When Corporate Results Matter Less (For Now)

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

By Rudi Filapek-Vandyck, Editor

Love it or loath it, but it won't make the slightest difference: this share market wants to go higher. Already, equity strategists have been lifting their expectations and targets for the calendar year ahead. This is remarkable since we're still less than one month into the New Year. Even then: revised targets of 5000-5200 are only 100-300 points away from where the ASX200 closed on Monday. This represents further upside potential of 2-6%, assuming those targets prove accurate and assuming there won't be any further increases.

So far, share prices in Australia have rallied their way higher on a perceived reduction in macroeconomic risks, on more quantitative easing from central bankers in the US and in Japan, on improved economic data from the US, Germany and China, on a mildly better than expected reporting season in the US and on a global switch out of cash and government bonds into equities; everything else but corporate earnings growth.

This, obviously, is not a sustainable phenomenon. Regardless of what happens overseas, Australian equities will at some point require earnings growth to justify the re-rating that has occurred since last year. Problem is nobody knows when that moment is due. Will it be during the local reporting season in February? That could be a problem.

Maybe all this rally requires is merely the absence of negative events rather than the emergence of strong corporate profits? Investors with a positive outlook will be hoping this is the case as the chances for significant surprises to the upside during February are widely considered unlikely. So maybe no big negative surprises in combination with positive hints about the outlook for the rest of the year can keep this positive momentum alive?

Supporting the view that corporate results in February might not sap investors' enthusiasm is the observation that, contrary to the final months of 2012, ASX-listed companies have not shaken market confidence in January via additional profit warnings or otherwise negative announcements. Yes, we had yet another profit warning from Perseus Mining ((PRU)) and it wasn't exactly pretty what Sims Metal Management ((SGM)) announced, while retailer Noni B ((NBL)) and a handful of smaller miners disappointed with their December quarter updates. But that's been it, so far.

A good omen for the February reporting season?

As things stand right now, forecast average growth in earnings per share (EPS) for the ASX200 sits at 3.7% for the year to June 2013. With projected earnings recoveries mostly starting in the second half, which is the present half calendar year, this leaves ample room for dismal reporting with a "tomorrow will be better" attachment to it. Rio Tinto ((RIO)), for example, might well report a CY12 profit dive of 50% in USD numbers, but consensus sees a strong recovery of +40% this year. The numbers look far less ominous for peers such as BHP Billiton ((BHP)) and Fortescue Metals ((FMG)) but they will still be enjoying the current six months period as part of their financial year to June.

The all-important number at this stage is 14.1%; that's the EPS growth number anticipated for the ASX200 in the twelve months between July this year and June next. On FY13 projections, the share market is now trading on a Price-Earnings multiple of just below 15, which under normal circumstances would have all kinds of alarm bells ringing. This might still be the case, at some point, but if those FY14 growth projections prove accurate the market PE drops to 13.2 which leaves a lot more room to pick and choose and to rally higher.

There are quite a number of companies for which FY14 could turn into a profit-boom year. Alumina Ltd ((AWC)), for example, is projected to nearly double its EPS that year (up 97%), while Boral's growth for that year is currently projected at 92%. And these aren't even the highest projections available.

Investors should note that when it comes to average EPS growth projections and average PE ratios for the Australian share market, FNArena corrects all calculations for outliers. This means that the numbers you just read might be a little different from numbers oft quoted elsewhere, but we believe ours provide a much more accurate assessment.

In the short term, upcoming earnings reports might count for less than they usually do, but they cannot be completely dismissed. Things change after a grave disappointment and equally so in case of a significant surprise. Regardless of the context or circumstances, every reporting season will provide both negative and positive surprises. With many stocks trading on seemingly elevated PEs going into February, investors might still be inclined to pull the trigger first and reassess later in case of an unexpected negative surprise.

Analysts at Goldman Sachs are of the view that overall earnings growth will be soft in February and the bias is likely to remain to the downside. They suspect additional disruption from recent weather events on top of what have been relatively weak indicators for the domestic economy. On Monday, insurance stocks were sold down following tornadoes and floods in Queensland and NSW. Goldman Sachs thinks investors should focus on three possible opportunities in the Australian share market:

– companies likely to surprise to the upside in February
– companies looking reasonably valued vis-a-vis the growth path ahead
– re-rating of stocks offering strong growth throughout the cycle

As far as the first category is concerned, GS has lined up Transfield Services ((TSE)), Boart Longyear ((BLY)) and Select Harvests ((SHV)) as candidates most likely to deliver a positive earnings surprise in February. GS had also selected Insurance Australia Group ((IAG)) and Suncorp ((SUN)) but given the weather-related events over the long weekend, this may no longer be accurate.

On the other hand, companies poised to surprise in a negative sense, according to GS, include Cochlear ((COH)), Transpacific Industries ((TPI)), Downer EDI ((DOW)), Sedgman ((SDM)), UGL ((UGL)), FKP Property Group ((FKP)), M2 Telecommunications ((MTU)) and Western Areas ((WSA)).

In addition, GS has lined up companies whose EPS projections this year rely on a bigger than usual performance in the second half. These companies include Sims Metal Management, Treasury Wine Estates ((TWE)), UGL, Stockland ((SGP)), ASX ((ASX)), Calibre Group ((CGH)), WHK Group ((WHG)), Coventry Group ((CYG)), Matrix Composites & Engineering ((MCE)), Kathmandu ((KMD)), Oakton ((OKN)), Hills Holdings ((HIL)), Breville Group ((BRG)) and Norfolk ((NFK)).

And which stocks still look reasonably valued in the eye of strong growth ahead? GS has nominated Asciano ((AIO)), ANZ Bank ((ANZ)), Orica ((ORI)), WorleyParsons ((WOR)), Arrium ((ARI)), Beach Energy ((BPT)), Primary Healthcare ((PRY)), Regis Resources ((RRL)) and Suncorp. Again, we have to assume the inclusion of Suncorp goes beyond the matter of whether climate change might be affecting the insurer's business more than in the past in the years ahead. I would argue that at the very least the risk profile has shifted higher up the risk ladder for insurers in general.

Quant analysts at Macquarie conducted a similar exercise as at GS and they selected Caltex Australia ((CTX)), Henderson Group ((HGG)) and Westfield ((WDC)) as companies likely to deliver a positive surprise in February.

Companies trading on a high PE and likely to surprise to the downside include, according to Macquarie, Alumina Ltd, OZ Minerals ((OZL)) and Macquarie Atlas Roads ((MQA)).

On Macquarie's research, shares in companies that positively surprise on average outperform by 3.6% in the forty days after the event. Company's that disappoint see their share price on average underperform by 1.5% over the following forty days. These averages have been calculated since 2011. However, acknowledge the analysts, given valuations for many stocks are much higher today, the number to the downside might well turn out larger this time around.

Macquarie points out defensives in particular are trading on meaty valuations, which makes for added vulnerability in case of negative news. This observation is offset by Goldman Sachs' prediction that companies that can deliver consistent growth throughout the cycle will be rewarded with an additional valuation premium in the year(s) ahead.

I fully agree with that last assessment and would argue the past few years have shown exactly that. This is why shares in CSL ((CSL)) are trading on a PE of 23 and ResMed shares on a PE of 21, to name but two examples.

Last week I wrote the biggest upside potential remains among stocks that have been out of favour and are now regaining their former mojo. For this particular segment of the share market (relatively larger than usual at this stage) a small change in dynamics can make for significant changes in valuations and investment returns.

The Australian Broker Call Report on Monday provided the following examples:

– BA-ML raised earnings forecasts for Goodman Fielder ((GFF)) and as a result the target price moved from $0.40 to $0.80 (current share price: $0.69)

– JP Morgan increased its target for Perpetual ((PPT)) to $32.73 from $26.81 (+22%). Macquarie raised its target to $35 from $29.19 (+19.9%). Unfortunately, the share price already is at $38.75.

– JP Morgan raised forecasts and the price target for Prime Media Group ((PRT)). Target moved to $0.98 from $0.89 (+10%). The share price is currently at $0.98.

– Citi raised its target for Specialty Fashion Group ((SFH)) to $1.10 from $0.75 (+46%). Current share price is at $0.94.

These examples not only show the big differences that can occur when analysts shift from bear market scenarios to a little more optimism, but also that in many cases the anticipated upswing is already reflected in today's share price. This makes the outlook for profits in FY14 and beyond even more important.

Monday's Broker Call Report also nominated SMS Management and Technology ((SMX)) and Telecom New Zealand ((TEL)) for likely disappointments in February.

(This story was written on Monday, 29th January 2013. It was published on the day in the form of an email to paying subscribers)
 

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website) 

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Rudi On Tour in 2013

– I will visit Melbourne in February for a presentation on invitation by the local AIA branche. Title: "The Big Confusion that is the share market". When: Tuesday 19th February 2013. Where: Telstra Conference Centre, Level 1, 242 Exhibition Street, Melbourne

– I will visit Perth in March for two presentations on Tuesday March 5 (AIA) and on Thursday March 7 (ASA)

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