Australian Equities Pre-August: Polarisation Remains The Word

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Download related file: FNArena-Reporting-Season-Monitor-March-July-2018

In this week's Weekly Insights:

-Australian Equities Pre-August: Polarisation Remains The Word
-Next Week
-Conviction Calls
-Inverted Yield Curve: Historical Perspective
-Rudi Talks
-Rudi On TV
-Rudi On Tour

Australian Equities Pre-August: Polarisation Remains The Word

By Rudi Filapek-Vandyck, Editor FNArena

Twice each year investor attention in Australia goes out to how well corporate profits are stacking up in comparison with share price valuations and market forecasts. However, not every ASX-listed company reports its financial numbers in February and August.

To my knowledge, FNArena is the only service around that consistently and meticulously keeps a close watch on corporate earnings reports in Australia. Earlier this year, we launched a dedicated section to the website:

https://www.fnarena.com/index.php/reporting_season/

Even though we counted 53 companies reporting in between February and the upcoming August results season, not much attention is usually given to what has happened in this corporate results sideshow. Admittedly, our coverage also includes banks and we know CommBank ((CBA)) reports in August, and stocks like ResMed ((RMD)) which, being US-listed, updates every three months.

But the bulk of companies reporting in let's call it the in-between season consists of smaller mining companies, retailers, infrastructure and mining services providers, agricultural companies, building materials and housing related companies, financial services providers and funds managers, plus a number of technology companies – quite the diversified bunch which, outside the banks, Macquarie Group ((MQG)), REA Group ((REA)), and Aristocrat Leisure ((ALL)) has little representation in the ASX50.

This week we closed off the in-between reporting season with the upside surprise delivered by Cimic ((CIM)) the final inclusion for this season. Before we zoom in on what August might deliver, are there any conclusions we can take on board from the 4.5 months past?

Conclusion number one has to be that significant parts of corporate Australia are doing it tough. Small cap analysts at Canaccord Genuity have counted more than 200 profit warnings have been delivered thus far in Australia since the beginning of calendar year 2018. Most of these warnings have remained outside the scope of most investors. Asaleo Care ((AHY)), despite many of its products being bought on a weekly basis by Australian households, never made it to common household name status in the share market, and the stock is no longer a member of the ASX200.

A similar observation can be made for smaller technology stocks such as Objective Corp ((OCL)), Hansen Technologies ((HSN)) and Integrated Research ((IRI)). And for agri-company Nufarm ((NUF)) who only a few months ago delivered a feeble result but with better-than-anticipated guidance. Since then a dire and extensive drought in rural parts of Australia has put a big dent into management's forecasts.

Hands up who had been anticipating a super result from Australian Pharmaceuticals ((API))? Myer ((MYR))? Village Roadshow ((VRL))? Even wealth manager Perpetual ((PPT)) never seemed primed for a result that would instantly turn around the stock's downward sloping trajectory.

In broad, general terms we can conclude the in-between results season largely confirmed what we already knew about the Australian economy and the transformation that is currently taking place. We have sectors under pressure, including bricks and mortar retailers, banks and financial services providers, plus telecom and, apparently, smaller technology service providers. Corporate results from companies in these sectors came out in-line at best, with the risks skewed towards a negative disappointment.

On the other hand, we have mining and infrastructure services providers and engineers, we have building materials stocks, miners and energy producers, and we have healthcare on the positive side and -lo and behold- companies operating in these industries have been prone to more likely deliver a positive surprise.

The one added observation that is worth mentioning is that a number of disappointing releases have stemmed from small cap mining companies, likely indicating that, no matter the overall environment shaped by commodity prices, there will always remain an above average risk attached to drilling and mining a small operation exposed to nature's brutality.

Equally noteworthy is the fact that share market darlings including Macquarie Group, Aristocrat Leisure, Fisher & Paykel Healthcare ((FPH)), Hub24 ((HUB)), Netwealth Group ((NWL)), Praemium ((PPS)), REA Group, ResMed, Synlait Milk ((SM1)), and Xero ((XRO)) have kept up their performance despite many criticising their valuations – in all cases this was underpinned by robust results that at the very least met elevated expectations.

The share market's polarisation has been firmly on display post the February reporting season and it'll be anyone's guess whether the upcoming August results season might deliver the change in dynamics so many value-investors have been waiting for. My guess is that the underlying bifurcation between the Haves and the Have Nots is unlikely to change soon, but let's wait and see what August has to offer.

No matter how well prepared one can probably be, every season delivers unexpected surprises, in addition to one or two hallmark events. This year earnings estimates are rising, albeit slightly, and predominantly because analysts are marking-to-market commodity prices, while also incorporating a weaker Aussie dollar into their models.

Insurance companies seem to enjoy a favourable wind ahead of the season. Miners and energy producers seem poised for solid performances, with capital management certain to be on the agenda. But there are equally very few who anticipate disappointment from CSL ((CSL)), or from ResMed, or from Charter Hall ((CHC)), or Goodman Group ((GMG)).

As per always, companies that manage to positively surprise, and force analysts to upgrade forecasts, often enjoy positive momentum for many months after the reporting season. Those who fail to meet expectations can often expect severe punishment, in particular if the share price has rallied prior, or if the longer term trajectory is being called into question.

Quant analysts at Macquarie have singled out Lovisa Holdings ((LOV)), Qantas ((QAN)), a2 Milk ((A2M)), Nine Entertainment ((NEC)) and Emeco Holdings ((EHL)) as likely candidates to deliver a positive surprise in August. On the other hand, their quant modeling shows Ramsay Health Care ((RHC)), Tabcorp ((TAH)), Western Areas ((WSA)), Commbank ((CBA)) and Japara Healthcare ((JHC)) are most likely to disappoint with their results releases.

All shall be revealed over the coming six weeks.

From the moment the corporate results season starts gaining genuine traction, FNArena's dedicated corporate results monitor shall be refreshed and updated daily (see website or the link above).

By then we will also add an extra compartment that covers the monitors we produced since August 2013; for those who like to analyse past data, percentages and company performances.

The Monitor for this year's March-mid-July period will be attached when this story is published on the website on Wednesday morning.

Next Week

Next week I will spend across the border in Queensland where the Australian Investors' Association's (AIA) National Conference takes place on the Gold Coast. I am an active participant in the Monday's Grand Debate, while presenting my views about what's happening in the local share market, and outside of it, on Wednesday.

By Friday, I will be in Canberra to present to local members of the Australian Shareholders Association (ASA).

As a result of the above there will be no Weekly Insights next week. The next edition will be written and published in the second week of August, when daily Broker Call Reports are filling up.

If you happen to be around on the Gold Coast or in Canberra, do come over and say Hi. No doubt, the August reporting season is going to keep us all busy, as per always.

Conviction Calls

Deutsche Bank analysts, both here, overseas and on the ground in China, are expecting more support from Chinese authorities to cushion their domestic market against an intensifying trade conflict with the Trump administration in the US. As a direct consequence, equity strategists in Europe are calling for increased exposure to mining stocks, having upgraded the sector to Overweight.

One of the consequences of the recent switch in Chinese policy towards more accommodation is that infrastructure spending should again start growing at a faster rate, predict Deutsche Bank analysts, while China's monthly PMI surveys should at the very least stabilise in the months ahead.

Investors should also be aware the Chinese government is considering cutting taxes to further stimulate domestic consumption, with interest payments on mortgage loans, and education, training and medical expenses soon to be made tax deductible.

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One of the mining stocks that has put in a remarkable recovery over the past twelve months is rare earth producer Lynas corp ((LYC)). The share price had been in a long downslope since April 2011, having peaked above $24, but the year past has seen a steep recovery to $2.80 from circa 80c.

The share price is trying to find new momentum around the $2 mark. Lynas also made its re-entrance into the S&P/ASX200.

Friday's quarterly production update did not please everyone, and higher costs were one element of disappointment, but this has not deterred analysts at CLSA to reiterate their High Conviction Buy rating for the shares. Fundamentals for both rare earth elements and for the company remain supportive, say the analysts.

They find the stock significantly undervalued, arguing the political/regulatory risk for operating in Malaysia has been well and truly priced in. CLSA's price target is $3.50.

UBS reinstated coverage on Tuesday with a Buy rating and $3.30 price target. We hadn't heard from UBS since July 2015. Back then, the rating was Neutral with a price target of 5c.

In the latter's view, Lynas owns the best global rare earth deposit in the world, and it is being exploited through the only active non-China processing facility. The company's key product, generating circa 90% of all revenues, is Neodymium-Praseodymium (NdPr), which is used in high growth new energy applications such as Electric Vehicles and Wind Energy.

To add to the attraction, UBS points out Lynas is highly cash-generative and de-gearing quickly. According to the analysts, the difficulties the company has had to get its operation up and running signals just how tough it will be for anyone with the intention of building the next project.

Needless to say, investors looking to jump on board must have the stomach to cope with above average share price volatility. It was only in early May that the share price had reached $2.88. UBS points out the new Malaysian government has a few members who have been long-time critics of Lynas operating in the country. Plus a long-term tailings solution for the plant's waste still needs to be approved.

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One does not often see sector analysts preferences fall in line with each other, hence investors looking to add exposure to AREITs, be it for yield/income or for other reasons, might want to pay attention to the common denominator in sector updates by Morgan Stanley, Macquarie and Citi.

Forget about the usual this stock looks undervalued, while another one might have rallied too hard. All three teams of analysts agree that potential outperformance is likely to come from those companies that have the ability to add genuine growth. All three are pointing towards funds management operations which highlights the quality and long-term sustainability of Lend Lease ((LLC)), Charter Hall ((CHC)) and Goodman Group ((GMG)).

Equally interesting is that earnings risk for the sector overall is seen as relatively low ahead of the August reporting season.

Inverted Yield Curve: Historical Perspective

Flattening and inverting yield curves. You probably heard these terms a number of times already in the weeks/months past. Have no doubt: you are going to hear a lot more about it as the calendar year progresses.

According to some, the curve inside the US bond market (the difference in yield between 2-year Treasuries and ten-years) is the most reliable financial indicator around, but this sounds a lot scarier than history shows us about how to treat the current set-up in US bond yields.

The current context is one whereby the difference in yield between two-years and ten-years continues to narrow, suggesting the US economy might be facing its next economic recession sometime in late 2019-mid-2020, all else remaining equal. Further tightening by the Federal Reserve pushes up the two-year yield while the ten-year seems to have decided that above 3% yield is a bridge too far.

But things are seldom this straightforward in global finance, let alone during times of quantitative easing/tightening on this Grand Scale.

Economists at Citi recently lined up a few historical references (with assistance from Haver Analytics) and one would have to conclude history by far is not as straightforward as some experts would like it to be.

Since the late 1970s, the US yield curve has seven times flatlined, of which a grand total of two occasions saw an actual inverted curve. On both occasions (1980 and 2000) the US share market was in the negative twelve months later, but not in the months immediately after the curve went negative.

Here are the raw data:

Rudi Talks

Audio interview from Tuesday last week on why value investing has become such a hard slog in the Australian share market, and what are the dynamics behind the scenery:

https://www.boardroom.media/broadcast?eid=5b4e878073d9bb0cd6e6be58

Audio interview from Tuesday the week prior about the local share market and high valuation stock outperforming their lesser peers:

https://www.boardroom.media/broadcast?eid=5b4429a484c6a07ee10af84f

Rudi On TV

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

-Tuesday, 10.30am Skype-link to discuss broker calls (earlier than usual)
-Thursday, from midday until 2pm
-Friday, 11am, Skype-link to discuss broker calls

Rudi On Tour

-AIA National Conference, Gold Coast QLD, July 29-August 1
-ASA Presentation Canberra, 3 August
-Presentation to ASA members and guests Wollongong, on September 11
-Presentation to AIA members and guests Chatswood, on October 10
-Presentation to ATAA members and guests Sydney, October 18

(This story was written on Tuesday 24th July 2018. It was published on the day in the form of an email to paying subscribers at FNArena, and again on Wednesday as a story on the website).

(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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