August Reporting Season 2016: Valuations Versus Earnings

This story features DOMINO'S PIZZA ENTERPRISES LIMITED, and other companies. For more info SHARE ANALYSIS: DMP

 In this week's Weekly Insights:

– August Reporting Season 2016: Valuations Versus Earnings
– Rudi On Tour
– Nothing Ever Changes, Or Does It?
– Rudi On TV

August Reporting Season 2016: Valuations Versus Earnings

By Rudi Filapek-Vandyck, Editor FNArena

When it comes to investing and the share market, things rarely are what they seem like at face value and this year's August reporting season in Australia is not any different.

At first glance, the market is taking an extremely rose-tinted view on falling bond yields and further central bank action. The Australian share market just closed off its best month in a long while gaining no less than 6.28%, but the Price Earnings (PE) ratio now sits in between 19x and 20x for industrials ex-banks.

The FY17 PE for the ASX200 sits now above 16x; even at historically low bond yields this seems a long way off from the 14.5x long term average.

And for the first time since FY08-FY09, Australian companies are poised to report back-to-back negative profit performances. Take out the resources sector, however, and things don't look so bad. Besides, resources are projected to deliver plentifully in the growth department in the years ahead.

An alternative approach, and certainly one that has spread widely throughout the local investment community over the past twelve months, is that a lot of the apparent negatives can be explained through Australia's Top Twenty.

Growth and opportunities instantaneously changed colour when we excluded the banks, major miners, oil & gas producers and supermarket operators, but this is by now also reflected in relative valuations. The banks look even cheaper than they did last year, but does this automatically mean they represent better value?

A lot shall depend on the actual figures and guidance when financial reports are being released this month. An encouraging sign is the preceding "Confession Season", when companies who come to realise they are not going to meet their own or market expectations have to come clean publicly; this year has been noticeably benign.

There was the occasional warning from the likes of Asaleo Care, or from Silver Chef, or Cimic Group, but overall the weeks past have been rather quiet. Most resources companies issued strong production reports for the June quarter.

The scarier observation is share prices for those companies who did confess got pummeled, with no immediate sign of a serious attempt to recover. So elevated valuations do matter, at least in scenarios when companies fail to deliver. An alternative blue guide was provided by GUD Holdings last week.

At first assessment, the weaker operations disappointed yet again, and the share price weakened, a little. On second thought the core automotive business is strong and full of promise and management is looking to divest commercial storage and racking business Dexion anyway, so the share price recovery was quick, swift and forceful.

Herein lies the dilemma for investors as the August reporting season is about to ramp up. Is it time to worry about stocks on historically stretched PEs? The communis opinio seems to think the answer is "yes".

But we all know a (seemingly) low valuation with low expectations does not automatically mean guaranteed success. Plus there will be plenty of companies trading on High PEs who will surprise to the upside. Domino's Pizza ((DMP)) is still being nominated by analysts as likely to do so this month, would you believe it. And so is Sydney Airport ((SYD)).

To further complicate things, all of REA Group, Carsales and Seek disappointed in August last year, share prices subsequently fell, but one year later all are trading higher and all have outperformed the broader market. Regardless, elevated PEs have many an investor nervous and, so my gut feel tells me, trigger happy at the start of what is likely to be an eventful four weeks.

Market strategists at Macquarie point out companies that positively surprised since 2010 subsequently generated on average an excess return of 7.54% in the twenty trading sessions either side of the reporting date while for those delivering a negative surprise ("disappointment") the relative underperformance is -4.29% .

Below is a pre-assessment of what likely lies ahead on the basis of analysts' and strategists' previews to the August reporting season.

Australian Banks

Earnings expectations for Australian banks remain under pressure ahead of FY reports by CommBank ((CBA)) and Bendigo and Adelaide Bank ((BEN)) as well as trading updates by three other majors. Banks are still mixing tailwinds (repricing mortgages, cost cutting) with headwinds (funding costs, increasing competition, NIM pressure) hence August should not be too bad, except maybe for "Bendelaide".

The pressure remains to the downside for the sector overall and clearly it is now far easier to be a major bank than to be a regional lender.

Banks have underperformed both other yield beneficiaries and the broader market and one reason for this might be because the likes of Citi's banking research team believe the toughest year since the GFC downturn still lies ahead for the sector. Most analysts anticipate stable dividends for many years to come, except maybe for National Australia Bank and Bendelaide which are both believed to be on (potentially) unsustainable payouts.

These forecasts can be proven wrong, of course, but not this month. Cheap for a reason appears to be the most logical conclusion to draw.

While few analysts anticipate a genuine disappointment from the banks this season, even fewer see a swift turnaround in the sector's persistent underperformance, except maybe in case of yet another rally for yield stocks in a general sense.

Resources

Miners and oil & gas companies have weighed upon the market's growth potential over the past two years, keeping the market's average firmly in the negative. For a few months, the sector has been making a come-back, assisted by analysts upgrading expectations on the basis of higher-than-expected prices for iron ore, coal, gold and the likes.

Extreme valuation discounts are no longer in place, but analysts are still prepared to acknowledge the risk seems to be to the upside for this segment of the market.

Santos ((STO)) is often quoted as likely to deliver a surprise through better-than-expected ramp up of GLNG and Woodside Petroleum ((WPL)) is believed to announce a larger tax benefit. Continued outperformance will remain at least partially dependent on the macro picture and on price movement for commodities in the months ahead.

Many remain skeptical about iron ore's resilience, while being confounded by crude oil's present weakness. Forecasts for gold are still receiving upgrades, but not so for base metals. What could work in the sector's favour is most analysts are working off lower prices estimates.

The Philippines' controversial new populist leader, Rodrigo Roa Duterte, keeps market expectations buoyant for nickel. Oz Minerals ((OZL)) should announce a share buyback.

Engineers and contractors have seen investor funds flow back into the sector this year, but analysts remain largely skeptical. Their advise is to pick and choose, and to do it carefully.

Experts at Ord Minnett nominate RCR Tomlinson ((RCR)) as one to keep an eye on. The upcoming results should look awful, but it should also mark the low point. The company has re-directed its efforts towards the solar sector and should enjoy a better looking future from here onwards.

A-REITs, Infrastructure And Building Materials

They might look expensive and over-stretched, but sector analysts remain of the view most reported financial results should look solid, with few (if any) nasty surprises. As said, Sydney Airport is seen as a candidate to deliver a positive surprise and so is Dexus ((DXS)).

Investors looking for "better value" are guided towards Mirvac ((MGR)), Stockland ((SGP)) and Lend Lease ((LLC)) with building materials in general still enjoying solid momentum.

Expensive Defensives

They used to be dull and colourless, now they are super hot and wanted by everyone; defensive stocks that seldom deliver a genuine shocker, while growing profits and dividends at steady pace. Amcor ((AMC)) is believed to once again prove its defensive mettle this month, but it is offshoot Orora ((ORA)) that is seen carrying upside surprise potential.

InvoCare ((IVC)), on the other hand, might not meet expectations due to milder weather and a relatively benign flu season. There are still question marks about the US expansion too.

Bapcorp ((BAP)), formerly known as Burson Group, is a prime suspect for delivering potential upside surprise too.

Healthcare Sector

Healthcare stocks are part of the Expensive Defensives in Australia and many an analyst worries share prices for the likes of CSL (CSL)) and Cochlear ((COH)) have by now run well ahead of what the companies can possibly deliver this month. Not making matters any easier is some analysts believe Cochlear remains poised for an upside surprise.

Medibank Private ((MPL)) still has room to surprise on the upside, say analysts, and momentum remains strong for IVF clinics.

High PE Stocks

Domino's Pizza surprised last year and remains a prime candidate to do it again this year. But all of REA Group, Carsales and Seek didn't quite deliver what investors were looking for and their share prices were punished as a result. Shaw Stockbroking recently reminded investors the same occurred in August 2014.

The stockbroker understandably has urged its clients to be cautious vis-a-vis elevated PEs that have kept on rising in July. Deutsche Bank has downgraded REA Group to Sell.

Diversified Financials

The sector is no longer seen as a hotbed of outperformers, even though global equity markets have outperformed expectations recently. Funds managers are battling tougher times, and the same holds true for insurers who also feel the pain from ever lower bond yields.

Challenger Financial ((CGF)) remains everyone's favourite, while no one wants a piece of Computershare ((CPU)) these days. QBE Insurance ((QBE)) is regularly mentioned both in negative and positive context of expectations.

Stocks that are persistently being mentioned as poised for a potential positive surprise (in addition to the ones mentioned above):

Bellamy's ((BAL)), Beach Petroleum ((BPT)), BlueScope Steel ((BSL)), Corporate Travel ((CTD)), Harvey Norman ((HVN)), JB Hi-Fi ((JBH)), Link Administration ((LNK)), NextDC ((NXT)), oOh!Media ((OML)), Origin Energy ((ORG)), Qantas ((QAN)), Star Entertainment ((SGR)) and Webjet ((WEB)).

Stocks that are persistently being mentioned as a prime candidate for a nasty disappointment (in addition to the ones mentioned above)::

Ainsworth Gaming ((AGI)), Ansell ((ANN)), Coca-Cola Amatil ((CCL)), Computershare ((CPU)), Monadelphous ((MND)), Myer ((MYR)), Navitas ((NVT)), Sandfire Resources ((SFR)) and Sims Metal ((SGM)).

Stockbroker Moelis sees a short term opportunity in Shine Corp ((SHJ)) while Goldman Sachs initiated coverage on Lifestyle Communities ((LIC)) with a Conviction Buy alongside a price target of $4.00. Another key change from the past is that Coles ((WES)) should report a higher operating margin than Woolworths ((WOW)). Qantas should announce the return of dividends.

Rudi On Tour

I will be presenting:

– At the Australian Investors' Association's (AIA) National Conference in August on Queensland's Gold Coast.

– To Chatswood chapter of Australian Investors' Association (AIA) on September 7, 7pm, Chatswood RSL

– To Perth chapters of Australian Investors' Association (AIA) and Australian Shareholders' Association (ASA) on 7 February 2017

Nothing Ever Changes, Or Does It?

Yes, of course, investing in the share market is never really different and best working strategies today are the same that worked pre-GFC. Seriously. I tell you, seriously.

Now that we had a good laugh about it, let's get straight to business. This is a low growth environment. Has been since 2010 (it was masked at the time because of the V-shaped recovery from the global recession) and it is not likely to change fundamentally in the near term. I wrote a book about this (see below). This means investment strategies must adapt. You'll be turning your portfolio into a wish list for dinosaurs otherwise (and your returns will be a reflection of it).

Those not afraid to contemplate "this time is different" can subscribe to FNArena and read all about it in our bonus eBooklets 'Make Risk Your Friend' (free with a paid 6 or 12 months subscription) plus the freshly published eBook 'Change. Investing in a low growth world' (equally free with subscription, or available through Amazon and other online distributors).

Here's the link to Amazon: http://www.amazon.com/Change-Investing-Low-Growth-World-ebook/dp/B0196NL3KW/ref=sr_1_1?s=digital-text&ie=UTF8&qid=1454908593&sr=1-1&keywords=change.investing+in+a+low+growth+world

See also further below.

Rudi On TV

– On Tuesday, around 11.15am, on Sky Business, I shall make a brief appearance through Skype-link to discuss broker ratings for less than ten minutes
– I will be appearing as guest on Sky Business, 12.30-2.30pm, on Thursday
– On Friday, around 11.05am, on Sky Business, I shall make a brief appearance through Skype-link to discuss broker ratings for less than ten minutes

(This story was written on Monday 1st August 2016. It was published on the day in the form of an email to paying subscribers at FNArena).

(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.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via Editor Direct on the website).

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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow. This book should transform your views and your investment strategies. Can you afford not to read it?

Subscriptions cost $380 for twelve months or $210 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): https://www.fnarena.com/index2.cfm?type=dsp_signup

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