All About Corporate Profits, Or Is It?

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In this week's Weekly Insights:

-All About Corporate Profits, Or Is It?
-Beware: Cheap For A Reason
-New Website: Earnings Forecasts
-Conviction Calls: Canaccord, Morgans, Macquarie, DB, and Wilsons
-2016 – L'Année Extraordinaire
-All-Weather Model Portfolio
-Rudi On TV

All About Corporate Profits, Or Is It?

By Rudi Filapek-Vandyck, Editor

Let's start the week with some good news: the proprietary leading indicator for US corporate profits at Morgan Stanley is pointing towards ongoing noticeable improvement.

This supports MS' strategists positive view on the outlook for US equities, suggesting share prices are a lot less elevated than they seem, in isolation, and further gains should be recorded in the second half of 2017, and in 2018.

Now that I have also touched upon the "valuation" of US equities; those worried US equities have rallied too far by historical standards can maybe take solace from Morgan Stanley's proprietary valuation model, which also incorporates extremely low bond yields, inflation and interest rates.

According to this modeling, US equities are nowhere near overvalued. In fact, they have failed to properly catch up with ongoing rising intrinsic value. Fair value, on Morgan Stanley's calculation, for the S&P500 is a little above 3000. The index is currently trading around 2433, implying a gap in excess of +20%.

Even if we don't agree with the strategists' view at Morgan Stanley this gap will be closing in the six to twelve months ahead, at the very least it raises a few questions about how easy it is to call the US share market overvalued, but that doesn't necessarily mean it is true. Or that a significant correction is forthcoming, for that matter.

Morgan Stanley's optimism does guide our attention towards the holy grail of share market investing: beyond the daily noise of corporate press releases and geopolitical events, eventually the direction of corporate profits should prevail.

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Morgan Stanley's assessment has by now received support from strategists at Citi who, independently, reported their own proprietary leading indicators for US corporate profits and for profit margins remain supportive for further gains in US equities.

Citi strategists do believe a switch in investor attention might be appropriate. Instead of using the FANG acronym, Citi talks about FANTASY stocks, a basket comprising of Facebook, Alphabet, Nvidia, Tesla, Amazon, Salesforce and Yahoo. These stocks have run hard to date, and valuations could act as an impediment to ongoing gains, suggest Citi strategists.

Both Morgan Stanley and Citi stress the recovery in corporate spending and earnings is much broader than FANG/FANTASY, and much broader than just Technology. Hence investors will simply have to broaden their horizon in order to properly participate in further upside.

At the same time, others like Societe Generale suggest the failure of delivering the promised tax cuts by the Trump administration looms as a potential black swan over positively minded equity markets. This is unmistakably a major risk, and share prices will take a dive come the moment Wall Street gives up on the near-term delivery of these tax cuts. But concentrating on Trump's potential failure(s) is missing the crucial point.

US corporate profits don't need extra stimulus or tax cuts to grow further.

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One major caveat for all predictions and projections for share markets in the months/year(s) ahead is that US bonds have thus far refused to move in line with predictions and by doing so, they have facilitated strong gains for growth stocks, in particular in the technology sector.

Last year, a major shift in direction for global bonds caused a rout in highly priced growth and reliable yield stocks. Think about what happened post August to the likes of CSL ((CSL)), Transurban ((TCL)) and REA Group ((REA)) in the Australian share market. However, a switch again in direction of bonds post February this year has allowed these stocks to fully recover, plus some.

The Big Unknown for the second half, and beyond, is whether global bonds might change direction again, and whether they will do it swiftly and in sharp fashion, or gradually and in a contained manner.

So far just about all predictions for the direction of longer term US bond yields have proven incorrect, and blatantly so. Two Big Factors that will determine the accuracy of any forecasts near term are: is inflation about to raise its head in the USA; plus are central bankers in Japan, China, the UK and Europe ready to abandon further stimulus?

The US Federal Reserve is preparing to start reducing its own balance sheet by no longer converting all expiring US bonds it currently owns through buying replacements, but it remains anyone's guess (speculation?) as to how this is going to affect bond yields.

One thing worthy to keep in mind is that if ten year yields in the US do not appreciate and short term bond yields continue to move higher on the back of scheduled Fed interest rates normalisation, the gap between the two will continue to narrow and ultimately trigger market concerns about a pending economic recession, as every historian will tell us every single recession has been preceded by an inverted bond yield trajectory (short term yields higher than long term yields).

What they usually fail to mention is not every inverted bond yield curve has been followed up by an economic recession.

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Ironically, China has an inverted bond yield curve today. Of course, nobody is predicting an economic recession will be next. But there are plenty of analysts and commentators around who see pressure on economic growth to the downside for the Middle Kingdom.

Economists at Longview Economics, to name but one, point out the PBoC is now tightening monetary liquidity, while China's housing markets and banking sector are being subjected to macro prudential restrictions. The result, predicts Longview, will be slower credit growth, a slowing down in house prices growth and construction activity, plus a fading in Chinese reflation.

It is no stretch to assume all this is being reflected in the Chinese bond market, as slowing growth and disinflation translate into an inverted yield curve.

I'd also wager this partially explains why resources stocks are strenuously trying to find firmer footing, but with not much success so far as the likes of BHP ((BHP)), Rio Tinto ((RIO)), Fortescue Metals ((FMG)) and Woodside Petroleum ((WPL)) are all trading well off their highs from earlier this year, and nearly all now below the 200 moving average. (Rio is still an exception, albeit just).

Is a relaxation in monetary policy by Beijing the best investors in these companies can hope for?

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Against the background of all of the above, underlying dynamics have not been as supportive in Australia. Stockbroking analysts have been reducing forecasts since April and it has started to appear on investors' radar.

On Monday, Shaw and Partners Chief Investment Officer Martin Crabb highlighted the profit growth picture in Australia is deteriorating, and doing it fast too. The graph below, taken from Crabb's report titled "Earnings Picture Deteriorating Fast", shows how rapidly forecast EPS for the ASX200 index recovered in the second half of 2016 to above the prior peak registered in late 2014. But now the trend is faltering, and while the week past on FNArena's own observation provided relief, the underlying trend seems to be pointing firmly to the downside.

(Graph: Martin Crabb at Shaw and Partners)

If we take a more positive view than Crabb, who seems to the suggest a larger correction is likely to follow on the back of this negative trend in earnings estimates, then we can point out a large contribution to the negative trend comes from downgrades to forecasts for retailers and other companies exposed to discretionary spending domestically, while banks, miners and energy companies have also contributed their fair share in reduced forecasts, alongside auto dealers, private health insurers, and the telecommunications sector.

The positive offset has come from companies such as a2 Milk ((A2M)), Aristocrat Leisure ((ALL)), Amcor ((AMC)), CSL ((CSL)) and Qantas ((QAN)) whose upgrades, alas, cannot make up for the reductions elsewhere, though they do explain why these share prices have performed strongly.

As things stand, the outlook for reporting season in August (only six weeks away now) remains strong, despite the negative trend, but this is largely on the back of much higher commodity prices, which have since reverted towards lower levels. Worrywarts like Crabb rightfully point out current profit projections for FY18 and FY19 seem rather light, and they are falling.

This will be the crucial factor to watch over the two months or so ahead of us. Though investors whose portfolios are stacked up with banks and resources stocks can always hope the global reflation trade, so fierce and unforgiving in the second half of 2016, might resume in the months ahead.

[Special Note: I will follow up later this week with a story containing multiple graphs and charts to further illustrate and complement the above].

Beware: Cheap For A Reason

Recent analysis by Goldman Sachs generated some interesting insights into buying "cheap" stocks, to say the least.

The research points out so-called "value" investing has had a much tougher execution post GFC. The stockbroker's basket of value stocks in the Australian share market, for example, still sits -17% below its value in 2017 and that is after a tremendous rally in 2016.

Another noteworthy snippet from the report is the conclusion that 60% of stocks that fall in price, actually deserve to be cheaper, which, on the other hand, also implies there is genuine opportunity in 40% of de-rated stocks. Regarding the latter, it is Goldman Sachs' assessment that a more efficient share market (more smart beta, etc) has led to a reduction in obvious mis-priced stocks to the tune of -20%.

In other words: value investing has become a lot tougher than it used to be. Not that any of this will ever stop investors' attention to be reignited whenever a sudden dive announces itself.

It goes without saying, research spread over many decades pre-GFC shows value investing has generated a superior return vis-a-vis any other form of market strategies or passive indices, which is why Warren Buffett is still revered as the best ever, and why money keeps on flowing into "cheaply priced" stocks.

But as every investor worth his salt should know by now, a falling share price does not by default mean here's an opportunity waiting to be exploited. As said, Goldman Sachs makes a distinction between share prices that look cheap, and are justifiably so when looked more closely into their fundamentals, and those stocks that do not deserve to be at seemingly cheap entry levels.

The first group makes up 60% of cheap stock and the second 40%. In other words: simply buying stocks because they have fallen in price, and look cheap, means investors are more likely to buy into a lemon, rather than in a mis-priced opportunity.

To help improve the odds, Goldman Sachs analysts have attempted to distinguish between the two groups.

Stocks that are probably cheap for a good reason, according to the analysis, include Spotless ((SPO)), Downer EDI ((DOW)), Sigma Healthcare ((SIG)), QBE Insurance ((QBE)), CYBG ((CYB)), Vocus Communications ((VOC)), Macquarie Group ((MQG)), Estia Health ((EHE)), EclipX ((ECX)), Virtus Health ((VRT)), Myer ((MYR)) and Automotive Holdings ((AHG)).

Stocks that, according to the same analysis, are more than likely mis-priced (and thus poised for sustainable recovery at some point) include JB Hi-Fi ((JBH)), Retail Food Group ((RFG)), Tassal Group ((TGR)), Harvey Norman ((HVN)), HT&E ((HT1)), Greencross ((GXL)), Super Retail ((SUL)), Telstra ((TLS)), TPG Telecom ((TPM)), Brickworks ((BKW)) and Bank of Queensland ((BOQ)).

Further complicating matters, a little, is that mis-priced stocks have outperformed the "cheap for a reason" peers in 20 out of the past 25 years. This means sometimes (1 in 5 years) the dogs outperform the diamonds. It is a funny place, the share market.

As to why "value" has had such a hard time to perform post GFC, Goldman Sachs analysts explain it as follows:

"As our US strategy team recently showed, 'Value' has historically posted its strongest returns during periods of strong economic growth early in the economic cycle. The factor typically wanes late in the cycle as investors search for secular growth opportunities when economic growth slows. This explains in part why 'Value' has performed poorly in the post-GFC period given the prolonged period of below-trend growth, but it is only part of the picture."

The other part explanation, suggest the analysts, has been a noticeable smaller supply of mis-priced cheap stocks. The analysts also refer to an ever larger portion of funds that enters markets through passive investment tools, such as ETFs. Certainly, being part of popular industry and thematic baskets makes it a lot harder for stocks to sharply underperform peers.

Goldman Sachs observes stocks that are cheap and deserve to be cheap tend to trade at a premium vis-a-vis those that are cheap but don't deserve to be. Bluntly put: the market ignores weak fundamentals and is constantly looking for the turnaround, which is far more likely for the second basket of stocks; the minority of cheap stocks.

Interesting detail: while not highlighted inside the report, the broader table at the back also puts the likes of Flexigroup ((FXL)), ANZ Bank ((ANZ)), Seven West Media ((SWM)), National Australia Bank ((NAB)) and Westpac ((WBC)) in the basket where deteriorating fundamentals imply a cheap looking share price may eventually turn out not to be as cheap as it seems at face value.

New Website: Earnings Forecasts

If one only had one indicator to use when making investment decisions, that indicator should be corporate earnings going forward. Of course, by the time we all find out how good/bad corporate earnings are, the horse has usually long bolted. Which is why market forecasts become the next best indicator.

Share prices do not always move in line with profit forecasts, at times share prices and forecasts can move in opposite directions, but it is not too far fetched to conclude that, ultimately, share prices end up where corporate profits lead them. Here's how legendary investor Peter Lynch put it:

"If you can follow only one bit of data, follow the earnings – assuming the company in question has earnings. I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction."

Which is why FNArena registers and monitors changes in stockbroking analysts expectations. The new website, launched in February 2017, offers three obvious tools for paid subscribers to monitor changes in forecasts:

–The Australian Broker Call Report – report published daily about changes and updates on analysts' views, ratings and forecasts
–Stock Analysis – data and insights on more than 400 ASX-listed stocks
–Weekly Ratings, Targets, Forecast Changes – weekly update story published every Monday on the FNArena website

A special mention goes out to the price charts that are available via Stock Analysis, underneath which a visual set of two lines (yellow and purple) shows the evolution of earnings per share (EPS) forecasts for the current and following financial year. Shares of companies for which projected EPS in year two (purple) is lower than for year one (yellow) usually don't perform well, unless a change in dynamics is forthcoming.

FNArena's team of journalists updates these forecasts every day as yet another Australian Broker Call Report is being compiled and published, so paying subscribers have no excuse for not being aware that market forecasts are changing, either way.

Conviction Calls: Canaccord, Morgans, Macquarie, Deutsche Bank, and Wilsons

In case you hadn't noticed, share prices in local producers of lithium and graphite have hard a rough ride recently. But stockbroking analysts are increasingly jumping to the rescue, so to speak. The common view is that fast moving money has abandoned the sector on expectations that rising supplies through Direct Shipping Lithium Ore (DSO) will place the global market in dramatic over-supply, but it appears such fears are unwarranted.

See upgrades for the likes of Mineral Resources ((MIN)) and Orocobre ((ORE)) in Stock Analysis on the FNArena website.

The latest to dismiss market concerns as nothing but noise is the team of commodities analysts at Canaccord Genuity. It is the analysts view that any "suggestions of large volumes of lithium from DSO sources are dramatically overstated. We see significant economic and technical reasons why it is unlikely for this material to ultimately present as a meaningful or sustainable supply."

Both price incentives and technological limitations do not support the DSO oversupply thesis, say the analysts.

As a result, Canaccord Genuity has reiterated its "Conviction Buy" calls for Galaxy Resources ((GXY)) and Orocobre, while maintaining a Speculative Buy rating for Altura Mining ((AJM)).

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Stockbroker Morgans' recent update on its selected list of Conviction Buys revealed the removal of two stocks: Macquarie Atlas Roads ((MQA)) and Beacon Lighting ((BLX)).

With no new additions, the stockbroker's list has thus reduced to six remaining stocks: ResMed ((RMD)), Orora ((ORA)), Westpac ((WBC)), Oil Search ((OSH)), Speedcast ((SDA)) and Bapcor ((BAP)).

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Over at Macquarie, portfolio strategists remain of the view that offshore earnings are to remain a dominant theme in the Australian share market (obviously supported by a view that the only way is down for the Aussie). Macquarie's portfolio thus remains Overweight Aristocrat Leisure ((ALL)), Corporate Travel ((CTD)), Orora ((ORA)) and Wesfarmers ((WES)). They have now added Boral ((BLD)) and Brambles ((BXB)) to increase the exposure.

On the other hand, Macquarie's portfolio no longer includes JB Hi-Fi ((JBH)), Fortescue Metals ((FMG)), or Smartgroup corp ((SIQ)) while exposure to Sydney Airport ((SYD)) has been reduced. The portfolio strategists believe it makes sense to add gold as a safe haven exposure and their chosen stock is Evolution Mining ((EVN)).

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Equity strategists at Deutsche Bank also suggest investors may want to consider adding extra exposure to offshore profits. Their most preferred candidates are Amcor ((AMC)), Aristocrat Leisure and James Hardie ((JHX)).

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Recent Model Portfolios updates by Morgans revealed the stockbroker has dumped Macquarie Atlas ((MQA)), Tatts Group ((TTS)) and Ingham's ((ING)). In particular the latter was eye-catching because of its reason:

"Our earlier comfort in ING has been dented by the difficulties facing other IPO's recently listed out of private equity ownership, where small misses can be disproportionately sold-off in this unforgiving market. We prefer to see a longer listed track record of ING and prefer to reduce our exposure to unknowns in this market."

The difficult decision to (finally) exit Vita Group ((VTG)) was also made. The shares were trading around $5 last September. They are hovering around $1. Morgans portfolio loss is reportedly circa -42% and the strategists have no qualms in admitting they got this one badly wrong.

Weakness in banking shares has triggered the strategists' interest.

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The most recent update on Wilsons' Conviction Calls comprises of eleven small cap names: EML Payments ((EML)), Afterpay ((AFY)), TechnologyOne ((TNE)), Class ((CL1)), Rural Funds Group ((RFF)), Collins Foods ((CKF)), Ridley Corp ((RIC)), ImpediMed ((IPD)), Nanosonics ((NAN)), SomnoMed ((SOM)) and Opthea ((OPT)).

Paid subscribers note: all Weekly Analysis updates published since early March have contained updates on stockbrokers' Conviction Calls. See Rudi's Views on the FNArena website for past editions.
 

2016 – L'Année Extraordinaire

It was quite the exceptional year, 2016, and I did grab the opportunity to write down my observations and offer investors today the opportunity to look back, relive the moments and draw some hard conclusions about investing in the world today.

If you are a paid subscriber to FNArena, and you still haven't downloaded your copy, all you have to do is visit the website, look up "Special Reports" and download your very own copy of "Who's Afraid Of The Big Bad Bear. Chronicles of 2016, A Veritable Year Extraordinaire" (in PDF).

For all others who still haven't been convinced, eBook copies are for sale on Amazon and many other online channels. You'll have to visit a foreign Amazon website to also find the print book version.
 

All-Weather Model Portfolio

In partnership with Queensland based Vested Equities, FNArena manages an All-Weather Model Portfolio based upon my post-GFC research. The idea is to offer diversification away from banks and resources stocks which are so dominant in Australia, while also providing ongoing real time evidence into the validity of my research into All-Weather Performers.

This All-Weather Model Portfolio is available through Self-Managed Accounts (SMAs) on the Praemium platform. For more info: info@fnarena.com

Rudi On TV

This week my appearances on the Sky Business channel are scheduled as follows:

-Tuesday, 11.15am Skype-link to discuss broker calls
-Wednesday, 8-9pm, hosting of Your Money, Your Call
-Thursday, 12.00-2.00pm, co-host in the studio
-Friday, 11.15am Skype-link to discuss broker calls

(This story was written on Monday 19th June, 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 the direct messaging system on the website).

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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) 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.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

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

Click to view our Glossary of Financial Terms