5 areas investors should be wary of in 2023

DohInsideWarren Buffett’s two golden rules for investing are, 1. Don’t lose money 2. Never forget rule one.

To assist investors adhere to these rules, some of Australia’s leading investors shine a light on where some of the dangers may be hiding in the current markets.  These dangers are in 5 categories:  crowded trades, expensive investments, earnings downgrades, business models and popular short positions.

crowded trade is a popular position or theme embraced by large numbers of investors.  Crowded trades may not be wrong, but are usually associated with high prices, bubbles and irrational behaviour.  Matt Williams, Portfolio Manager at Airlie Funds Management says that the resources sector is currently a crowded trade.

Hugh Dive, Chief Investment Officer from Atlas Funds Management nominates  lithium as a crowded trade.  He says there are currently 62 lithium stocks on the ASX but only a few are profitable.  The majority of lithium miners are exploration companies or companies with a resource that may or may not be economical to mine.  He believes the great bulk of these lithium companies will never see their projects developed and are likely to head towards insolvency as investor patience wanes.

Investments that look expensive according to Dive include consumer staple companies and the tech sector.  Dive supports this by saying that the food retailers have done well out of COVID lockdowns, but are now moving through tougher comparable sales periods that will see declining earnings and higher costs from labour and supply chain issues.  While Woolworths and Coles are efficient retailers, paying over 21 times earnings that are declining, doesn’t make much sense.

Reporting season is just around the corner with investors braced for earnings downgrades as a result of higher interest rates and consumer caution.  Williams is most worried about earnings downgrades for consumer exposed retail companies and the building sector.  The difficulty for investors is to determine what is already priced in.  For example James Hardie has sold off by 35% in the last 12 months and may well already have adjusted for expected earnings downgrades. 

Nathan Bell, Portfolio Manager at Intelligent Investor says that business models likely to struggle in the higher interest rate environment are those that have borrowed lots of money, particularly for shorter terms.  He suggests many of the new breed of fintech companies could have this issue exposed if higher interest rates send a deflationary pulse through the economy.

Williams believes that business models most at risk are those that are not yet profitable and hence rely on equity markets to fund their operations.  This is prevalent in the tech sector and investors should exercise great care when investing in companies that do not make a profit.

Investors are always wise to be aware of stocks that are being heavily shorted.  A short position is essentially betting against the market, and the short position profits when prices decline.  Some of the most heavily shorted companies in the ASX200 currently include Megaport (tech), Sayona Mining (resources) and Core Lithium (resources).

Williams nominates REIT managers exposed to the retail sector as a source of potential danger as they continue to face a difficult environment as the economy softens.  They are also negatively impacted by rising rates on valuations and borrowing costs.

Dive is cautious on the iron ore sector going into 2023, which has been a short term beneficiary of China amending their COVID Zero policy on the basis that it leads to a rise in construction activity.  Dive’s concern centres around China recently announcing the establishment of a centralised state-owned buying company for iron ore to consolidate the purchases of iron ore for the 20 largest Chinese steel makers.  This will likely reduce the pricing lower the four main iron ore producers currently enjoy from selling their iron ore to a fragmented group of steel makers.  With China consuming 70% of globally traded iron ore, more disciplined centralised buying leads Dive to believe that the price of iron ore is likely to face downward pressure.

Bell is wary of the oil and gas sector.  He says that while a higher oil price may increase short term profits, paying high multiples for capex heavy companies that don’t control their product prices is usually a recipe for disaster.

Avoiding permanent capital loss increases investment returns.  2023 has its unique list of things to be wary of.