Let Earnings Forecasts Be Your Guide

This story features TELSTRA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: TLS

By Rudi Filapek-Vandyck, Editor FNArena

Last week I reported how three-quarters (75%) of share price movements can be explained through changes in earnings forecasts. This week, I follow up with a few tips and strategies about how investors can use this knowledge to their own benefit.

Three years ago, market analysts at BA-Merrill Lynch started researching global equities through the prism of changes in consensus forecasts versus movements in share prices. Their initiative has since led to what has become a popular monthly exercise among the investment banker's worldwide clientele. BA-ML talks about "Contenders" and "Defenders" and one quick explanation will instantly reveal the importance of both labels in equity markets.

"Contenders" are companies that enjoy rising profit expectations but whose share price valuation has not yet fully captured this improvement. "Defenders" are companies for which earnings expectations are deteriorating but the valuation is still relatively high.

The importance between these two labels has been underscored by continued research since 2010, as well as through back-testing more than two decades. To put it in simple terms: the first group is likely to re-rate, the second is likely to de-rate. The end result is a pronounced gap in investment returns between the two. No second guessing as to why BA-ML's monthly updates on "Contenders and Defenders" has become a popular feature.

Personally, I believe the usually strong (and straightforward) relationship between re-rating/de-rating and profit estimates has become more blurred this year because of fragile confidence and fleeting risk appetite, which has turned investor attention towards "solid dividends" and we've all witnessed the effect on infrastructure, banks and Telstra ((TLS)). This is one key reason why I'd be cautious in joining the herd at present share price levels and I am certain BA-ML analysts would share my view.

There should be little doubt that rising profit estimates can be a real boon for a share price that does not as yet reflect this prospect. Take consumer goods producer Breville ((BRG)) as an example. The share price started the calendar year at $2.73 and with expectations of "moderate growth". This has since changed into forecasts of some 24% growth in earnings per share this year. The result? Breville shares are now trading at $5 (up 83%, dividend not included). Medical devices company ResMed can serve as another, more recent example. The share price is up significantly after the company's market update last week surprised even the most positive experts.

The problem investors today are facing with examples such as Breville and ResMed is whether the strong growth outlook is by now reflected in the share price? In Breville's case (note I did highlight the company at the beginning of the year) I'd be cautious given expectations for next year currently assume 7% growth only while the implied forward dividend yield has dropped to 4.6%. With the Price-Earnings ratio at 14.6, this smacks of "moderate upside" only from here onwards, so probably better to wait for share price weakness or for a renewed rise in expectations, preferably for both.

ResMed's case is a little different in that expectations remain for circa 18% growth beyond FY12, but then investors have to feel comfortable with a Price-Earnings multiple of 17+ on FY13 projections. CSL ((CSL)), by the way, is now on a FY13 PE ratio of 18. Cochlear ((COH)) is on 23. The healthcare sector in Australia is the only sector that has enjoyed rising profit expectations this year and this has once again translated into high PE multiples for these former market darlings. Observe how the share price for Ansell ((ANN)) has gone the other way with consensus forecasts now anticipating no growth in FY13. This can easily serve as the reason why Ansell's PE ratio has fallen to 14.

Within the framework of BA-ML's analysis, Ansell had become a "Defender" earlier in the year and the share price has ultimately followed suit. Given that high multiples depress dividend yields, shareholders in ResMed, CSL and Cochlear will have to keep an eye open in order to avoid a similar de-rating taking place while they're on the books. As long as growth momentum remains intact, however, the odds remain in favour of market beating investment returns.

In the last global update, released only a few days ago, analysts at BA-ML put Amcor ((AMC)) forward as a typical "Contender" in Australia as, on their observation, recent share price weakness is not being matched with a deteriorating earnings outlook, suggesting Amcor has become cheaper for all the wrong reasons. On the other hand, gold and copper producer Newcrest ((NCM)) is used as one stand-out example of a "Defender" in the Australian share market, suggesting any upside in the share price is unlikely to last unless market expectations for Newcrest earnings start improving, and this is as yet not the case.

As said, BA-ML's analysis covers the main equity markets across the globe, so there are no further Australian stocks on the lists of preferred Contenders and Defenders, but there are lots of interesting insights in the update that can assist investors in their own market focus and analysis. For the record: other typical examples of Contenders are China's Lenovo Group, the UK's BT Group, Svenska Handelsbanken in Sweden and Amgen and Microsoft in the US. Typical examples of Defenders are Petrobras in Brazil, Carrefour in France, Sharp in Japan and Johnson & Johnson, Avon Products and Tiffany & Co in the US.

With regards to the largest companies on the Australian share market, investors should note BA-ML analysis puts CSL and Westfield ((WDC)) firmly amongst the potential re-raters (Contenders) while more companies receive the label "Defenders" including BHP Billiton ((BHP)), Woodside Petroleum ((WPL)), as well as Wesfarmers ((WES)), Woolworths ((WOW)) and Westpac ((WBC)) and National Australia Bank ((NAB)).

Another remarkable observation is that while many a stockbroker/investment expert has become more excited about seeking exposure to oil and gas stocks recently, the BA-ML analysis suggests quite the opposite as only two companies -worldwide- in this sector are considered to be a true Contender, while the list of Defenders for the sector seems overpopulated. The opposite is the case for global healthcare stocks, as well as for global media. News Corp ((NWS)) sits firmly among fellow-Contenders such as Disney, Time Warner Cable, Pearson and McGraw-Hill.

It would appear the tide has turned for global retailers as well (but not for Wesfarmers and Woolworths – see above) while most major players in software and IT services also seem to have the blessing of Dame Fortuna, including giants such as Google, Yahoo, eBay, IBM, SAP and Red Hat. BA-ML's analysis doesn't mention Facebook but there should be no doubt Facebook is a pretentious, overhyped Defender.

Maybe as a warning to those who believe Telstra shares have at least another 50c upside up their sleeves, BA-ML analysis suggests most international telcos have now become Defenders.

Having said all of the above, the reporting season in Australia has only just started and as per usual this means earnings forecasts are likely to be shuffled, cut, mixed, adjusted and increased over the coming four weeks. Analysts at UBS warned their clientele last week that -given circumstances- outperformance was likely to come from avoiding mines and torpedoes, implying taking on too much risk can lead to a plunging share price in case of disappointment.

Analysts at RBS have found that investors who want to avoid such pain might as well take guidance from publicly available data on short positions in the Australian share market. Because, conclude RBS analysts after yet another in-depth research exercise, it would appear rising short positions often point into the direction of a disappointing profit report as those shorters try to benefit from too rosy market expectations. RBS's analysis is supported by academic studies in offshore markets.

Investors should note there is no watertight guarantee as shorters do occasionally pick the wrong target which then leads to the exact opposite outcome, but to the credit of RBS's research, the analysts had picked Harvey Norman ((HVN)) as their prime target for disappointment this reporting season and guess who issued a profit warning on Monday? Earnings forecasts are likely to drop further from what already looks like a dog's breakfast for what was once one of the standout success stories in corporate Australia.

Maybe the fact the share price only dropped marginally is equally as important information for investors?

Other stocks selected by RBS for likely disappointments this reporting season are:

– JB Hi-Fi ((JBH))
– Wotif.com ((WTF))
– Gindalbie Metals ((GBG))
– Mesoblast ((MSB))
– Leighton Holdings ((LEI))
– Mount Gibson ((MGX))
– BlueScope Steel ((BSL))
– Sims Metal ((SGM))
– Cochlear ((COH))
– The Reject Shop ((TRS))
– Sandfire Resources ((SFR))
– Lynas Corp ((LYC))
– Flight Centre ((FLT))
– Troy Resources ((TRY))
– Cudeco ((CDU))
– FKP Property ((FKP))
– GWA Group ((GWA))
– Qantas ((QAN))
– Aquarius Platinum ((AQP))

Note Aquarius Platinum's share price already plunged in weeks past on the back of ongoing troubles in South Africa.

(This story was originally written on Monday, 6th August 2012. It was published on that day via an email to paying subscribers at FNArena).

P.S. FNArena offers subscribers access to the most up to date earnings forecasts in the Australian share market via tools and services such as The Australian Broker Call, StockAnalysis, the R-Factor and the "Top Ten Weekly Recommendation, Target Price, Earnings Forecast Changes". In addition, we publish a daily updated overview of short positions as released by ASIC, called "The Short Report" on the website.

P.S. See also last week's "Earnings Forecasts: Yet Another Groundhog Year?"

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