3 mid-caps to consider in a sell-off storm

Savage share market sell offs are equal parts terrifying and frustrating for small investors.

Terrifying because nobody knows how long the selloff will last or if early bargain hunters will be burnt. And frustrating because investors are often fully invested at market tops and lack cash to buy back in.

Professional investors get excited by market sell offs. Those who increased their portfolio’s cash weightings as markets rallied have cash to buy stocks at lower prices. Having sat on the sidelines as valuations became stretched, they are back in the game, buying good companies below fair value.

These are interesting times for value investors. As I wrote last week for this Report, the market sell off has further to run. Global equity prices will go lower before resuming their uptrend. Nobody knows how much lower, but I can’t see any great need to buy stocks aggressively now.

We’re at that point in market cycles where good news is interpreted as bad. For example, strong employment and wages growth data that is good for the United States economy is seen as portending higher inflation and more interest-rate rises than expected.

This uncertainty will increase volatility this year as the market adjusts to the likelihood of higher inflation and US interest-rate rises. But I can’t see the start of an entrenched bear market, given there are no signs of recession here or overseas, which usually feeds the grizzlies.

The upshot is emerging value for investors, provided they can withstand higher short-term volatility in the next few months.

Last week’s column identified a handful of blue-chip companies to focus on, most of them cyclical growth stocks, such as the big diversified miners. This week, I extend that analysis to mid-cap companies that were sold off during the market rout in early February.

Focusing on higher-quality mid-cap companies during bouts of heightened volatility, to mitigate risk, is the best approach. Take care with speculative small- and micro-cap stocks: investors are often surprised at how far and how quickly they can fall when markets turn.

Here are three stocks to consider:

1. JB Hi-Fi (JBH)

The retail star slumped to $21.20 at the height of sector paranoia in November. Then JBH soared to $29.23 as the market realised Amazon was not Armageddon for the sector and that it had overestimated the outlook for retail sales growth.

JBH closed at $26.77 yesterday, having tumbled about 10% during the February sell-off. JBH’s FY18 interim result, released this week, was slightly concerning given signs of rising margin pressure and a weaker-than-expected result from The Good Guys. I don’t see either issues forcing JBH to miss its earnings guidance.

JBH is as good as it gets in Australian discretionary retailing. Yet it is trading on a forecast Price Earnings (PE) multiple of just 12.3 times, appears to have issued conservative guidance and has plenty of synergies still to derive from The Good Guys acquisition.

Also, new gadgets such as the Apple HomePod and laptops and smartphone upgrades should continue to drive store traffic and sales.

An average price target of $27.60, based on the consensus of 12 broking firms, suggests JB Hi-Fi is moderately undervalued. Macquarie’s 12-month target is $31.30. I’ll stick with the bulls on this one.

Chart 1: JB Hi-Fi

Source: nabtrade

2. NIB Holdings (NHF:ASX)

The mid-cap health insurer has fallen from a 52-week high of $7.04 to $6.21 at the close yesterday, much of the damage done in the past few weeks. There’s been no company news to warrant the sell-off.

I outlined a positive view on NIB in The Switzer Super Report in October 2017 when it traded at $5.73, noting that the market “was too cautious on NIB”. At the time, I suggested NIB would retest its then 52-week high of $6.48, and it happened earlier than expected.

My view on NIB remains unchanged: the company is superbly positioned to increase its market share as more customers move from larger health insurers to smaller providers, in search of cheaper policy premiums. Even a small lift in NIB’s market share (just above 8%) has a big impact on earnings.

NIB has good organic growth prospects and continues to make sensible acquisitions in corporate-health and related areas. As I wrote in October, NIB has traits of exceptional companies: a high and rising Return on Equity, strong growth in net operating cash flow and low debt to equity.

These are the mid-cap stocks to buy when valuations fall during market sell-offs, for reasons beyond company fundamentals.

An average price target of $6.23, based on the consensus of 12 firms, suggests NIB is trading near fair value. Again, that looks a little conservative, although it will pay to wait for the company’s interim result, due February 19, before diving in.

Chart 2: NIB Holdings

Source: nabtrade

3. Magellan Financial Group (MFG:ASX)

Buying a global equities fund manager during a global equity sell-off seems reckless. Market volatility inevitably leads to fund outflows, performance-fee challenges for asset managers and lower earnings and company valuations.

But if one believes the global bull market is still intact, the sell-off in wealth manager’s looks overdone and a long-term buying opportunity. None are better than Magellan.

The stock fell from $28 in early February to $25 in a few days. The sell-off undid much of Magellan’s price rally since early October.

Magellan’s FY18 interim result, released last week, broadly met market expectations.

The fund manager continues to deliver superior earnings-per-share growth compared to its rivals, yet only trades at a slight premium to ASX-listed fund managers after the recent sell-off.

I like Magellan’s strategy to acquire smaller managers, such as Airlie Funds Management and Frontier Partners Group, which are expected to be moderately EPS accretive. The launch of the Magellan Global Trust is another positive step for the firm’s asset growth and earnings.

It would be more reassuring if Magellan grew funds under management organically rather than by acquiring other firms. But there’s logic in it supporting earnings growth through modest acquisitions and product innovation, provided the core business continues to grow.

The main concern is whether the market sell-off has placed more of Magellan’s performance fees at risk. But again, that depends on one’s view of the sell-off and whether the bulk of the damage has been done. If markets stabilise in the next few months, as I expect, concerns about lost performance fees weighing on full-year earnings might prove to be overdone.

An average share-price target of $29.06, from the consensus of 9 firms, suggests Magellan is undervalued at the current price. Estimates range from about $27 to $31.

Magellan will probably be more volatile than other stocks on this list, given its leverage to global equity conditions. As the bull market resumes later this year and the spectre of sharply higher inflation and interest rates recedes, watch investors rotate capital back into Magellan.

Chart 3: Magellan Financial Group

Source: nabtrade