By Philip Baker
Australia’s top fund managers are hoping profit reporting season will justify rising stock valuations that have propelled the ASX to six-year highs.
While earnings-per-share growth has averaged around 7.6 per cent per annum over the past decade, the past four financial years have seen growth average minus 2 per cent.
“A year and a half ago, shares were cheap, but now they’re not.”: Airlie Funds Management founder John Sevior Credit: Angus Mordant
But in a two-year bull run, investors have looked past this and brushed off concerns about a lacklustre local economy, profit downgrades, a drop in the iron ore price and an Australian dollar that keeps punching higher.
Instead they have opted to place their faith in the ability of global central banks to restore order to the world economy and stayed loyal to shares, and their healthy dividends, as record low interest rates make other investments look second-rate.
But fund managers such as Schroders head of Australian equities, Martin Conlon, said ageing populations, excessive debt levels and a range of other headwinds are conspiring to make revenue and organic earnings growth increasingly difficult to generate.
“A disproportionate amount of earnings growth is currently being driven by acquisition, buy-back and re-leveraging activity stimulated by the lure of low-cost funding,” Mr Conlon said.
“This has rarely ended well in the past, however identifying inflection points is always guesswork.”
For Australia’s top companies, the reporting season is crunch time.
Patchy season forecast
Overall, the season is tipped to be a patchy one, with most analysts forecasting earnings-per-share growth of 7.9 per cent for 2013-14 against the previous financial year. But just 3 per cent of that will come from rising revenues – the remainder is from cost-cutting.
Airlie Funds Management founder John Sevior said the sharemarket is above fair value but has been holding that level for some time and could even trade higher. “A year and a half ago, shares were cheap, but now they’re not,” he said. “The conundrum for investors is that with interest rates low, and unlikely to charge away, shares are still relatively attractive.”
On Monday, Leighton Holdings is slated to report its latest half-year profit, while education group Navitas will announce its full-year result.
The busiest days for results will be August 13, when Commonwealth Bank and CSL report, Telstra on August 14, BHP Billiton on August 19 and more than 20 companies on August 21.
Investors will also be focusing on dividends, payout ratios, other forms of capital management, revenue and sales growth, and how much cost-cutting and one-off items have helped results.
The performance of companies that have expanded into offshore markets will also be a focus, with a report from Macquarie Group suggesting that companies such as Sonic Healthcare, CSL, Domino’s, Computershare and James Hardie are poised in the years ahead to post better results than companies which just rely on local demand.
Outlook statements and the possibility of any merger and acquisition activity will also be scrutinised.
Sell-off fears for analysts
Unlike US companies, which report four times a year, local firms step up to the plate twice a year, making it a pivotal time for investors.
Some analysts fear shares remain vulnerable to a selloff after the rally of the past two years, a rise in geopolitical risk, a drop in junk bond yields, and a US economy that is recovering fast enough to have investors worried the Federal Reserve will need to raise interest rates, despite signals it’s not in a hurry to do so. The Reserve Bank of Australia is also expected to keep rates on hold for a year, regardless of the latest inflation reading, as the economy makes the transition from the mining investment boom to broader-based growth.
Perpetual’s head of investment research, Matt Sherwood, said that although earnings growth is likely to come in at a three-year high, it is being dominated by the large-cap stocks.
“Outside the banks, resources and Telstra, there is little earnings growth, which suggests that the earnings improvement is reasonably narrow and highlights the importance of stock selection in the impending subdued economic climate.”
Mr Sherwood also thinks the risks this time around appear to be tilted slightly to the downside, with the key being whether recent earnings downgrades by analysts have caught up with operating models. “The primary theme in the impending reporting season is likely to be cost-out once again, as the lacklustre global recovery and uninspiring increase in domestic demand weigh on revenue growth, with corporations having to work harder internally to deliver on earnings expectations,” he said.
The reporting season comes at an unusual time for investors, with volatility at record lows despite the global geopolitical and economic instability.
Investors have already endured a raft of profit downgrades from retailers including Kathmandu, Pacific Brands, Super Retail Group, Funtastic and The Reject Shop. Unseasonable warm weather in May and a drop in confidence from consumers following the federal budget was blamed.
Mining contractors have also been out of favour following downgrades from Downer EDI, Transfield Services and Boart Longyear.
Consumer, resources stocks key
But none of it has stopped the sharemarket from steadily rising, thanks to a lift in the major banks’ stocks, as investors lapped up their healthy dividends. Payout ratios are close to the peak of just over 70 per cent that they reached in 2009, so there are some concerns companies can’t keep increasing them despite the strong demand.
The benchmark S&P ASX 200 index returned 12.35 per cent over the past financial year and as much as 17 per cent once dividends are included. It has risen almost 40 per cent since the bull market began in June 2012.
But just as the rally has been a narrow one, dominated by banks and resources, this reporting season will also be driven by a limited number of companies.
And with only the Commonwealth Bank reporting among the banks, the bulk of the action is likely to be in the consumer and resources space.
CIMB equity strategist Shane Lee thinks that Australia’s earnings growth is finally picking up, but has warned clients that he sees more downside risk to earnings estimates this profit season than at this time last year.
“We remain confident the earnings upswing will endure, but expectations need to be reset lower,” he said.
Mr Lee thinks revenue growth is still relatively weak and control of operating costs is the key. He is cautious on the resources sector and has told clients to trim their exposure to Fortescue Metals, Sandfire Resources, Newcrest, Atlas Iron, Arrium and Mount Gibson ahead of their results.
The materials sector, which includes BHP Billiton and Rio Tinto, is forecast to show earnings growth of 21 per cent despite the drop in the iron ore price and the rise in the Australian dollar.
The spot price for iron ore, delivered in China, sank to $US89 per tonne in June, before ending Friday at around $US93.60. Iron ore is trading 40 per cent lower since January 1, and over the past year has averaged closer to $US122 a tonne. Prices have fallen, but a tight cost-cutting program and increase in production have helped offset some of the losses.
Housing construction ‘bright spot’
Deutsche Bank equity strategist Tim Baker has looked at the earnings season and thinks that revisions to forecasts are weakening, mostly because of slack in the cyclical sectors.
The one bright spot he sees is housing construction. Companies that Deutsche believes could surprise with better than expected results include Aurizon, BHP Billiton, Commonwealth Bank of Australia, Echo, Federation Centres, IAG, James Hardie, Orora, Rio Tinto, Seek, Suncorp and WorleyParsons. The broker has warned clients that Amcor, Arrium, Computershare and Resmed could disappoint with bad news.
The forward price-earnings ratio of the sharemarket, a key measure of valuation, is around 14.5 times earnings, in line with its average multiple over the past 20 years, but up from closer to 12 times a few years ago.
The rise in the sharemarket over that time has been due to a rise in the PE ratio, not necessary driven by earnings.
Mr Conlon said that, by definition, multiple PE expansion is borrowing from the future, as expanding multiples and higher prices must lower future returns. “Earnings will always rise and fall in the short to medium term, however the earnings power of the collective businesses in the economy will always be relatively stable,” he said.
“It is hardly rational that investors should increase their level of optimism as prospective returns decline, however we have decades of evidence suggesting that is exactly what happens, until it stops.”
Record low bond yields have also helped analysts with their valuations, providing an artificial boost to cash flow-based valuations.
Sharemarket analysts typically use the 10-year bond yield when calculating today’s value of a company’s future cash flows. A lower bond yield delivers a higher value and vice versa.
Bond yields have fallen this year, surprising many managers, who expected them to rise as the US economy recovered. Bond yields in developed markets are close to all-time lows, implying all is not well with the global economy.
Mr Lee said that the local economy should continue to transition away from mining investment over the next couple of years, supported by RBA policy, and he expects sector earnings growth to follow this transition.
“We think a currency depreciation will begin to take shape before year end as the market begins to price a higher fed funds rate,” he said.
The Australian dollar has risen to US94.4¢, up from US92¢, over the past year as offshore investors have been lured by the nation’s solid economic fundamentals when compared to the rest of the world.