Where Is The Growth In Australia? (And At What Risk?)

This story features TELSTRA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: TLS

By Rudi Filapek-Vandyck, Editor FNArena

The share market is, ultimately, all about earnings growth but sometimes other factors occupy the minds of investors. Witness, for example, how US equities have posted their strongest January performance since 1996, yet the Q4 reporting season over there has been the weakest on record post 2009 (see table below, with thanks to the institutional desk at Goldman Sachs).

The good news remains that corporate earnings in the US are still growing and they are anticipated to continue growing this year, albeit at much slower pace than in previous years. This, many an investment specialist believes, will help to close the valuation gap in 2012.

What about Australia?

The sad thing about Australia, believe it or not, is that earnings growth has largely proved elusive in the post-Lehman Bros world. Thus, I believe, we have found the key reason as to why the Australian share market in general has so badly lagged many overseas peers. The currency, the government, the labour market, the local consumer and the Reserve Bank (RBA) have all negatively contributed to Australia's record of dismal earnings growth in the years past.

Earnings estimates for Australian companies have pretty much endured constant decline for most of the past three years now. There have been short interruptions of increased optimism along the way, but all in all the underlying trend has remained firmly negative. Thus far there has been no change in this trend which implies FY12 will simply be another year of disappointing to negative earnings growth. This outlook is further supported by the fact many an analyst believes the most obvious of headwinds for corporate Australia, slowing growth in Europe, is yet to fully announce itself in the quarters ahead, feeding expectations the Australian share market is looking towards another wave of earnings downgrades.

A further negative is the fact the Australian currency continues to defy gravity helped by the fact the Australian government's AAA credit rating is now one of the few globally. As many stockbrokers in Australia have incorporated lower AUD values for the years ahead in their models, the Australian dollar remains one of the key risks to profit growth for corporate Australia.

It's not all bad news though. Note how the RBA is now cutting interest rates instead of lifting them, while commodity prices are expected to at least stabilise at elevated levels in 2012. For dozens of household names, including BHP Billiton ((BHP)) and QBE Insurance ((QBE)), a silver lining from left field has presented itself in the weeks past. As earnings estimates in the short term have slumped, this has opened the door to growth in the following financial year. Sounds spurious? The share market often works on very simplistic terms. Note how QBE shares have now recovered about three-quarters of their loss following the company's sudden profit shock at the start of the year.

Consensus forecasts are anticipating a 70% increase in earnings per share for QBE for the year to December 2012. (The early January profit warning was for 2011). This puts the shares on a ridiculous looking Price-Earnings ratio (PE) of 8.3 for this year with an implied forward looking dividend yield of 8.5%. If correct, this means QBE's yield will be better than Telstra's ((TLS)) in the year ahead. When did this last happen? (Note Telstra's dividends are fully franked and QBE's only partially).

The problem with all this is that, arguably, market forecasts for Telstra look a lot more solid than for QBE which has now built up a legacy of continuous disappointments. Telstra, on the other hand, is now enjoying the wind in its sails and market forecasts anticipate mid-to-high single digit growth for years to come, with the board flagging it will look into capital management further down the track while keeping the annual dividend at least on 28c.

Hereby we have identified the potential traps and opportunities that are currently on offer in the Australian share market. After three years of virtually no growth in earnings, analysts' forecasts anticipate a strong bounce in corporate profits from the second half of 2012 onwards. This lifts average growth in earnings per share (EPS) for the ASX200 to no less than 17% for FY13. At face value this looks very promising. If correct this implies Australia will finally do better than overseas peers in Europe and the US. This suggests, all else being equal, the Australian share market can finally recover some of the lost ground since 2009.

The key problem is, however, only few believe 17% growth is realistic (unless, maybe, FY12 turns out a lot worse than is anticipated today, just like what happened to estimates for the likes of BHP and QBE).

Market strategists at BA-Merrill Lynch reminded their clientele in early January that market forecasts for FY12 looked pretty similar to about a year ago, yet today all that is left from growth expectations of circa 19% back then is 5% with further cuts to follow. No wonder,\ market analysts at Macquarie talk about the market going through a "ground hog cycle of earnings downgrades".

Of course, the key difference between this time last year and today is that most share prices in the Australian share market are considerably lower today. Add strong growth forecasts, if not for this year, then for next, and it is easy to conclude today's share market is overloaded with bargains. Investors are reminded this can change instantly from the moment earnings forecasts prove imaginary, which presents today's key challenge: how to distinguish tomorrow's heroes from the wannabes?

A few easy to apply rules come to mind:

– A company such as Campbell Brothers ((CPB)), which largely works with longer contracts and recurring revenues and which had to increase its profit guidance last year (not once but twice), looks solid and safe from an earnings growth perspective but then investors have already acknowledged this, which is why the share price is trading on a Price-Earnings ratio of 17 for the year to March (14.7 for FY13).

– On the other hand, regional lender Bank of Queensland ((BOQ)) is projected to improve its earnings per share by no less than 42% this year (to August) which makes the PE of 7.6 look like a joke. Of course, the market doesn't give away free lunches so what's holding back BOQ's share price? Market concerns about asset quality and what further deterioration can do to the bank's balance sheet, for starters. Secondly, BOQ is even more suffering from funding costs than the Big Four in Australia. This is why Bank of Queensland is today one of the cheapest stocks in the Australian share market (according to FNArena's R-Factor, which does an excellent job in ranking ASX200 stocks on relative value).

The challenge for investors today is: find stocks in the second category that will deliver and you can potentially reap rich rewards. Don't go crazy and bet the whole farm on it though as bad mistakes can and will trigger severe punishment. There are still plenty of companies in the first category that are as yet not trading at full potential. These stocks may not offer the same upside potential, they do offer positive returns plus the ability to sleep at night. (see also "The Big De-Rating", e-booklet that comes with a paid subscription to FNArena).

Some stockbrokers have tried to identify those stocks likely to surprise in a positive manner and those poised for disappoinment in the upcoming reporting season. Investors might want to take these assessments on board this month and next.

Poised to disappoint, in the opinion of RBS, are: Toll Holdings ((TOL)), Southern Cross Media ((SXL)), CSL ((CSL)), Macquarie Group ((MQG)), Seven West Media ((SWM)), Primary Healthcare ((PRY)), Harvey Norman ((HVN)), OneSteel ((OST)) and Ten Network ((TEN)). In a very telling sign, the stockbroker offers no ideas for potential positive surprises.

Healthcare analysts at UBS disagree with RBS's selection of CSL, which they believe could be one of few to genuinely surprise next month.

Quant analysts at Macquarie have taken a different approach. They have looked into the past and come up with the following list of companies that have a history of positive share price responses to their results: Perseus Mining ((PRU)), Whitehaven Coal ((WHC)), Campbell Brothers, Bank of Queensland, Tatts Group ((TTS)), Boral ((BLD)), UGL ((UGL)), News Corp ((NWS)), Rio Tinto ((RIO)) and WorleyParsons ((WOR)).

On the other hand, stocks that have a history of negative responses to released results include Echo Entertainment ((EGP)), Fairfax Media ((FXJ)), Transurban ((TCL)), Goodman Fielder ((GFF)), Boart Longyear ((BLY)), Suncorp Group ((SUN)), Paladin Energy ((PDN)), Iluka Resources ((ILU)), Amcor ((AMC)) and Insurance Australia Group ((IAG)).

Market strategists at BA-Merrill Lynch advise investors to be extra-cautious with companies whose revenues and profits have large exposure to Europe and, yes indeed, the US (BA-ML does not share the widely carried optimism towards this year's outlook for the US economy). Such stocks include (in no particular order) Nufarm ((NUF)), Cochlear ((COH)), Brambles ((BXB)), Lend Lease ((LLC)) and Transfield Services ((TSE)), among many others.

BA-ML also compiled a short list for likely positive surprises: QR National ((QRN)), Seven West Media, Virgin Australia ((VAH)), Ausdrill ((ASL)) and Grange Resources ((GRR)). Those deemed set for disappointment include Ten Network, Goodman Fielder, Lend Lease, Navitas ((NVT)) and Myer ((MYR)).

Past research has taught us that companies which manage to release financial results that genuinely positively surprise are more likely to see their share price outperform the broader market for up to three months after the event. Companies that disappoint might find their share price put in the doghouse for much longer.

Also, and this one's from me, be wary of forecasts that require a big increase in margins. The odds are simply against it.

As corporate balance sheets are in good shape and with many companies enjoying solid cash flows, capital management remains high on the agenda while dividends are expected to continue to grow harder than net profits (average yield is now 5.3%, expected to rise to 5.7% next year).

Last but certainly not least, on current forecasts the Australian share market is trading on circa 13.4 times average EPS for FY12, which seems closer to "fair value" than to "cheap". But then questions can be asked whether such a generalised calculation is still useful as a benchmark given the individual differences between companies in the share market are simply enormous. As pointed out by Macquarie analysts this week, the current trend in estimates suggests all major sectors in the Australian share market (banks, industrials and resources) might end up with a slight negative performance in terms of EPS growth this year. Which would make Listed Property Trusts (or REITs as they are called these days) the unexpected champions of growth this year in Australia. Forecasts for the sector have remained largely unchanged at 4% growth.

Don't be surprised if the market's attention shifts to prospects for FY13 in case the February reporting season proves underwhelming, as seems to be the general expectation.

Remain prepared for big changes to any of the above over the next five weeks. After all, that's what reporting seasons are meant to do: recalibrate market expectations with day-to-day reality.

(This story was written on Monday 30th January. It was published on the day via an email sent out to paying subscribers of FNArena).

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