Everyone Prepared For The Bad News?

This story features ENERGY RESOURCES OF AUSTRALIA LIMITED, and other companies. For more info SHARE ANALYSIS: ERA

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

If you know bad news is coming, exactly how bad is it when the news finally arrives? Is it possible the anticipation is worse and we respond with relief instead of more sadness once the bad news we were expecting announces itself?

While the Australian share market remains mired by international, macro-economic and sovereign uncertainties, there seems to be a near universal agreement the upcoming local reporting season will turn into a slaughterfest whereby companies cannot meet profit expectations for the year ahead and thus securities analysts will be forced to use knife, axe, chainsaw and whatever tool available to reduce forecasts to more nimble growth assumptions.

The list of culprits behind these cuts is long, but well-known; ranging from wet weather and natural disasters, to a strong currency, to dismal consumer spending, to lack of political leadership in Canberra (both sides), to the pending introduction of the carbon tax, to a moribund housing market, to disappointing, decelerating growth in developed economies, to accelerating labour costs, to delayed business spending, to sovereign debt uncertainties,..

Right now, Australian companies might well be battling more mountains than cyclists during three weeks of le tour de France, and what has made matters worse than during the previous (interim) reporting season in February is that economic circumstances overall have worsened considerably since then, with the domestic economy showing noticeable deceleration in the June quarter.

But it's not like investors didn't see any of the above coming, isn't it? Which is why not everyone is convinced the August reporting season is poised to push the Australian share market to lower levels.

A few facts before we start digging a little deeper:

– Growth for Australian companies outside the resources sector has remained largely absent post 2007 and if current indications are accurate, FY11 will provide a continuation on the theme, marking the fourth year in a row of below trend growth in earnings per share for ex-resources companies

– Arguably the true story remains what will happen in FY12

– Current expectations are that industrial companies will finally show some growth in FY12, but probably not to the extent (+17%) as is currently reflected in consensus forecasts

– Note that average EPS growth for non-financial industrials is likely to print a negative number for FY11

– All sectors currently trade below historical valuations and industrials today are as cheap as they were in the mid-nineties

– All sectors are expected to see downgrades to earnings forecasts this reporting season – all sectors, but not necessarily every single company

– Company boards are expected to remain cautious with potential consequences: soft guidance, deferred investments, limited increases in dividend payments and no decisions (yet) on capital management and/or acquisitions

– Usually, companies that heavily disappoint will underperform for months, while those who clearly beat expectations tend to outperform long beyond the first month

– The Australian share market is trading on an estimated forward looking Price-Earnings ratio of circa 12, well below the historical average of 14.5, but then growth has been largely absent for 60% of the market

– Because valuations are lower than usual, dividend yields are higher than "normal" (assuming today's situation is not a "new normal")

Let's put all this in two easy to comprehend examples: shares for media companies have been heavily de-rated over the two years past and again in recent months as expectations for advertisements have been downgraded further. As a result, shares in companies such as APN News and Media ((APN)) and Southern Cross Media ((SXL)) have been sold down to levels not thought likely only weeks ago. But does this automatically mean both companies are about to issue profit warnings or miss market forecasts? Or does this merely open the door to a positive surprise since the market is already so negative?

Similarly, mining services provider Monadelphous ((MND)) is often mentioned as one candidate that appears poised to deliver a positive surprise in August, but then Monadelphous shares have already outperformed the share market recently. On Monday, when the Australian share market lost more than 1.5%, Monadelphous shares managed to close higher on the day. Doesn't this mean the pendulum is now swinging towards too high expectations and rather limited upside potential?

These, and many more questions are about to be answered during the next six weeks – if not in full, than at least partially.

In the meantime, analysts, strategists and quant experts are busy trying to line up names they believe are likely to disappoint (most companies) while trying to pick the few companies that remain poised to surprise to the upside. Below is an incomplete overview of research done in the past weeks, leading into the August reporting season in Australia (which effectively starts this week with Alesco ((ALS)), Australand ((ALZ)), GUD Holdings ((GUD)), OceanaGold ((OGC)), Austar ((AUN)), Coal and Allied ((CNA)) and Energy Resources of Australia ((ERA)) on the calendar).

Investors should keep in mind that, no matter how much research done, there is no such thing as a watertight conclusion. The fact that both David Jones ((DJS)) and Premier Investments ((PMV)) had been lined up as "looking pretty safe" prior to their respective profit warnings might serve as a reminder within this context. As everyone seems convinced the upcoming reporting season will be a bleak experience in Australia, with downgrades anticipated to significantly outnumber upgrades, I have only focused on the more extreme expectations, and more specifically on those candidates believed to have upside surprise potential.

Goldman Sachs is of the view that only a relatively small group of companies has the potential to deliver results that might clearly beat market expectations. The list of potential candidates, according to GS, includes Aditya Birla ((ABY)), ARB Holdings ((ARP)), Austbrokers ((AUB)), Challenger Diversified Property Group ((CDI)), Charter Hall ((CHC)), Domino's Pizzas ((DMP)), Flexigroup ((FXL)), Graincorp ((GNC)), Iress ((IRE)), Kathmandu ((KMD), Sedgman ((SDM)) and Sigma Pharmaceuticals ((SIP)).

Over at Citi, the team of quant analysts has once again relied upon their in-house developed model, which this year has been tweaked further even though the analysts report reliability and accuracy in the past has been pretty high. Citi's quant team selection of companies likely to surprise to the upside this season includes GUD Holdings, Navitas ((NVT)), Telstra ((TLS)), Ansell ((ANN)), Brambles ((BXB)), Charter Hall Office ((CQO)), Carsales.com ((CRZ)), Mermaid Marine ((MRM)), Flightcentre ((FLT)), Monadelphous, Ausdrill ((ASL)) and NRW Holdings ((NWH)).

Investors should note the Citi model throws up more likely surprises from the major banks, BHP Billiton ((BHP)), lots of property developers and trusts, gaming stocks as well as Fleetwood ((FWD)), Woolworths ((WOW)), Lend Lease ((LLC)) and others, but the above mentioned names come with a higher probability (according to the model).

Quant colleagues at RBS have done a similar exercise, but they only came up with a few upside surprise candidates: Sims Group ((SGM)), CSR ((CSR)), Aristocrat ((ALL)), Coca-Cola Amatil ((CCL)) and Carsales.com. Similar to other surveys, RBS quant predicts there will be many more disappointments than positive surprises.

Market strategists at Citi agree. Their selection of stocks likely to surprise only includes AGL Energy ((AGK)), Ansell and "some office REITs". Probably not unimportant, Citi strategists also point out that while resources stocks are also expected to suffer from downgrades this season, the overall risks for the sector remain "modest" overall. Most resources companies are believed to suffer from the strong AUD, ongoing impacts from wet weather disruptions earlier in the year and from rising labour and operational costs.

All this means the list of stocks likely to miss forecasts and to suffer from downgrades will be a very long one this season. Most at risk, suggest Citi strategists, are the more cyclical industrial stocks for which significant earning recoveries continue to be expected. Think Boral ((BLD)), James Hardie ((JHX)), Aristocrat, Fairfax ((FXJ)), Harvey Norman ((HVN)), Billabong ((BBG)), Macquarie Group ((MQG)), and many others.

Goldman Sachs's list for potential disappointers contains many similar names, plus companies such as Asciano ((AIO)), Downer EDI ((DOW)), Foster's ((FGL)), Primary Healthcare ((PRY)), Toll Holdings ((TOL)) and Wesfarmers ((WES)).

Quant analysts at RBS focused on other parts of the market and ended up selecting CSL ((CSL)), Southern Cross Media, Commbank ((CBA)), Cochlear ((COH)) and Kingsgate Consolidated ((KCN)) as companies that can potentially disappoint.

Citi's quant model throws up many more candidates, but the following (extensive list) comes with the tag "very negative", indicating the quant model believes chances are very much in favour of disappointment this season: Seven West Media ((SVW)), Leighton Holdings ((LEI)), Primary, ASX ((ASX)), Downer EDI, Gunns ((GNS)), The Reject Shop ((TRS)), Billabong, Coalspur Mines ((CPL)), DUET Group ((DUE)), BlueScope Steel ((BSL)), Charter Hall, Foster's, Kagara ((KZL)), Origin Energy ((ORG)), Western Areas ((WSA)), Asciano, AWE ((AWE)), Pacific Brands ((PBG)), Qantas ((QAN)), Suncorp ((SUN)), Abacus Property Group ((ABP)), Insurance Australia Group ((IAG)), Toll Holdings, Transpacific Industries ((TPI)), Virgin Blue Holdings ((VBA)), Cabcharge ((CAB)) and Panoramic Resources ((PAN)).

As said earlier, facing downgrades to earnings forecasts is not the only denominator that will impact on investment returns for the year ahead. The severity of these cuts will be equally important, as well as the low/high valuation that is currently priced in.

Taking a leaf from the same book, market strategists at UBS recently took a different approach. They tried to take into account what is coming, and then to determine which stocks are likely undervalued and which ones overvalued. The first group (undervalued) contains names such as Santos ((STO)), Billabong, Perpetual ((PPT)), Boart Longyear ((BLY)), JB H-Fi ((JBH)), Sims Group, Woodside Petroleum ((WPL)), ASX, Boral, OZ Minerals ((OZL)), Stockland ((SGP)), Incitec Pivot ((IPL)), Oil Search ((OSH)), BHP Billiton, Wesfarmers, Bendigo and Adelaide Bank ((BEN)), Lend Lease ((LLC)), Westpac ((WBC)) and Cochlear.

On the other side (overvalued) we find names including Foster's, ResMed ((RMD)), Ansell, Downer EDI, Transfield Services ((TSE)), Newcrest Mining ((NCM)), Goodman Fielder ((GFF)), News Corp ((NWS)), AMP ((AMP)), Qantas, AGL Energy, QBE Insurance ((QBE)) and Primary Healthcare.

All shall be revealed over the weeks to come.

(This story was written on Monday, 25th July 2011. It was sent out on the day in the form of an email to paying subscribers).

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Having just returned from a presentation on the Gold Coast, August is shaping up as a busy month with presentations during the Trading and Investing Expo in Sydney (Aug 5 and 6) as well as to ATAA members and guests in Newcastle (Saturday, August 13).

For more info about the Trading and Investing Expo presentations see http://www.tradingandinvestingexpo.com.au/speakers/rudi-filapek-vandyck-sydney-2011/

The ATAA presentation will take place at the Kahibah Bowling Club, 63 Kenibea Avenue, Kahibah (near Charlestown) between 11.30-3pm (luncheon break in between) on Saturday, August 13.

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