27 Mar 2017
By Shadforth Financial Group
With reporting season over, we can now examine the overall results and key trends.
This reporting season was dominated by company-specific issues rather than an overarching theme. The exception was resource companies, which benefitted from stronger commodity prices and upgraded earnings both going into and after reporting.
Overall, earnings tended towards upgrades, which were heavily skewed by upgrades to miners, healthcare, consumer staples and banks. Since these sectors comprise the heavyweights of the market, there was also a bias to the large cap stocks.
Following reporting seasons, analysts tend to decrease forward growth expectations. However, for the first time in many years analysts have increased earnings growth expectations post-reporting season.
Not only did the bigger companies perform better from an earnings perspective, they also experienced the largest earnings upgrades. As many of these companies are miners and banks, the top 20 stocks experienced greater earnings upgrades than the broader market. The smallest upgrades were in the small ordinaries 100-300 stocks. The market is now forecasting growth of 18 per cent for 2017 and six per cent for 2018, but small caps are only expected to grow at four per cent.
It is important to note that since analysts have upgraded earnings post-reporting season, it is possible we may be at the start of the first earnings upgrade cycle in many years. These historically last an average of five years.
Another market trend was capital returns from buybacks and increased dividend payments. This was especially the case for the miners, despite general consensus that they would retain capital. Dividends per share upgrades came from the likes of BHP Billiton, Rio Tinto, Fortescue Metals Group Ltd, Crown Resorts Ltd and National Australia Bank, though defensive stocks lacked upgrades.
Stock price reactions have always been volatile at reporting time, and this year was no different. This was a result of how investors were positioned, stock valuation and perceived quality of the result post-announcement. Stock price reactions (both positive and negative) were often in excess of the underlying earnings change, and thus not a true reflection of the stock’s outlook, quality of earnings or actual results.
Digging deeper: The sectors
The big four banks showed strong results, maintaining margins despite funding pressures and capital requirements. The regionals, however, disappointed given that they have less levers to pull and more funding pressure. Overall there was limited deterioration to asset quality and better bad debt provisions as the environment for the troublesome areas improved, especially in mining and dairy. The general loan book and consumer environment was better, with the exception of Western Australia. The insurance sector performed better as premium income improved, though AMP disappointed on major restructuring costs. The fund managers experienced mixed fund flows, however performance fees were hard to come by as a volatile 2016 proved a difficult environment to outperform in.
As expected, miners delivered better earnings. However they also paid larger dividends than expected as companies delivered strong cashflow. Factoring spot commodity prices into valuations, we foresee earnings upgrades going forward.
Despite offshore competition and expected increased domestic competition and margin pressure, rational competition between Coles and Woolworths actually stabilised margins. Overall, consumer staples were better than expected, highlighting the defensive nature of these shares.
Consumer discretionary was a little more hit and miss. The areas exposed to housing-related spending fared better (JB Hi-Fi Ltd, Harvey Norman Holdings Ltd), with JB Hi-Fi benefitting from the lack of competition from Dick Smith. The balance of the sector, however, struggled.
Gaming in general disappointed, driven by weak VIP revenue as the high rollers stayed away after the gambling crackdown in Macau. Mass market gaming was a little below trend, but this was a good result given the interruptions occurring as many casinos upgrade their facilities. Weaker wagering continues as a trend as competitors continue to enter the domestic market, take market share and squeeze margins.
Real estate investment trusts (REITs) and infrastructure
Results were generally in line, but retail landlords witnessed softer retail conditions. This was probably driven by the poor wage growth we have seen over the last year or so. Looking forward, however, all the tailwinds are starting to shift towards headwinds as rates rise, capitalisation rates bottom and rents potentially ease.
Healthcare in general provided better-than-expected upgrades, but the poorer quality companies disappointed relative to the more established, higher quality and more well-diversified businesses, justifying the view to buy quality.
Telco and media
Results were disappointing as the industries face structural headwinds due to weaker advertising spend, changing communications trends and changing legislation for telcos and the NBN.
The outlook from companies remains a little constrained, with expectations of slim revenue improvements but no real commitment to future investment. Companies continue to cut costs, which are becoming increasingly difficult to reduce and in some cases may start to drift higher. Not surprisingly, CEOs who disappointed investors were quick to blame Brexit, Trump or Turnbull. Few were very committed about the outlook given the potential macro and political risks on the horizon and they will now look to create and focus on shareholder value.
Overall, valuations remain slightly elevated (see chart), with sectors trading just above long term average price to earnings ratio. However, in a supportive low interest rate environment, and with companies experiencing earnings upgrades post-results, we believe it remains justifiable. Furthermore, the cost cutting executed over multiple years should enable companies to leverage earnings at any sign of top line growth.
While the local environment is set to improve for the Australian market, it is subject to negative outside influences, providing an element of risk. These influences include the political environment, particularly in Europe, and the elevated valuations across some global markets, especially the US. The end of the secular bull trend in interest rates may also impact local valuations over the year ahead.