REPEAT Rudi’s View: Watch The New Trend In Corporate Profits

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FNArena editor Rudi Filapek-Vandyck shares his insights and analyses on a regular basis with paying subscribers via stories labeled 'Rudi's View'. On occasion, one of these stories is shared with non-paying members and with readers elsewhere. This is one such occasion. The story below was originally written and published on Wednesday, May 5, 2010.

By Rudi Filapek-Vandyck, Editor FNArena

Greece, Australia's tax proposal for super profits for miners and a general retreat in risk appetite are catching most headlines across the globe these days, and they are all mentioned as the reasons why equities and commodities have rolled over while rolling into May.

As per usual, I beg to differ, and I beg to differ profoundly. What is happening right now is the fallout that should be expected when everyone jumps on board of the same ship (over-leverage and over-exposure) while pushing up asset prices to lofty heights (pricey valuations), meaning there simply is no room for doubt or disappointments, or else.

High asset valuations, be it sugar, oil, nickel or otherwise, are best compared to stocks that trade on high Price-Earnings ratios. As long as high growth and positive surprises continue to feed upward momentum, there's plenty of upside to keep an ever growing base of groupies and fans happy and satisfied. But beware when the first bumps on the road start impacting on the speed moving forward.

Last week, I pointed out that upgrades to corporate earnings in Australia had unexpectedly come to an end in April. You wouldn't have read much about this elsewhere, but I'd like to again take the opportunity to emphasise the importance of this observation.

Ultimately, and despite all the media's attention for political issues, economic data and temporarily important matters such as funds flows, interest rates and new taxes and laws, what really matters for share markets is what kind of profits investors can expect from listed companies.

Some of Australia's prime export products -coal and iron ore- are enjoying near unprecedented favourably market conditions. The fact that underlying profit growth for the 200 largest companies on the Australian Stock Exchange ceased lifting higher in April is thus of major importance.

To put it simply: if April marks the reversal from upgrades to downgrades for corporate earnings forecasts this will not reflect well on the share market going forward. Remember that on this year's profit forecasts (FY10) the share market looks well overpriced trading on an average Price-Earnings ratio of circa 16.5 – well above the long term average of 14-14.5.

The only reason why such a high multiple is in place, and why it can be regarded as acceptable, is because of high expectations for fiscal 2011. In other words: investors were happy to hold on to their stocks even though these stocks look expensive on this year's profit estimates, but only because next year's jump in profits will reduce relative valuations for these stocks to a far more acceptable level.

What follows next is an open question about what price exactly investors should be willing to pay on the basis of earnings projections for 2011. Most of this is pretty much academic stuff, as most investors buy shares because they are moving up and most shares will move up as long as market expectations are on the rise.

Rising earnings projections feed into positive market momentum because it makes shares look cheaper, hence the improved buyers' appeal.

Falling earnings projections, however, do the exact opposite. The best example I can offer in this regard takes us back to 2007 when I warned everyone who cared to pay attention the underlying trend in earnings in Australia had turned negative because of an ever appreciating Australian dollar.

But share prices kept on rising and rising, until it all came to an end into the following year.

Maybe we should say thank you to George Papandreou, to Kevin Rudd and to Hu Jintao for preventing share market valuations once again from getting too far ahead of themselves?

It is important to note that all of the above has occurred against a background of continuously improving economic indicators. The forward looking index from IHS Global Insight (“2009 Forecaster Of The Year”), for example, is now indicating the US economy will continue growing at a pace of at least 3% throughout September, and possibly longer. Only a few months ago this same index suggested US GDP growth would hold up until May, possibly until June, but after that the outlook was looking rather bleak.

Improving -and ultimately solidifying- economic fundamentals are without any doubt a positive for companies and for share markets. They take away the idea that economies are getting ready to fall off a cliff again in the near future. Witness, for instance, how predictions about a double-dip for the US or for Europe have all but disappeared.

Coming out of the abyss of the post-Lehman brothers international credit freeze, this process of economic recovery has translated into continuous upgrades to corporate earnings forecasts. This, in return, has underpinned positive sentiment which helped share prices recover from their troughs in March last year.

At some point, however, further economic growth does no longer translate into even higher profits. The best example for this are the Australian banks, world class members by anyone's standard. Profit results so far this reporting season have mostly exceeded market expectations, but the impact on future estimates has been benign (at best). This while valuations for Australian banks prior to this week's sell-off seemed pretty full, on FY11 projections.

The key question regarding the Australian share market is now whether April will simply turn out a pause in an ongoing up-trend, or whether this really is “it”.

If this is as far as it goes for next year's profits in Australia, then this is in itself nothing to be sour about. Apart from resources companies, most Australian companies never saw their profits disappearing at the same rate as companies in the US and Europe did during the Global Financial Crisis.

Coming back with a (projected) profit improvement of some 6% on average this year, followed by 17% next year is something most CEOs (and investors) usually would instantly sign up for. But we are now facing two problems: trend and valuation.

At 4674, the Australian share market is currently trading at an estimated 14 times FY11 average earnings per share (EPS). A few weeks ago the index was closer to 5000 and the average multiple for Australia's top 200 stocks was also 14. That was courtesy of the fact that the average projected jump in earnings per share for FY11 stood above 19%. Today this number has fallen below 18%.

Investors should note these numbers are averages and do not take into account significant differences between companies. Certainly, the sell-off from 5000 to current levels has again created upside potential for most banks. In addition, resources stocks such as BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)) have seldom looked as attractive as they do today (on pure valuation metrics).

Every day now I see securities analysts slicing more off their future earnings projections. That is a worry.

This would turn into a major concern if it turns out the Australian share market is leading the rest of the world in this. It is my understanding earnings projections in Asia and the US are still rising, though the rate of revisions has slowed down sharply. This earnings season in the US, for example, has reportedly added an average 3% to projected earnings per share.

Probably no wonder then the Australian share market has underperformed most international peers in April. What we have to find out however, is whether earnings estimates will continue falling in Australia and whether this will soon spread to other markets too.

I have a feeling the answer might be affirmative on both accounts. If correct, this means further upside for share markets should be less than most experts are modelling.

See also “Status Quo”, Weekly Insights, 23 April, 2010 and “Listen To What April Has To Say”, Weekly Insights, 03 May, 2010 (email in subscribers' inbox, available as a news story on the website from tomorrow onwards).

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.

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