2 'overlooked' but 'exciting' ASX shares to buy: fund manager

Ask A Fund Manager: Auscap Asset Management's Tim Carleton names a pair of stocks that have excellent prospects.

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Ask A Fund Manager

The Motley Fool chats with the best in the industry so that you can get an insight into how the professionals think. In this edition, Auscap Asset Management portfolio manager Tim Carleton picks two ASX shares that are set for an outstanding future.

Hottest ASX shares

The Motley Fool: What are the two best stock buys right now?

Tim Carleton: Yeah, so the first one directly feeds into what we were just talking about and that is Nick Scali Limited (ASX: NCK). So, it's obviously discounted at the moment because of its exposure to furniture. And everyone's aware that we've been through a housing boom during lockdowns. The majority of households experienced no change to their income during this period, but for many of them, their expenditure was significantly lower, in many instances, just because they couldn't travel. So the savings rate increased. And when you combine that with everyone being stuck at home, expenditure in categories around the home obviously increased quite dramatically. So that included homewares, appliances and furniture. So Nick Scali, as a seller of lounges, was a big beneficiary of that.

And the end result is that everyone's now concerned that we [had] an increase in demand, surely we've got to have the other side of that, which is a significant fall in demand. So that's going to unwind the considerably higher profits that Nick Scali saw over the last couple of years and result in earnings downgrades on a go-forward basis.

That's [a] very simple analysis why the stock's trading on 10 to 11 times last year's earnings, which is abnormally low for a company [of] this quality. 

Why are we bullish? The short answer is that there is far more inside Nick Scali's control than outside. So if we think about the Scali business today, compared to what it was pre-COVID, it's an entirely different business. Believe it or not, they did not have an online presence prior to COVID. There was no way of purchasing either online or over the phones before COVID hit. But now that business is very profitable and it's growing very quickly.

It also purchased one of its competitors, Plush, at what we think was a pretty attractive price before synergies. And the synergies to drop out of that acquisition look like they are very, very significant. So that's given it another angle for growth. Across the two brands now, it has plans to nearly double the number of stores that it has in Australia and New Zealand, which should give it very substantial organic growth.

It's also enabled the business to expand into adjacent categories, particularly this move into online, because they can sell other case goods that they don't have room for in store, in their online channel. And they do that very, very profitably.

So at the moment, if you think about all of these growth avenues that they have within their control, to us, they're more considerable than the macroeconomic headwinds. And we think it means that they should be able to grow earnings, revenue and earnings, even if we see a pullback in demand for some of their key categories. 

What you're getting is a very high-quality retailer, that's at a discount because of the macro. When the reality is they've got a very, very healthy pipeline or revenue and earnings growth for quite some time, from our perspective.

And that's in a business where we think the retail management is probably amongst the best in the industry. Anthony Scali and his senior management team are very, very strong, and it's a very high-quality business. And the numbers bear this out. They've averaged over 50% return on equity over the last decade, which is extraordinary, in fact. They're the only company in the exchange that we're aware of that's done that.

So we're quite excited by what is a pretty simple business. And it's often the simple businesses that get overlooked by the market.

But the second business is probably a bit more exciting for a lot of people just because of its exposures and that's Mineral Resources Limited (ASX: MIN). And Mineral Resources is really four businesses in one. 

Their core business is a mining services business. So they do a lot of the contract mining work for some of the big iron ore miners, such as BHP Group Ltd (ASX: BHP) and Rio Tinto Limited (ASX: RIO). That's a very, very good business. It's consistently grown over the last couple of decades and should continue to grow very, very substantially in the coming years, but they've also got three other businesses. 

They've got an iron ore operation, and historically that iron ore operation has been a high-cost business. So it makes very good money when iron ore prices are high and it's fairly marginal when iron ore prices are low. In fact, in some years, they have closed parts of the operation because they've been unprofitable when iron ore prices have pulled back.

At the moment, they're going through a stage of development where they're trying to move from high-cost operator to low-cost operator in that iron ore business. So they've got two projects that are very substantial in scale, that will take them from where they are today down into probably the bottom quartile of operators from a cost-per-tonne perspective. And that will make that business far more sustainable and a far more reliable generator of income for the business on a go-forward basis.

But, really, the exciting business is the lithium business. And lithium demand is exploding the world over and that's being driven by the increasing uptake of electric vehicles. And I think we're through that point on the S-bend where you are guaranteed mass adoption. And so we are coming into a time where EV take-up will accelerate very, very considerably. To be honest, it's difficult to work out where the lithium that's required for the batteries that go into electric vehicles will come from.

I think in that environment, what you want to own is the high-quality lithium producers with very, very large resources that are at the bottom of the cost curve. And certainly, Min Res's lithium business fits that bill. They have two world-class deposits in Wodgina and Mt Marion, both are currently in production. We expect, as they continue to grow output from both of those mines, that they will consolidate a position in the top five global producers of lithium. 

Not only that, they're looking to make sure they capture as much of the value chain as possible. So they're going to convert all of their product that they produce out of these mines into lithium hydroxide, which is the product that's used in the production of lithium-ion batteries. When you convert it from lithium spodumene into lithium hydroxide, there's quite a considerable uplift from a value and, therefore, price perspective. So they'll capture a lot more of the economics of the whole supply chain, by selling all of their output as lithium hydroxide. 

At current prices, we have the whole business trading on mid-single digit P/E [price-to-earnings ratio]. And that's for a business that we think will grow very substantially over the coming years and has delivered a return on equity that's averaged over 20% since listing, which is pretty extraordinary for a mining and mining services business.

So we're very excited about that. And that's before I really get to the fourth business, which is really a free option at this point in time. That is their gas business, their energy business. They look like they have made the largest onshore gas discovery in Australia's history. So the gas business alone may end up being worth many billions of dollars. In the notes that we see at the moment from analysts, it's not factored in, virtually, at all. But it could become very, very meaningful for it. 

So there are a lot of reasons to like this company. People are obviously wary about lithium stocks broadly because of the moves that they've had, but this is probably one where the valuation still looks very attractive to us.

MF: Resources companies are notoriously cyclical — but that doesn't necessarily worry you as a long-term investor?

TC: Well, you're mindful of the cyclicality, but we're in an environment where we think, for lithium, the demand will exceed the supply for some time, in which case the cyclicality may work in your favour.

Because you are in a situation, whether it's likely to be perpetual deficits, which imply high prices. So just to give you a comparison, it feels to us like this is relatively similar to iron ore in the early 2000s. And what you ultimately needed to see was an incentive price, well above the marginal cost of production for the incumbents at the time, to encourage people to develop the lower grade deposits, so that supply would be sufficient to meet demand. I think that's what we are seeing in the lithium space and the tier-one assets, such as those that Min Res own, will end up becoming very, very profitable enterprises for the owners.

Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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