Rudi's View | Mar 07 2018
In this week's Weekly Insights (published in two separate parts):
-The Battlelines Are Drawn
-February 2018 Reporting Season Review
[Note the non-highlighted items appear in part two on the website on Thursday]
February 2018 Reporting Season Review
By Rudi Filapek-Vandyck, Editor FNArena
What is the most important focus for share market portfolios? Is it growth? Is it disruption?
Most commentators and professional investors have argued the former since the middle of 2016. I have been advocating the latter since 2015.
Maybe it's not a case of either this or that. Warren Buffett, in his recent annual missive to Berkshire Hathaway shareholders, and to investors across the globe, tried his best to dismiss rather simplistic labeling such as "value" and "growth". Good investing, Buffett argues, implies both are connected at the hip.
I'd argue the same applies to growth and technological innovation, which is what causes the disruption in many of today's industries. If the February reporting season in Australia has proved one thing, it is that for successful investing in the Australian share market, growth and disruption are best seen as co-joined twins connected at the hip.
"Value", as defined by forward looking Price Earnings (PE) multiples, more often than not confused investors, and proved them terribly wrong on numerous occasions. February 2018 was the reporting season in which High PE market darlings significantly outperformed their lower priced peers, with their financial results outperforming market expectations, forcing analysts to increase forecasts, and share price valuations – often by double digit percentages.
The pain for shorters, and for many other investors who found themselves on the wrong side of the trade, was extra confronting since it had become a popular view that inflation is coming, interest rates and bond yields are on the way up, and high PE stocks should be avoided for risk of de-rating.
Yet the exact opposite happened in February, despite the fact the month opened with increased volatility and selling pressure as the world watched US bond yields lift and anti-volatility derivatives implode. Best performing sector for the month, by a long stretch? Healthcare, led by High PE outperformers CSL ((CSL)) and Cochlear ((COH)). Information Technology (IT) also proved a stand-out, equally led by High PE outperformers Computershare ((CPU)), REA Group ((REA)), NextDC ((NXT)), Altium ((ALU)), and numerous others.
[Note: I do not agree with the inclusion of Computershare, REA Group and NextDC, but the IT sector index promoted by the ASX does include these names, as well as Domain Holdings. Hence for the sake of simplicity, I'll just stick by it for the purpose of this review].
On the other end of the spectrum, cheap looking out-of-favour stalwarts such as Harvey Norman ((HVN)), QBE Insurance ((QBE)), Myer Holdings ((MYR)), Vocus Communications ((VOC)), IPH ltd ((IPH)), Asaleo Care ((AHY)) and iSentia ((ISD)) simply continued their bad news cycle, and share prices are sharply lower in the aftermath of yet more disappointing financial results.
One should never forget, in the short term, reporting season is all about market expectations and how the financial performances that are being released compare to those expectations. Hence, immediate share price responses are not always an accurate indicator of what follows next.
One relationship is direct and undeniable: if analysts are forced to upgrade or downgrade their forecasts and valuations, the share price virtually always follows suit, unless the price is already accounting for it. The stand-out example this February was delivered by a2 Milk ((A2M)) with many an expert adopting a cautious approach beforehand given the share price had quadrupled over the prior twelve months. But since January 1st, a2 Milk shares are up more than 40% (not a typo) and most of these gains have occurred on the day the company released its interim financials.
FNArena subscribers can observe via Stock Analysis on the website how earnings forecasts and stockbroker valuations equally jumped higher since that day. Today, consensus target sits double digit percentage above a sideways moving share price.
Seen through the prism of stockbroking analysts expectations, February 2018 delivered one of the best reporting seasons for corporate Australia over the past five years. FNArena statistics are not definitive as yet, but on our assessment some 37% of 318 reporting companies throughout the season have clearly beaten market expectations. This is equal the highest percentage with February 2016.
Back then, 21% of reporting companies disappointed. This time around profit misses represent 25% of all released results. The average increase in price target of 4% is well above average, but still beaten by two 5%+ increases respectively in February 2014 and February 2015. Changes in recommendations throughout the season favoured upgrades above downgrades; 87 versus 54. Only one other reporting season had more upgrades than downgrades. In August 2015 the ratio stood at 116 up versus 40 down.
Other factors worth mentioning:
-Earnings estimates usually decline by the end of most reporting seasons, but most brokers report the opposite happened this February. Average profit growth sits around 6-7%, which is reasonable yet below double digit growth in 2017, as well as double digit growth internationally.
On a relative basis, Australia remains a laggard, as illustrated by the table below taken from a recent market update by UBS.
-Positive surprises include capital management and dividends, with the added observation that a lot remains dependent on mining companies enjoying higher for longer prices, while boards remains hesitant to start investing in new production capacity. Analysts have noted a renewed appetite for corporate action, but also that cost growth is making a come-back. This kept numerous market updates by resources companies rather underwhelming, despite the apparent buoyant global conditions.
–Margins are near cyclical peaks, and now coming under pressure as costs are rising, but top line growth in general is positive and companies seem to be positioning for additional investment, backed by positive outlooks and guidances. Note all of Woodside Petroleum ((WPL)), Newcrest Mining ((NCM)), South32 ((S32)), Evolution Mining ((EVN)), OZ Minerals ((OZL)), Sandfire Resources ((SFR)) either announced new transactions during the season, or their management teams indicated they are ready to pounce whenever opportunity presents itself.
–Stand-out performances were delivered by a2 Milk, Altium ((ALU)), Appen ((APX)), BlueScope Steel ((BSL)), Bravura Solutions ((BVS)), Breville Group ((BRG)), Corporate Travel ((CTD)), Costa Group ((CGC)), CSL, Flight Centre ((FLT)), Hansen Technologies ((HSN)), Insurance Australia Group ((IAG)), Kogan ((KGN)), Moelis Australia ((MOE)), NextDC ((NXT)), Nine Entertainment ((NEC)), Orora ((ORA)), Qantas ((QAN)), Reliance Worldwide ((RWC)), ResMed ((RMD)), Seven West Media ((SVW)), Smartgroup Corp ((SIQ)), and Webjet ((WEB)).
–Notable disappointments include Blackmores ((BKL)), BWX ltd ((BWX)), Domino's Pizza ((DMP)), Harvey Norman ((HVN)), InvoCare ((IVC)), IPH ltd, iSentia, JB Hi-Fi ((JBH)), Mayne Pharma ((MYX)), QBE Insurance, Vocus Communications, Ramsay Health Care ((RHC)), Silver Chef ((SIV)), Star Entertainment ((SGR)), Suncorp ((SUN)), Super Retail ((SUL)), Tabcorp ((TAH)), and WiseTech Global ((WTC)).
–Resources' report card was rather mixed, as illustrated by the fact BHP ((BHP)) disappointed and Rio Tinto ((RIO)) broadly met expectations, including extra capital for shareholders through additional buyback and higher dividend. But Origin Energy ((ORG)) is oft cited as one notable outperformer for the sector, as is Mineral Resources ((MIN)). Notable disappointers for the sector include Beadell Resources ((BDR)), Dacian Gold ((DCN)), Northern Star ((NST)), Perseus Mining ((PRU)), Santos ((STO)), Senex Energy ((SXY)), South32, and Western Areas ((WSA)).
Earnings forecasts for resources stocks have fallen after rising strongly late in 2017, but they remain negative for 2019.
–Travel stocks, from Corporate Travel to Qantas, including Flight Centre, Helloworld ((HLO)) and Webjet, defied market scepticism about lower prices and margin pressure in Asia and a direct link to consumer spending in Australia.
–The retail sector proved a hotch-potch of solid momentum and sorry disappointments, mixed with plain disasters. AfterPay Touch ((APT)), Kogan, Breville Group, Lovisa ((LOV)) and Noni B ((NBL)) are clearly performing well. Harvey Norman, JB Hi-Fi, Myer, Michael Hill, and many others not so. The jury remains out for Accent Group ((AX1)) which might have benefited from expectations having fallen too low. A factor that might also have benefited Coca-Cola Amatil ((CCL)), as well as The Reject Shop ((TRS)).
A weak result was delivered by Westfield ((WFD)), with questions being raised as to how this might potentially impact on the proposed acquisition by Unibail-Rodamco.
For investors here lies a much broader question waiting to be answered: how does Westfield's rapid deterioration impact on Scentre Group ((SCG)) and other supermarket owners elsewhere? What does it tell us about changing patterns for consumer spending in general?
-February also marked a come-back for traditional media on the back of advertising dollars flowing away from the Internet and from social media platforms. If sustained, this would mark an important reversal which should have the attention of all investors.
-In terms of ongoing potential for capital management, Qantas and resources giants BHP and Rio Tinto remain prime candidates, as are Crown Resorts ((CWN)), GWA Group ((GWA)), Inghams Group ((ING)), Investa Office Fund ((IOF)), Stockland ((SGP)), Wesfarmers ((WES)) and Woolworths ((WOW)).
Analysis of past reporting seasons suggests those who manage to deliver a positive market beat are most likely to continue enjoying positive momentum for up to three months after their results. Whether this also applies post February is an intriguing proposition given many a fund manager is afraid of equities de-rating on the back of rising bond yields, and is positioned in accordance with this concern.
Similarly, those who fail to meet market expectations might find a lack of buyer's appetite for a while longer.
In broad terms, the Australian share market outperformed international markets in February, but it still clocked a small net loss for the second month in a row. Investors with exposure to outperforming small and mid-cap companies (see above) might have had a different experience. FNArena's All-Weather Model Portfolio experienced its best reporting season since inception in late 2014.
In terms of profit expectations, large cap companies ex-banks and ex-resources are expected to grow by between 5-8% in both FY18 and FY19. Expectations for small and midcap industrials are twice as high. While some might argue this is already reflected in relative valuations, the February reporting season has shown that PE ratios, when judged at face value and in a static format, can be quite the misleading tool.
In terms of "growth" versus "disruption", I think the connection is there for everyone to see. While growth might falter or slow down, I don't think disruption will.
February has shown even long-time reliable growth stocks Ramsay Health Care and InvoCare are now finding the going a lot tougher than used to be the case. Whether this fundamentally changes the outlook for the years ahead remains to be seen.
Investors looking for cheap value among the downtrodden might want to reconsider before jumping on board the likes of Retail Food Group ((RFG)) and Silver Chef with February updates revealing risks are plenty and elevated with a cheap looking share price not necessarily the best gauge available.
Last week's audio interview on Reporting Season and pending index changes:
Rudi On TV
This week my appearances on the Sky Business channel are scheduled as follows:
-Tuesday, 11.15am Skype-link to discuss broker calls
-Friday, 11am Skype-link to discuss broker calls
Rudi On Tour
-An Evening With Rudi, Paddington, 11 April
-Presentations to ASA members and guests Gold Coast and Brisbane (2x), on 12 & 13 June
-ATAA members presentation Newcastle, 15 July
-Presentation to ASA members and guests Wollongong, in September
(This story was written on Monday 5th March and the second part on Wednesday 7th March. This first part was published on the Monday in the form of an email to paying subscribers at FNArena, and will be published again on Wednesday as a story on the website. Part two shall be published on Thursday).
(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. All views are mine and not by association FNArena's – see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: firstname.lastname@example.org or via the direct messaging system on the website).
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