Rudi’s View: Lessons To Learn From An Unusual Reporting Season

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– The Great Disconnect
– An Avalanche Of Broker Downgrades
– Trends Beyond Debate
– Notable Beats And Misses
– All-Weather Performers
– Recent IPOs
– The Final Verdict

By Rudi Filapek-Vandyck, Editor FNArena

There is a reason as to why investors spend a lot of time digesting and analysing corporate reports twice per year in Australia. In the end, while we can all theorise and speculate as much as we like, bottom line is the value and direction of what we own in the share market is determined by how much cash (dividends) and profits (PE ratios) a particular company is able to generate. And we only find out when interim or final financials are released.

Viewed from this perspective, the recent February reporting season has been one of the most unusual in recent times. With so much impact from movements in government bonds, reserve banks lowering rates (including the RBA), currency movements and market positioning by investors, at times it genuinely seemed like corporate reports played second or even third fiddle, at best.

While short term price movements may not be the best guide available (in particular not with so many macro influences), investors with a longer term horizon may still want to pay attention to the various trends and, yes indeed, "revelations" that have been confirmed during the past four weeks.

The Great Disconnect

The mantra for investing in the share market is that, ultimately, it all comes down to company profits. Not so this year. At least not on macro level (we deal with the micro further down).

Below is a projection of average growth in corporate profits as published by analysts at Deutsche Bank late in 2014. It points to one very good reason as to why investors should expect a better outlook for Australian shares: corporate profits for FY15 & FY16 are looking noticeably better than they have done at any other time since the GFC, with exception of that one single year when resources had their final hallelujah.

Unfortunately, things have gone seriously pear-shaped since Deutsche Bank released that chart. Falling metals prices, falling bulk commodities, falling energy prices, more cost cutting, consumers staying on a cautious course… earnings forecasts in Australia have been in serious decline since late 2014 and the decline has continued in February. In so far as that on many a strategist's calculation, the average growth in earnings per share for the Australian share market has now fallen to be at or near zero.

Meaning: despite widespread anticipation that FY15 would herald a better environment for corporate profits, it has all but vanished in a matter of weeks. Unless there's a turnaround in the months ahead, the average might not even stay above zero.

This is where things get interesting. Working with market averages is dangerous under the best of circumstances, it is extra-extra dangerous when we are dealing with a market that is as polarised as the Australian share market. Look beneath the averages and what do we discover? The sharply negative trend for everything resources (miners, explorers, energy companies) and for resources related sectors (services providers, transport and logistics) is taking away the gloss from financials and industrials.

If we only concentrate on the latter two sectors, then the underlying trend is looking pretty good.

Analysts at UBS have illustrated the underlying divergence with the two charts below. I think the "evidence" speaks for itself.

Time to point out contradiction number one: resources stocks as a group have been the best performing during the February reporting season. This seems rather odd given the predicted, and delivered, heavy falls in profitability. There are a few easy points to make here:

– expectations had weakened significantly ahead of the reporting season, and short positions had built up too
– in many cases companies surprised through rigorous cost cutting, reductions in spending and reporting "not as bad as feared"
– many resources stocks are joining financials and industrials in becoming attractive from a dividend/yield perspective

All in all, profit forecasts for Australian companies have remained largely intact for FY16. This also applies to the resources sector. No doubt this is inspiring bargain hunters today as many a share price looks cheap on FY16 forecasts. Of course, any cynic would point out this was also the case on FY15 forecasts, until a few months ago. (Only investors with suitable risk appetite need apply).

A special mention regarding the in-house calculations at FNArena. Instead of relying on "dumb" averages, we always exclude blatant outliers from our own averages and calculations. Usually, this means that FNArena's profit forecasts are below averages published elsewhere, while PE ratios tend to be higher. This year, however, our average EPS growth forecast for FY15 sits well above calculations at stockbrokers and investment bankers, at 6.5%. For FY16 our consensus calculation shows nearly 11% growth in EPS.

Apart from the obvious differences in sample size and compilation (FNArena uses eight stockbrokers applied to the ASX200, brokers often use their own coverage), I think getting rid of the outliers, which in this case means many resources and related stocks, is providing FNArena's calculations with a more accurate, underlying growth outcome. Average dividend yields are 4% for FY15 and 4.3% for FY16.

In terms of average Price-Earnings ratio, FNArena's (cleaned) calculation shows the market's PE for FY15 is approaching 19, but on FY16 forecasts the PE sits at 16.2. This is in line with PEs published elsewhere, confirming the Australian share market is not at all cheap. The long term average PE is somewhere in between 14-14.5.

An Avalanche Of Broker Downgrades

Market strategists at UBS lowered their estimates for bond yields post the February reporting season. The reason as to why I point this out is because at the start of the calendar year, those strategists had a year-end fair value target for the ASX200 of 5700. Incorporating lower bond yields in their modeling has pushed up the target to 5900. That's pretty much where the index sat earlier this week.

UBS is not the be all and end all when it comes to modeling fair value for the Australian share market, but these strategists are not ultra-bearish China, the Australian economy or corporate profits. At the very least, this should give investors some food for thought.

Supporting UBS' assessment is the stockbroking analyst community in general. During the reporting season in February, FNArena registered no less than 118 rating downgrades for stocks and only 38 upgrades. This gap is exceptionally wide, in particular given analysts had been busy downgrading already in the weeks leading up to the reporting season.

As a comparison, during August last year, analysts issued 86 downgrades and 52 upgrades. In February last year there were 74 downgrades and 64 upgrades. In August 2013 the numbers were 86 down and 61 up.

What is a positive is that price targets, on simple average (not cap-weighted), rose by 5.5% , which is up there with the best reporting seasons and more than twice the 2% increases registered in August last year and in August 2013. February 2014 saw targets rise by 5.3%. Offsetting this is the observation the index has risen by nearly 10% and many share prices are up by double-digits.

Trends Beyond Debate

– companies leveraged to housing continue enjoying wind in the sails
– the tide has turned for general insurers, but luckily many of them pay high dividends and potentially some extras
– industry dynamics are toughening for food and liquor
– very patchy performances for companies dependent on consumer spending
– you don't want to be reliant on capex from miners and energy companies. No, you don't
– things seem to be going slightly less smoothly in the telco sector
– with exception of CommBank ((CBA)), most banks underwhelmed (but few investors actually cared)
– industry dynamics have toughened for private health insurers
– (most) airlines are having the time of their lives
– in vitro fertilisation is not a guarantee for success
– salary packaging remains an excellent growth sector (too bad about the Canberra risk)

In a more general sense, top line growth remains a challenge and profit growth often is achieved on the back of lower costs and reductions in spending. Dividend payout ratios continue to rise, but this is more related to the fact that resources companies have now joined the trend as well.

Note, for example, the updated dividend guidance by BHP Billiton ((BHP)) implies the company will pay out 100% of its estimated profits in FY16.

Notable Beats And Misses

Every reporting season generates big beats and misses. This year's February shall be remembered because of disappointments, and subsequent share price sell-offs, from Woolworths ((WOW)), iiNet ((IIN)) and Ardent Leisure ((AAD)). All three had been popular and outperformers in recent years.

Remarkable was the share price performance of CSL ((CSL)) with investors first selling the stock down after management guided the market towards a slower pace of growth (10% instead of 12%), but the recovery was swift and rapid and CSL shares ended up trading above the price level prior to the profit warning.

Other notable disappointments came from Pact Group ((PGH)), Seek ((SEK)), Carsales.com ((CAR)), BlueScope Steel ((BSL)), Insurance Australia Group ((IAG)), Navitas ((NVT)), Transpacific Industries ((TPI)) and Suncorp ((SUN)).

One key difference with past reporting seasons in February were the sharp rallies to the upside in many instances of positive surprises. Amongst the surprises delivered were Adelaide Brighton ((ABC)), BHP Billiton and Rio Tinto ((RIO)), Caltex ((CTX)), Crown Resorts ((CWN)), Harvey Norman ((HVN)), Orora ((ORA)), Qantas Airways ((QAN)), Ramsay Health Care ((RHC)), ResMed ((RMD)), and Tabcorp Holdings ((TAH)). The stand-out positive surprise goes to Domino's Pizza ((DMP)), widely considered too expensive to touch and then rallying to the moon on the day of the results release (and holding on to its gain).

February also saw remarkable come-backs from companies that had been out of favour for a while, including Flight Centre ((FLT)), AMP ((AMP)) and Flexigroup ((FXL)). If there is a Lazarus prize for a stock that has risen from the dead, it has to go to QBE Insurance ((QBE)), with investors happy to assume the worst is finally over, even as the insurer still didn't manage to quite meet its own guidance delivered in December. A similar theme made Coca-Cola Amatil ((CCL)) one of the stronger performers too.

When it comes to genuine corporate turnaround stories, alas, the verdict proved rather negative with more disappointment coming from GWA Holdings ((GWA)), Transpacific Industries, Salmat ((SLM)) and Hills ((HIL)), not to forget most contractors and engineers dependent on capex by miners and energy producers.

All-Weather Performers

One consistent theme of reporting seasons post-GFC is that strong business models continue to generate strong results. Think Domino's Pizza, and Ramsay Health Care, and REA Group ((REA)). Many of these consistent performers are part of my selected All-Weather Performers in the Australian share market. Most of these companies continue to exhibit solid growth, though February has seen a few changes that are worth highlighting:

– with two out of three online media companies (carsales.com and Seek) not quite living up to expectations, overall investor interest for the sector has dropped
– A similar observation can be made for CSL, though a brief sell-off (twice) has thus far not dented investor enthusiasm. Quite to the contrary
– G8 Education ((GEM)) remains out of favour
– Many of these All-Weather Performers have made double-digit gains since January 1, though none of them was particularly cheaply priced. Think Invocare ((IVC)), Ansell ((ANN)), Blackmores ((BKL)) as well as Domino's Pizza and Ramsay Health Care, and others
– The former observation implies many of these stocks continue to outperform the broader market, after having done exactly that for many years now
– All-Weather Performers can still fall victim to changing market dynamics and this season the demise of Woolworths shows exactly that

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Recent IPOs

The Australian share market has seen an outburst in new listings and spin-offs in the year past and many of these "new" names are building a positive legacy already, beating expectations and/or forecasts printed in IPO prospectuses. A number of these companies is on my radar for two reasons. Firstly, some of them have All-Weather potential. Secondly, being unknown often means undervalued, until, of course, an excellent report forces investors to pay attention.

A number of such companies comes with a healthy dividend yield, as long as the PE isn't too high. Here's an incomplete list of recent IPOs that, in my view, stood out during results season in February: 3P Learning ((3PL)), APN Outdoor Group ((APO)), Asaleo Care ((AHY)), Burson Group ((BAP)), Capitol Health ((CAJ)), Cover-More ((CVO)), Godfreys ((GFY)), Healthscope ((HSO)), IPH Ltd ((IPH)), iSentia ((ISD)), Japara Healthcare ((JHC)), Life Healthcare ((LIC)), Mantra Group ((MTR)), oOh!Media ((OML)), Orora, Pact Group, Regis Healthcare ((REG)), SurfStitch Group ((SRF)) and Veda Group ((VED)).

The Final Verdict

All in all, investors can thank the RBA, and dozens of central banks across the world, for an excellent start to calendar year 2015. The February reporting season was rather disappointing with the climax of a big profit warning by investor staple Woolworths on the final day of the month. This certainly is a view shared by most strategists at stockbrokers who have reviewed the hundreds of corporate reports that were released in February. Underlying, however, industrial companies are stealing the show.

Below are two updated overviews as published by Macquarie earlier this week. Observe how projected EPS growth for the market in general is approaching zero in the first table (even though industrials are putting in more than their fair share). The second table shows how yields have converged in the Australian share market, across all sectors. This is an important observation. In my view, this is now a strong argument in favour of a switch in investment strategy. More about this in next week's Weekly Insights.

Note to subscribers: FNArena kept a diary of beats and misses throughout February with stats, changes and some commentary, all lined up in Excel. This Reporting Season Monitor can be downloaded – see top of this story.

(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.)  

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