Where Are The Earnings In Australia?

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– stockbrokers anticipate a pause in the equities rally
– 2012 rally has been all about higher PEs, with no earnings support
– some stockbrokers have lined up their favourites, as well as which stocks best to avoid

By Andrew Nelson

With equity markets having been on the run over the last three months, brokers are starting to take a much closer look at the outlook for corporate earnings to assess what are some fairly lofty looking valuations in some cases.

Analysts at BA-Merrill Lynch note that at a current 13.3x forward earnings, the Australian market is currently trading at its highest multiple in three years and only a tad below the long-term average of 13.6x. With the broker of the belief it is unlikely we’ll see any sort of sustained earnings upgrade cycle in the near-term, the market is starting to look stretched.

With share prices now ahead of earnings, the broker has outlined a number of stocks it sees as vulnerable to correction. Stocks that have rallied of late despite consensus downgrades to earnings forecasts make up many of the top spots. Domestic cyclicals like Seven West ((SWM)), Fairfax ((FXJ)), Toll Holdings ((TOL)), Boral ((BLD)), Tabcorp ((TAH)) and Seek ((SEK)) feature prominently, especially given the broker sees little chance of earnings upgrades among these names because the economy is slowing and RBA rate cuts are not having the desired effect. In fact, the broker notes retail sales have fallen short of expectations four times in the last five months.

There were a few other stocks that rated a (dis) honourable mention from BA-ML including Macquarie Group ((MQG)), Incitec Pivot ((IPL)), Wesfarmers ((WES)), ASX ((ASX)) and Boart Longyear ((BLY)). Interestingly, Citi downgraded its call on Incitec Pivot to Sell just this morning.

What the broker (BA-ML) does like are stocks that have a decent exposure to the US, which have seen smaller EPS downgrades than domestic cyclicals and thus do not look that expensive. The broker’s top picks for the year ahead are Brambles ((BXB)), News Corp ((NWS)), Amcor ((AMC)) and ResMed ((RMD)). The broker also likes stocks that are showing decent price and earnings momentum and these include Crown ((CWN)), Caltex ((CTX)), Primary Healthcare ((PRY)), PanAust ((PNA)) and CSL ((CSL)).

According to BA-ML, the stage is set for modest downgrades to current earnings forecasts, with the bulk skewed towards the second half of the year. On the broker’s numbers, earnings downgrades of around 2.5% and a 13x PE would represent fair value, which puts the ASX 200 at 4850 for the end of 2013.

Analysts at Macquarie say we're at a tipping point one way or the other, with the current relationship between market returns and EPS momentum making Macquarie believe that FY13 EPS forecasts need to begin to see upgrades soon to sustain current levels and returns.

PE ratios are looking a bit stretched after the recent run, says the broker, which makes the upcoming reporting season quite risky for those stocks that have risen in hopes of an improving growth outlook that has yet to materialise. The broker’s list of stocks that have delivered good returns without any EPS boost includes Ten Network ((TEN)), Arrium ((ARI)), Qantas ((QAN)), Whitehaven Coal ((WHC)), Boart Longyear, Boral ((BLD)), Bendigo and Adelaide Bank ((BEN)), Stockland ((SGP)), AGL Energy ((AGK)), Origin ((ORG)), Transurban ((TCL)), Sims ((SGM)), Fleetwood ((FWD)), David Jones ((DJS)), Iluka ((ILU)), Qube Logistics ((QBE)), and Billabong ((BBG)).

Conversely, there are a number of stocks that have delivered fairly weak returns over the last three months despite EPS upgrades; these include James Hardie ((JHX)), Investa Office Fund ((IOF)), News Corp, ResMed, Woodside ((WPL)), Duet ((DUE)), Coca Cola Amatil ((CCL)), Ansell ((ANN)) and Santos ((STO)).

Analysts from Citi disagree, seeing signs that earnings downgrades are moderating, which provides a better outlook for earnings growth. The broker notes downgrades in December were at their lowest in over 18 months, which tells Citi that expectations are modest about FY13 earnings growth.

The broker believes this has to do with the impact of lower interest rates flowing through, noting downgrades have slowed across financial stocks exposed to equity markets, as well as consumer discretionary stocks and overseas operating companies that are facing fewer headwinds from the rising AUD. And with the jury still out on how much traction the run of rate cuts will gain, the broker notes there’s still scope for more, so downgrades, in general, should remain modest.

Citi also sees stronger commodity prices stemming the flow of downgrades in the resource sector, which could even lead to upgrades a little further down the track. The broker points to the recent rally in mining and some financial stocks as evidence. The relative underperformance of banks and REITs is also suggesting some confidence in earnings growth, says the broker.

Analysts from Deutsche Bank see the year ahead as one of growing support for equities, with earnings expected to lift from below-trend levels and helped by cheap valuations when compared to bonds. The broker says that shares seem to have already started to price in some sort of rebound in global growth, thus we should start seeing a pause in downgrades soon.

While this could well play out, the broker does note there are some real near-term risks. First, PE ratios have risen quite a bit, and while the equity-bond yield gap is still high, the broker does note it has hit a 1.5 year low. What does it mean? Simply wait a little bit before you start adding more risk.

Deutsche Bank now sits Overweight on energy and Underweight on mining, on valuation grounds. Defensives still look OK, as the broker’s analysis suggests they’re not expensive versus cyclicals. Cyclicals are also starting to look better to Deutsche, especially housing, and it will look to build here if the currently easy monetary policy actually starts to put a floor under earnings. And while banks' valuations are starting to look reasonable, growth prospects are limited and the sector is also well-owned. So if you want yield, get it from insurers and real estate, says the broker.

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