REPEAT Rudi’s View: Lessons Learned And Observations To Remember

This story features TABCORP HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: TAH

This story was originally published on 11th August, 2010. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere.

Investors should approach results seasons as if they were about to cross a busy road: look both ways before leaving the footpath.

By Rudi Filapek-Vandyck, Editor FNArena

The Australian FY10 results season has only just started, but already there are some very valuable conclusions to be drawn. Number one, which should be obvious to everyone by now, is that the downward trend in earnings expectations is continuing in August.

This means earnings expectations are now in decline, on a net basis, since May; four months in a row.

For those investors who read FNArena's daily Australian Broker Call Report, this hardly comes as a surprise as most company reports, even those who seemingly beat the market at face value, tend to trigger a negative response with regards to future projections.

This is the true meaning of the quote above today's story: before crossing the road, one should look both ways. In results season this translates into answering the following two questions:

1. Have market expectations been met? (this relates to the past)
2. What is the overall impact on future projections? (this is the way forward)

Admittedly, question number two can only be accurately answered the following day when the next edition of the Australian Broker Call Report provides a detailed update on stockbroking analysts' responses, but subscribers can make an informed assessment on day one already.

This is especially the case during the August results season as most companies are reporting FY10 results and Stock Analysis on the website displays all consensus EPS and DPS expectations for the full year.

For those investors with an investment horizon beyond the next day in particular these assessments could prove of vital importance. Past experiences show companies disappointing the market more often than not continue underperforming the broader market for months after the results season has ended.

Given the fact that many stocks are still trading on rather lofty FY10 multiples (a fact casually forgotten by most market commentators) I would be inclined to think that meeting, exceeding or falling short of market expectations will trigger more pronounced market responses this month than is usually the case.

But, equally applies, that when companies manage to produce a genuine positive surprise, one that boosts future projections, they should be expected to outperform the broader market for months to come. Valuations permitting, of course.

(See Monday's dissertation on consensus price targets).

As expected, more downgrades than upgrades to earnings forecasts have occurred over the first ten days of the FY10 reporting season. However, the overall impact on my calculations prior to this season has been rather muted. I suspect this is because I already “cleaned” my data from the usual noise and aberrations beforehand which led me to project some 18-19% consensus EPS growth for FY11 instead of growth numbers of 24% or even 26% reported elsewhere. I would imagine the overall impact on these numbers has been greater already.

Some individual stocks have again taught investors some all-time, all-important lessons:

Tabcorp ((TAH)), for instance, has again shown that buying stocks simply because of their perceived high dividend yield is a strategy poised for failure. Tabcorp has been listed many times over the past year, not only in stockbroker reports, but equally so in newspapers and investment magazines, because of its high dividend yield.

Every time I shook my head.

How could I be so sure this was a disaster waiting to happen? Because there was no earnings growth to support an investment case for the shares. And there still isn't.

On current expectations Tabcorp should again post earnings decline at the end of the current fiscal year. FY12 should see growth (finally!), but that's still a long stretch into the future. First comes FY11 hot on the heels of a disappointing FY10.

The shares have now lost near 14% since December. Another tough lesson learned by those investors who only looked at the implied dividend yield, which has now run up to 8.2% for this year and to 8.5% for next (note: I always use consensus forecasts).

Even if these investors are happy with the annual dividends, the decline in share price keeps them trapped because they cannot sell without triggering substantial capital losses.

Don't just look at dividend yields, look at earnings prospects too. One without the other increases the odds for significant failure. Tabcorp has simply confirmed the rule adding to past investor experiences with Telstra ((TLS)) and others.

Having said all of the above, Tabcorp shares are now trading at forward multiples of around 8, while its implied dividend yield is now above 8%. I would not be surprised to see the stock actually outperforming at some point, especially with the overall share market looking very weak this week. (Tabcorp's share price performance this week is, however, not suggesting any such scenarios).

Another stock that drew my attention was Cochlear ((COH)), which should be of no surprise as in earlier analyses of Australian healthcare stocks I had already concluded this could be “the next CSL ((CSL))”.

This week's events have only strengthened my view.

It wasn't that long ago Cochlear shares were trading at $78, which might as well be compared with CSL's $38 price tag prior to the March 2009 share market rally. The ingredients are essentially the same: an excellent company, led by excellent management, with an excellent track record and many, many fans among financial planners, stockbrokers and investors.

But all this also leads to a high valuation for the share price. As I have tried to explain many times in the past: when growth forecasts fall these high multiple stocks are facing contraction in Price-Earnings multiples. The end result can be quite disappointing as every shareholder who held on to CSL shares throughout the share market rally since March 2009 has come to realise. Not only was there no participation in the upside since then, CSL shares today are still more than 12% below their $38 price level.

Analysts at Goldman Sachs this morning published another update following a conference call with so-called Group Purchasing Organisations for plasma in the US, as well as a proprietary survey on specialist doctors and IVIG usage.

Their conclusion: it remains too early to expect an industry turnaround just yet. Pricing growth for CSL should be of “limited” nature at best in FY11. I note consensus forecasts have now come down to 4% EPS growth only in FY11. The P/E ratio at 17 might well be below historical averages above 20, but so too is the projected growth potential.

I don't know whether Cochlear shares will follow into CSL's footsteps in exactly the same fashion, but what I do know is that the shares have now lost in excess of 10% since reaching above $78 in June. I also know that EPS growth is expected to halve to some 13% in FY11 and to some 10% in FY12.

In addition, I note that the PE ratio (FY11) has come down from 25 to 22 over the past few weeks and that still looks rather high with growth projections as they are. Should these multiples fall further to below 20 as has happened in the case of CSL? One would hope not on behalf of the many investors who listen to the positive recommendations that are being made across the market, but I fear it'll happen if and when the share market finds a more solid footing.

Post my Weekly Insights on consensus price targets on Monday, I also note that Cochlear shares have now fallen below their consensus price target, but only just (see Stock Analysis on the website).

When it comes to disappointing/better than expected corporate results, investors should always try to establish whether we are experiencing a one-off or a structural change. It goes without saying the second scenario carries a lot more weight.

Just so that we are all clear on this: the underlying trend in earnings expectations will remain negative this month, but it won't remove all upside potential.

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Lastly, some market commentators have been suggesting equity markets have been setting themselves up for a big sell-off in September as US investors will return from holidays only to find a much weaker economic environment than before.

Some subscribers have been asking about my view on this scenario. I have been responding by saying that share markets do not necessarily wait until September to slide lower. Judging by how things are developing this week, it would seem my warnings have been timely and correct.

Sometimes all an investor has to do is listen to the story the share market is telling and I think this week's story does not bode well for the immediate outlook. Treat carefully and be amazed, just like I am, that the confidence as exuded by many market expert only weeks ago that the US economy was now on a firm path of recovery has already been replaced by opposite scenarios.

It would appear that weeks of low volume rallies driven by short covering have been mistaken for increasing market confidence in some corners.

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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