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Reporting Season: Reality Versus Sentiment

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Mar 07 2019

In this week's Weekly Insights (published in two parts):

-Reporting Season: Reality Versus Sentiment
-Conviction Calls
-Aussie Banks & Market Sentiment
-Have Your Say
-No Weekly Insights Next Week
-Rudi On TV
-Rudi On Tour

[Non-highlighted parts will appear in Part Two on Friday]

By Rudi Filapek-Vandyck, Editor FNArena

Reporting Season: Reality Versus Sentiment

Corporate reporting seasons are important. They provide tangible indications about whether investor sentiment, assumptions and speculation are justified or misguided, but the release of corporate earnings reports never takes place in a vacuum. There are always other factors equally in play, be they macro-economics or geopolitical, or otherwise.

This year, the February reporting season took place against a background of a heavy, four month-long sell-down on the back of slowing growth globally, followed by a swift recovery that took everybody by surprise. That swift recovery was supported by Fed officials reversing their policy outlook towards a more market supportive "neutral" stance, with market participants now anticipating more accommodative policy reversals from central banks across the globe, and expectations of a trade war truce/solution/agreement between the Trump administration in the US and China.

Other factors that equally played a decisive role in February include far from worst case scenarios recommendations in the Hayne report to fix malfeasance inside the sectors of banking, insurance and wealth management in Australia, significant disruption to the availability of seaborne iron ore due to more production problems experienced by Brazil's Vale, and changing dynamics in the local telecom industry as incumbents start preparing for 5G and market share hungry TPG Telecom decided to shelve its own mobile plans on the back of the Australian government banning Huawei equipment, but also intending to merge with Vodafone Australia.


As positive momentum simply begat more positive momentum, equity indices in Australia rose some 13% from the lows around Christmas time, with February adding circa 6% in total return, including the first round of dividend payments. At face value, one would be inclined to conclude everything is hunky dory in the land of falling house prices, collapsing construction of tiny apartments and declining car sales, but when it comes to actual corporate results releases, a different reality opens up.

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On more than one statistic, February 2019 has been one of the worst corporate reporting seasons in Australia post the GFC years of 2008 and 2009. FNArena's statistics only reach as far back as August 2013, but never have we registered more than 27% in companies failing to meet expectations. In fact, 26%-27% has been a rather common statistic during these eleven reporting seasons, accounting for four of the them, and this expands to six (more than half) if we expand the range to 24%-27%.

This year, however, the tally stopped at 33.4%; well above anything recorded in prior years.

Now consider also that analysts had already been lowering forecasts since last year, and that many of February's "misses" were due to rising costs and a more subdued outlook, and it should be clear: corporate Australia is genuinely experiencing challenging conditions. On UBS's assessment, some 15% of companies upgraded their guidance, but 17% of companies guided towards a less profitable outlook.

The numbers released by quant analysts at Credit Suisse look a lot worse, with 16.9% of companies beating expectations, 36.2% missing expectations, and 46.9% reporting in-line. (Different sample & methodology, different results).

Equally unprecedented is the fact that FNArena's average price target adjustment for the season as a whole ended up flat (strictly taken the end result was -0.06%). This too occurred against a background of valuations and price targets already in decline since the prior year. Looking back at the series since mid-2013, average price target increases have ranged between +5.6% in February 2015 and +1.2% in August of that same year.

Never has our calculation for the 300+ companies reporting been flat, let alone slightly negative.

But not everything that happened during February set new negative records. Earnings forecasts dropped lower, but only mildly so and nowhere near the heavy reductions some were fearing beforehand. Here the outperforming sectors were mining companies and contractors to those mining companies.

EPS growth for ASX200 companies fell by a little over -1%, which is quite standard in Australia, leaving average EPS growth now at 3.3% for FY19 with only four sectors providing positive contributions in February: apart from miners, communication, utilities and real estate all forced analysts to upgrade forecasts. Industrials, Financials, Healthcare and Technology were all major detractors to the downside.

Counter-weighting the above average 34.4% in negative disappointments, was a virtually equal 33.3% in positive surprises. Past seasons have taught us corporate surprises ("beats") can run as high as 37% (in February 2018 and February 2016) but our history of eleven prior seasons offers only one prior example when "beats" did not outnumber "misses". It happened in August 2017, when both percentages stopped at 27%.

At face value, this suggests corporate Australia is still very much divided between "Haves" and "Not Haves", separating companies that are in good shape and achieving plenty of progress and profits from others that are struggling with persistent headwinds. It's a theme that has dominated reporting seasons in years past, also bifurcating expert views about "value" versus "growth".

But February 2019 was not simply an extension of trends observed and established in recent years. This time around the boundaries between groups and themes got significantly blurred with many of the registered "positive surprises" actually being a case of "not as bad as feared" while others still managed to put in a decent performance, but it simply was seen as not good enough.

What really blurred the distinction between "Haves/Quality&Growth" and "Not Haves" this February was that, all of a sudden, many that have been in the first group in years past this time around displayed signs of weakness and vulnerability. Combine all of this with extreme cases of share price volatility, in either direction, and it shouldn't be a surprise last month has proved an exceptionally tricky reporting season for investors to manoeuvre successfully.

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Before we highlight some of the individual companies and sector themes that should have investors' attention, let's spend a few more moments on the key themes that stand out from February reports (with thanks to EL & C Baillieu Chief Investment Officer Malcolm Wood):

Sluggish top line growth – at face value the statistics do not look bad, but average growth is being supported by a small group of rapidly growing outperformers. Underlying, argues Wood, average sales growth did not exceed 2.6% which is more than annual inflation, but hardly something to genuinely crow about.

Operational costs are on the rise – this was unmistakably one of the stand-out negative revelations during the season. Whether it be from input costs (energy, raw materials, etc) or from regulatory and compliance costs, or from higher wages, most negative surprises throughout February seemed to have a direct link to companies' inability to keep a lid on rising costs, or to pass it on to customers.

Scarcity of pricing power – inflation the world around remains below central bankers' targets, and a lack of pricing power by companies is showing up during reporting season.

Capital management funded by asset sales – Balance sheets are strong and which shareholder does not welcome a special dividend or share buyback, but Wood points out most are being paid for by asset sales and spin-offs. Great. But where then does future growth come from?

Limited growth prospects – Look beyond the "beats" and "misses" and but a small selection of companies in Australia is pursuing a significant growth agenda or acquisitions. Again, this poses the question: where is future growth coming from? Wood names Amcor ((AMC)), Transurban ((TCL)) and Woodside Petroleum ((WPL)) as positive examples of companies actively engaging in strategies to find additional pathways for growth.

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Anaemic top line growth proved one of the stand-out characteristics of healthcare companies reporting in February with all of CSL ((CSL)), Cochlear ((COH)) and ResMed ((RMD)) failing to meet or beat market expectations and share prices weakened in the immediate aftermath as a result.

In a defensive growth sector that has generated the best investment returns post GFC in Australia, all of a sudden achieving organic growth has become somewhat of a challenge. In addition to the three local market leaders already mentioned, we can add Ramsay Health Care ((RHC)), Healthscope ((HSO)), Healius ((HLS)), Mayne Pharma ((MYX)), and numerous others, including the listed aged care providers, and Ansell ((ANN)) and InvoCare ((IVC)) which are often also put inside the healthcare basket (note Ansell is 50% healthcare at most and InvoCare, well, yes, what can I say?).

One swallow does not a summer make, and one disappointing reporting season does not by definition imply investors are now abandoning the sector in droves, but it remains a remarkable turn of events when a whole reporting season flies by and nobody can remember one single healthcare company that blew the lights out.

Investors should also take into account that, since reporting, analysts have observed CSL continues to outperform its peers globally, suggesting its somewhat disappointing performance in February was not company-specific. The same observations have been made regarding Ramsay Health Care.

As per always, such observation brings out both the bears and the bulls in the share market. Sector analysts at Credit Suisse are worried about a de-rating for the sector over the year ahead, as growth is slowing and valuations remain at a market premium. Their peers at Citi, on the other hand, hold a strong view that share price weakness for quality healthcare stocks offers investors with an opportunity to get on board.

Citi has now upgraded heavily punished Cochlear to Buy with a price target of $198. Before anyone asks: CSL remains a Buy at Citi with a price target of $213. (See Stock Analysis on the FNArena website for all other healthcare stocks).

The rather sober performance of the healthcare sector last month has coincided with similarly less glamorous performances from a plethora of previously highly popular, quality growth business models, enjoying longer term growth trajectories that many would label as "secular". In contrast to prior reporting seasons, companies including GUD Holdings ((GUD)), Carsales ((CAR)), Bapcor ((BAP)), and Orora ((ORA)) this time around were unable to keep the positive momentum alive.

For others, including Blackmores ((BKL)), Bellamy's ((BAL)), Domino's Pizza ((DMP)), Hub24 ((HUB)) and Praemium ((PPS)), the market punishment was much harsher, and to date much more persistent too. It suggests investors have quickly distinguished between popular growth stocks that might have miss-stepped once, but still have a bright outlook, and others for which the future might now look more uncertain and challenged.

Most positive surprises were generated by discretionary bricks and mortar retailers, but the complicating matter here is this was to a large extent because of investors fearing the worst pre-February, a phenomenon described by some analysts as "peak pessimism" preceding results.

On balance, foot traffic in physical stores remains under pressure, sales are increasingly shifting online, and costs are rising here too. With analysts anticipating store rollouts domestically have peaked for most retailers, and margins will continue to face pressure into FY20, this segment is likely to remain tricky at best, and a graveyard for silly aspirations and lost ambitions for many an investor under most scenarios.

For those keen to invest in the sector, stockbroker Morgans' favourites are Lovisa Holdings ((LOV)), Baby Bunting ((BBN)), Adairs ((ADH)), AP Eagers ((APE)), and Noni B ((NBL)).

The many challenges for bricks and mortar retail shops are equally having an impact on the A-REITs sector, where many a landlord is battling sector transformation and decline. On some analysts' estimation, a record number of retail assets are currently up for sale in Australia. This is likely to depress prices, with flow-on impact for valuations of such assets on balance sheets of retail landlords.

The warning here is that "value" can easily turn into a "value trap" under less favourable conditions.

Most sector analysts continue to prefer fund managers, and industrial and office assets operators above retail landlords. Over at Credit Suisse, for example, the ranking order for AREITs post February has been updated to, in order of preference, Goodman Group ((GMG)) -still most preferred though others might consider it too richly valued- followed by Scentre Group ((SCG)), Mirvac ((MGR)), Vicinity Centres ((VCX)), GPT ((GPT)), Shopping Centres Australasia ((SCP)), and Charter Hall Retail ((CQR)), with  Stockland ((SGP)) least preferred.

Irrespective of all of the above, few would debate the fact the stand-out champions of the February reporting season have been large cap resources stocks, miners in particular. Product prices remain higher-for-longer, cash is flowing in and investments are only made in a measured manner. The formula is working to near perfection, at least for the time being.

To many sector analyst, miners remain in a free cash flow sweet spot, which is why shareholders continue to enjoy rising dividends, accompanied by special dividends, and share buybacks. Said mining analysts at Credit Suisse recently: "We cannot recall a time where balance sheets were so undergeared right across the sector."

Underneath the surface, however, rising costs and operational challenges are making their presence felt across the sector. Investors will have to stay agile and focused. The FNArena Reporting Season Monitor for February shows many a smaller cap mine operator disappointed in February, making the sector not a risk free winner for all.

Capex growth from resources (including energy thus) is projected around the 20% growth mark, which bodes well for contractors. Macquarie's favourites are Downer EDI ((DOW)) and WorleyParsons ((WOR)).

A special mentioning remains reserved for a select number of companies that truly has the wind in the sails, with company management doing all the right things, while showing investors true opportunity does not necessarily lay with turnaround attempts at beaten-down share prices, but equally so with Champion stocks at above market multiples that continue exhibiting their quality, ingenuity and strength.

Companies worth pointing out within this context include Magellan Financial Group ((MFG)), Cleanaway Waste Management ((CWY)), Appen ((APX)), Altium ((ALU)), a2 Milk ((A2M)), Bravura Solutions ((BVS)), Goodman Group, Charter Hall ((CHC)), IDP Education ((IEL)), and Nanosonics ((NAN)).

Plenty of others proved why cheap looking share prices were probably appropriate.

Have Your Say

FNArena has been receiving a number of complaints from paying subscribers who are not happy with the email alerts in current format.

I can see a win-win for all of us involved and will soon engage in two-way communication about this.

If you too have a view on how our alerts can be improved, this is your opportunity to have your say. Send us an email via info@fnarena.com and we will follow-up shortly.

No Weekly Insights Next Week

Due to commitment for an on-stage presentation on Tuesday next week, I won't be writing a Weekly Insights. Everything should be fine again from the following week onwards.

Rudi On Tour In 2019

-ASA Inner West chapter, Concord, Sydney, March 12
-ASA Sydney Investor Hour, March 21
-ASA Toowoomba, Qld, May 20
-U3A Investor Group Toowoomba, Qld, May 22
-AIA Adelaide, SA, June 11
-AIA National Conference, Gold Coast, Qld, 28-31 July
-AIA and ASA, Perth, WA, October 1

(This story was written on Tuesday 5th March 2019. Part One was published on the Tuesday in the form of an email to paying subscribers at FNArena, and again on Thursday as a story on the website. Part Two will be published as a story on the website on Friday).

(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: info@fnarena.com or via the direct messaging system on the website).

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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

Subscriptions cost $420 (incl GST) for twelve months or $235 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): https://www.fnarena.com/index2.cfm?type=dsp_signup

(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.) 

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