Feature Stories | Sep 07 2015
This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB
By Rudi Filapek-Vandyck, Editor FNArena
August 2015 was in many ways yet another unusual domestic reporting season, potentially revealing trend changes that might well prove pivotal for investors in the year(s) ahead.
A Tsunami Of Broker Upgrades
Share market volatility always picks up noticeably when (most) companies report their financial performance in February and August. The process always includes big surprises and equally big misses, while large short positions for beaten down, largely abandoned market underperformers tend to command a prominent role as well.
This year, local results coincided with a global growth scare on the back of persistently underwhelming data and developments from China as well as capital raisings by two of the Big Four Australian banks, following National Australia Bank’s ((NAB)) lead in May. The combination of all three made for a very powerful cocktail indeed with day-to-day volatility reminding investors of the bad old days of 2008. Shares headed south, through large swings in both directions, and the ASX200 briefly sank below 5000, a far cry from the 6000 that had briefly appeared within reach in April-May.
Stockbroking analysts responded accordingly. FNArena registered no less than 116 upgrades and 40 downgrades for individual stocks covered by the eight stockbrokers monitored. To put these numbers in context: in February, FNArena registered 38 upgrades and 118 downgrades (almost exactly the other way around). August last year generated 52 upgrades versus 86 downgrades. Moreover, if we include rating changes not directly linked to corporate results, total upgrades for August rise to 138 against 47 downgrades.
The explosion in stockbroker upgrades highlights the difficulty for investors to assess what was really going on during this last reporting season. Add short covering and the picture only becomes even more confusing. On relative sector performances, capital goods, media and materials all beat telecommunications and healthcare, go figure. On more than one occasion, price action on the day of the profit report release proved out of synch with the response from stockbroking analysts the following day.
It Wasn’t Great
For good measure: assessing reporting season is always subjective, but the straightforward, objective observation is August this year has left experts with a general sense of “disappointment”, “underwhelming”, “uninspired”, if not “worried”. This is reflected in strategists scaling back their projections for the ASX200. Gone are the 6000 targets for year-end 2015.
Instead, UBS is now hoping for 5550. Deutsche Bank is projecting 5600. Citi thinks 5700 might still be possible. Most retain a firm belief in the underlying uptrend and are now projecting the index at 6000 sometime in 2016. Others have turned more cautious. Like the strategists at Morgans. Strategists at Morgan Stanley suggest investors better not fool themselves and pare back expectations significantly.
Morgan Stanley’s new forecast for the ASX200 twelve months out is 5150. Yes, you read that correctly. Closer to where the index has found support around the 5000 mark than anywhere near the long targeted but ever so elusive 6000 level.
Australia Lacks Profit Growth
Investors like to moan about the divergence between the gains made by US equities since March 2009 and the rather sober performance from equities locally. To a large extent, this gap can be explained through the lack of profit growth locally. As shown on the graph below, resources companies (miners and energy producers) in particular have found the going tough post 2010, but industrials including healthcare companies, telcos, building materials and property developers have largely delivered consistent performances over the past years.
August 2015 has created some doubt about whether those industrials can continue to deliver with several high quality high achievers this time around unable to outperform market expectations (the likes of Ramsay Healthcare ((RHC)) and CSL ((CSL))), while others surprised negatively, either through higher costs or additional investments (like Seek ((SEK)) and InvoCare ((IVC))), or through increased competition (like Woolworths ((WOW)) and Insurance Australia Group ((IAG))).
One stand-out observation is that analysts and investors had been too confident about currency benefits for companies with offshore revenues. The general assumption that a weaker Aussie dollar benefits everyone with foreign customers was repeatedly given a hard reality check through companies such as Ansell ((ANN)), CSL and Brambles ((BXB)) for which the euro and other currencies had provided negative offset.
In an ironic twist, it turned out analysts and investors had in many cases been too bullish on foreign currency earners and past high achievers, while also too negative on beaten down underperformers which allowed the latter to outperform the former during the season (also helped by short covering).
Underlying all these observations stands the undeniable fact that profit expectations have come down in August, and they seem unusually low for FY16 this early in the new financial year. As shown in the graph below, most years expectations start off on a higher level and they gradually trend lower as the year progresses. Margin pressures, cautious guidance and rather modest macro-expectations have lowered profit expectations for the year ahead to low single digit percentages. This suggests the outlook is yet for another year of negative growth for the ASX200, as was the case for 2015, while the moment of recovery for resources stocks is being pushed further and further out.
On Morgan Stanley’s observation, earnings per share revisions in Australia have now been negative in 20 of the last 24 months.
The question of the outlook for the Australian share market is therefore closely linked to investor confidence and global risk appetite. If you think the absence of solid, predictable profit growth for most companies in Australia is going to weigh on sentiment overall, while keeping appetite low, then strategists at Morgan Stanley and yourself are reading from the same script. If, however, you think low interest rates continue to make equities and high dividend yields attractive, both against alternatives and in comparison with global equities, then you’re more likely to find your soul mates at Deutsche Bank, Credit Suisse, Citi and UBS, hoping the index might be ready to reach 6000 by or before year-end next year.
Whatever the angle or view, and regardless of macro-economic danger and risks, it would appear the overall context leans towards more caution rather than more risk. Even Australia’s Future Fund, one of the most successful Sovereign Wealth Funds since inception, has signalled as much in its latest quarterly update.
This may surprise many an investor, but the 15% decline in share prices since May has merely pulled back the share market’s valuation in line with its long term average (PE 14-something) while the average EPS growth forecast is below trend, but average yields are now higher than 5%, well above the historical average.
Price Targets Paint Subdued Outlook
Corporate reporting seasons, both here and overseas, are often judged by the percentage of companies beating and missing expectations. However, I tend to look at the changes that are made by analysts after financial reports have been analysed and digested. Firstly, a positive surprise that is being followed up with positive revisions by analysts virtually guarantees a lasting market outperformance. Secondly, the changes made after the result are an indicator in their own right.
For example, price targets for individual stocks tend to rise throughout each reporting season. Usually, February delivers the largest increase with the past two interim reporting seasons pushing up price targets in excess of 5% on average. In the two preceding years, the average target increase throughout August was circa 2.5%.
This year the average increase was no more than 1.25%. Half of previous years. Less than one fourth of previous February increases.
At face value, this further corroborates the decision by strategists to scale back near term projections for the ASX200. There is, however, one complicating factor in play in that stockbrokers have been quietly adjusting their portfolios of stocks that are researched regularly. Out the window have gone mining services providers and small cap miners and explorers. In their place, analysts are now spending time on new tech innovators such as Aconex ((ACX)), 3P Learning ((3PL)), Nearmap ((NEA)) and Speedcast International ((SDA)) as well as young upcoming entrepreneurial business models inside the healthcare and aged care sectors, such as Regis Healthcare ((REG)), Estia Health ((EHE)) and Japara Healthcare ((JHC)), as well as young and upcoming retailers, including Adairs (ADH)), Lovisa ((LOV)) and Suftstitch Group ((SRF)).
It is difficult to accurately gauge how this switch might have impacted on average target revisions. Any impact on average profit forecasts is negligible (calculated market averages are typically ASX200-oriented). In terms of excitement, it has to be noted many of these young and upcoming small caps outperformed expectations, and often prospectus forecasts. Many have been rewarded for it too, trading on above average Price-Earnings (PE) multiples, albeit not necessarily on high trading volumes.
More Dividends, Less Growth
Overall growth, and the quality of it, might have been underwhelming, but one observation unites every analyst post August: dividends have again surprised to the upside. The average payout ratio has further risen to 75%.
While this seems “unsustainable”, in particular with top line growth challenged and profit growth tepid at best, the big boost in August came from the resources sector with energy companies such as Origin Energy ((ORG)), Santos ((STO)) and Woodside Petroleum ((WPL)) all pleasing their shareholders despite obvious pressures from a much lower oil price environment. Mining companies proved no different with the large diversifieds BHP Billiton ((BHP)) and Rio Tinto ((RIO)) defending their progressive dividend policies at all cost, while smaller peers such as Fortescue Metals ((FMG)) also continued to pay out dividends, also despite significant pressure.
On Goldman Sachs’ estimates, since 2011 average growth in earnings per share has been 5% while dividends have grown by 25%. In August, EPS for resources stocks on average declined by 25%, but dividends grew by 4%. The direct connection between sacrosanct dividends today and a lesser growth potential into the future is most obvious at BHP Billiton and Rio Tinto where projects do not receive the go-ahead in order to safeguard the company’s ability to pay out next year’s dividends.
Another stand-out example for what must be a great frustration for Glen Stevens at the RBA and for the government in Canberra, came from the largest rail freight operator in the country, Aurizon ((AZJ)), where management sees no better option than to lift its pay-out ratio for shareholders to 70-100%, effective immediately. Aurizon, whose customers are suffering due to low prices for bulk commodities, clearly shows the limitations of monetary stimulus in times of low growth and plenty of economic challenges.
The August reporting season further confirmed investors do not like investments with an uncertain or no tangible near term return. See Seek, Veda Group ((VED)), InvoCare, Insurance Australia Group, among others.
Any hopes for a bottom and recovery soon for resources stocks has pretty much been quashed, again, post August with analysts continuing to lower price expectations for crude oil and metals and minerals, while global growth concerns continue to dominate the macro picture.
The key concern that has arisen from the August results (and not only for strategists at Morgans and Morgan Stanley) is that beyond the resources and the weaker parts of the economy (such as regional TV and print media), it now appears growth for industrials also has reset below trend. This is the big contrast with previous years when industrials led by Ramsay, CSL, Telstra ((TLS)), Amcor ((AMC)), Wesfarmers ((WES)), REA Group ((REA)), and others, remained a source of solid and reliable growth. In August, some of these companies missed guidance, or expectations or otherwise provided cause for reduced forecasts.
Two core conclusions have been drawn: firstly, the domestic economy is obviously running at below trend speed, which since has been confirmed by the ABS’ GDP estimate for the second quarter. Secondly, global economic momentum appears to be weaker too, which further feeds into macro-economic concerns that are dominating global financial markets.
Analysts at Goldman Sachs report the downward revisions (290bp) made throughout August to profit estimates for industrial companies have been the largest since 2009, which certainly gives us something to think about.
Winners And Losers
The stand-out performance in August, in my view, came from Medibank Private ((MPL)) whose second financial report as a publicly listed health insurer defied sceptics, detractors and hedge funds with short positions. Contrary to Woolworths ((WOW)) in February and again in August, Medibank proved that just because half of the market turns negative on you and starts issuing negative research reports with negative predictions, it still doesn’t mean that particular half is right.
The reward has come through a quick turnaround in share price and in general market perception. Medibank remains beholden to a sector marked by increased competition and rising customer churn, but management’s ability to lift the operational margin overshadows all that. It remains far too early to nominate the health insurer as an All-Weather Performer (*) but any objective observer will agree the stock is now regarded a relatively low-risk, solid dividend-with-growth story for the 2-3 years ahead.
Other notable better-than-expected performances were delivered by BlueScope Steel ((BSL)), Blackmores ((BKL)), Domino’s Pizza ((DMP)), Echo Entertainment ((EGP)), Flight Centre ((FLT)), JB Hi-Fi ((JBH)), Magellan Financial ((MGF)), Qantas ((QAN)), Suncorp ((SUN)), The Reject Shop ((TRS)) and Treasury Wines ((TWE)).
Among smaller caps, many more managed to get analysts truly excited, including Aconex, Adairs, Amaysim ((AYS)), Austal ((ASB)), Bellamy’s ((BAL)), BigAir ((BGA)), Blue Sky Alternative Investments ((BLA)), Burson Group ((BAP)), Capilano Honey ((CZZ)), Estia Health, Gateway Lifestyle Group ((GTY)), IPH Ltd ((IPH)), Mantra Group ((MTR)), NextDC ((NXT)), Spotless Group ((SPO)), Select Harvests ((SHV)), Seymour Whyte ((SWL)), Surfstitch Group and TFS Corp ((TFC)).
APN Outdoor ((APO)) and oOH!Media ((OML)) proved outdoor advertising is booming, while Altium ((ALU)), SMS Management ((SMX)), UXC Ltd ((UXC)) and others raised hope for a sustainable turnaround for IT products and services. Conditions remain strong for fleet management as again proven by SG Fleet ((SGF)) and Smartgroup ((SIQ)). The retail sector in general seems to be in a better environment than back in February.
Also notable was that many a turnaround story still finds it difficult to excite the masses, including QBE Insurance ((QBE)), Adelaide Brighton ((ABC)), Breville Group ((BRG)), iSelect ((ISU)), Trade Me ((TME)), Transpacific Industries ((TPI)) and Virtus Health ((VRT)).
One of the notable shock disappointments was delivered by Ansell. Not only had the shares performed strongly earlier in the year, it showed overseas revenues are not a straightforward guarantee for outperformance on the back of a weakening AUD. Disappointment from ComputerShare ((CPU)) further emphasised the point.
Sonic Healthcare ((SHL)), on the other hand, proved that healthcare companies can issue profit warnings too (or maybe that not all stocks in the sector are of the same ilk). Further notable disappointments came from management teams at Bega Cheese ((BGA)), Dick Smith ((DSH)), FlexiGroup ((FXL)), Insurance Australia Group, InvoCare, nib Holdings ((NHF)), STW Communications ((SGN)) and Tatts Group ((TTS)). (We might as well include Woolworths too).
FNArena has kept a detailed diary of the August reporting season, recording misses & beats and changes post results. Paid subscribers can access the final update HERE
As eventful as the August reporting season has been, it remains in sharp contrast with how few changes stockbroking analysts and strategists are willing to contemplate for the six or twelve months ahead. In other words: the large trends that have dominated the Australian share market post-GFC remain firmly in place, regardless of falling share prices, increased macro-risks and the spike in day-to-day volatility.
Maybe the only noticeable change is a return to favour for Australian banks (after the significant falls suffered) with sector analysts starting to upgrade ratings for the likes of Westpac ((WBC)). UBS strategists moved to a tactical Overweight from Underweight on the sector in early September.
Most equity strategists continue to favour defensive yield, overseas exposure and other beneficiaries from a weakening Aussie dollar. Few would advocate adding to energy or mining stocks. Analysts at UBS offered the following observation: “Earnings expectations for the resources sector are back to mid-2004 levels. We don’t think they have bottomed yet”.
Just about everyone remains convinced, in broad terms, that structurally challenged industries remain under long term pressure, including free-to-air television, print media, fizzy drinks, steel, bricks and mortar retailers and contractors and services providers to miners and the energy sector. In addition, the cycle has turned for insurers while the going is much tougher now for the banks. Weaker oil prices have exposed weak balance sheets in the sector. Bulk commodities remain prisoners of over-supply.
Meanwhile, increased competition has roared its head for supermarkets and telecommunication while cheaper oil is providing relief for airlines. IT companies communicated early signs of better times ahead. Emerging new technologies are throwing up all kinds of excitingly looking, promising new business models. General commentary is less sanguine about the housing industry in Australia with some analysts starting to ponder whether a cyclical peak is near.
No doubt, the following observation will come as a big relief to a substantial part of the local financial advisory sector: small cap stocks seem to have stopped the long and enduring trend of significant underperformance vis-a-vis large cap stocks in 2015, helped by an almost uncharacteristically mild performance from small cap resources stocks (see chart below).
Strategists at Goldman Sachs provided the below summary of key reporting season themes and I cannot find anything to disagree with:
– 1) Defensives and USD names offered less protection from downgrades than in recent seasons
– 2) The commodity correction continued to put supply chains under pressure with impairments and earnings downgrades continuing
– 3) Growing concern across property-exposed firms that we’re close to the peak in the housing cycle
– 4) Domestic cyclicals showing small sequential improvements in both sales and margins
– 5) Persistent headwinds for bank sector profitability
– 6) Result quality remained an issue with lower interest expense and lower tax-rates continuing to support EPS while cash flow conversion was again soft
Maybe the ultimate defining event in August was that Nickel producer Mincor ((MCR)) stopped paying out a dividend to shareholders, having done so for more than ten years.
One final thought from the strategists at Morgans: “Macro volatility aside, there’s no hiding the fact that the corporate reporting season was patchy at best and concerning at worst”. Probably best to position portfolios and strategies accordingly.
(*) Paying subscribers have access to two (2x) eBooklets written by myself on All-Weather Performers. If you somehow haven’t received your copies, send an email to firstname.lastname@example.org
(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.)
P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi’s View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of ‘Rudi’s View’. You will receive an email alert every time a new Rudi’s View story has been published on the website.
P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
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