residential.

Admittedly, office, retail and industrial properties face cyclical risks from a recession, but we think the downside is substantially mitigated by long leases to strong tenants, and solid population growth.

Self-storage could be vulnerable given the sector has few leases, and it looks more richly valued, probably due to the favourable glow of strong rental growth. We fret it could evaporate in a recession.

Property developers may also be vulnerable in a recession, however we think the security prices of developers factor in tough times, leaving upside should a recession be avoided. Residential developers look well placed given Australia’s housing shortage looks likely to intensify.

Undervalued stocks in the Real Estate sector

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Utilities

The recovery in Australian utilities is gaining traction as the market focuses on the solid earnings outlook. Australian utilities generally remain undervalued.

High wholesale electricity prices in Australia will progressively flow through to customers. Federal Labor’s planned gas and coal price caps are expected to take some cream off the top, though.

Undervalued stocks in the Utilities sector

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