Rudi's View | Jul 25 2019
Dear time-poor reader: this week I explain why global equity markets have been paying scant attention to corporate earnings, which doesn't mean August will be a complete waste of time.
Part Two (on Friday) contains an interesting piece of research on Australian banks, and further zooms in on the threats and risks from super-accommodative central bank policies and the ever rising mountain of global debt; and why there still is no inflation danger.
In this week's Weekly Insights (published in two parts):
-Corporate Earnings Still Matter In 2019
-Dividends, Quality And Australian Banks
-Central Banks' Policies Not Without Risks
-Charts: Mind The Output Gap, And Global Debt
-Rudi On Tour
Corporate Earnings Still Matter In 2019
By Rudi Filapek-Vandyck, Editor FNArena
In the share market all that matters are corporate profits and growth, or so the mantra goes.
But sometimes the direction for the share market is guided by a number of other catalysts, relegating corporate earnings to merely a secondary role. See the past twelve months as Exhibit A in support of that statement.
In August last year, investors were fretting about high valuations for Quality and Growth stocks, while bruised value-oriented funds managers were speculating whether their moment under the sun was -finally- about to arrive.
The 2018 August reporting season did not provide any clues about a profound and sustainable switch in market dynamics. If anything, stocks like CSL ((CSL)) and REA Group ((REA)) surged to new highs upon release of financial performances.
Once the reporting season was finished, investors' hope soon turned into despair as markets started a relentless downtrend for the final four months of the calendar year. That downtrend turned into a savage sell-off as year-end approached. Then Christmas came and put general anxiety on pause.
Next the Federal Reserve reversed its policy outlook -there would be no more tightening via Fed Funds Rate increases- and financial markets have rallied circa 20% over the following seven months.
In between, consensus forecasts for corporate profits have continued to fall, with one notable exception: iron ore miners. The Australian economy too is notably weaker than one year ago, now also pulling the RBA into stimulus action through two rate cuts this year, and ongoing promise of more to follow.
Bond yields the world around are significantly lower. US Treasuries are still flirting with an inverted yield curve whereby longer duration government debt carries a lower yield than short duration debt. In Australia, this year's August reporting season has been preceded by what seemed an unusually crowded period of profit warnings throughout April, May and June.
On some estimates no less than 250 ASX-listed entities have warned their shareholders they will not be able to meet prior guidance or promises.
And yet, the ASX200 is trading within a one day's rally of the late 2007 all-time high. In the absence of improving profit prospects (outside of iron ore), share market valuations have risen instead and are now back to multiples that bring back memories of late 2007. At least for those stocks and sectors that have fully participated in the 2019 bull market rally.
If, after reading the above paragraphs, you might feel inclined to conclude that corporate profit growth hasn't really mattered post August last year you are partially correct.
Companies with the ability to power along, continuing to deliver where it matters most, have seen their share price enthusiastically rewarded. Those that had to acknowledge it couldn't be done, or that disappointed otherwise have been punished severely. Achieving a return in the footsteps of the share market's +20% advance has been a case of owning winners, but equally of avoiding the losers.
Yet, this is still only part of this year's share market story.
In contrast to prior global economic downturns post GFC, this time the Australian economy has been noticeably weak too. In addition, long-term mega-trends such as the emergence of online competition and changing consumption patterns still apply. Which is yet another reason why whole sectors and segments of the Australian share market have failed to keep pace with the broader market's upswing.
Some laggards are starting to attract attention, but only because investors are speculating that two RBA rate cuts, and more likely to follow, might stabilise housing markets, which then should translate in better conditions for builders and building materials companies, and in more spending by debt-constrained households.
The average profit growth forecast ex-iron ore sits in between zero and 1% ahead of the August reporting season, and is still falling as preparations are being made for the mid-year onslaught of corporate updates. Low expectations usually feed into investor confidence that not much is required to do a smidgen better. But it is still undeniably tough out there. 250 profit warnings are not a pretty-looking warm up.
August 2019 could well turn into a multi-level reporting season experience.
On one hand we have high quality, high achievers on elevated multiples. On the other side of the spectrum there are large swathes of the market that have been largely ignored and forgotten about up to this point. Clearly, there are problems that need to be dealt with, and preferably in a convincing and sustainable manner.
In between are the companies that haven't delivered yet, and they are unlikely to do so in August as it remains early days to see much crystallising in terms of improved building activity or increased consumer spending. My suspicion is these companies will continue to enjoy the benefit of the future promise; as long as the financial result in August doesn't shatter any reasonable prospects.
A Big Question Mark will remain for those on the wrong side of the world's tectonic shifts and regulatory scrutiny, including retail landlords, aged care centres and accommodation for seniors, and value investing-style asset managers. It's most likely equally way too early as yet to see any evidence of a turn in the cycle for new battery materials, or thermal coal, or travel and tourism enterprises.
Can some in the business nevertheless convince investors their efforts deserves a higher share price?
As has become the new norm, both locally and internationally, in the absence of solid growth numbers and market-beating guidance, a lot of attention will go out towards higher dividends, special pay-outs and share buy backs. Again, the sole market segment that continues to enjoy better-than-anticipated market dynamics -the iron ore producers- will be front and centre of investors' expectations for a little extra on top of robust looking growth numbers.
Dismal profit growth does not mean there cannot be further growth in dividends, as companies can decide to pay out extra to prove their confidence or to reward shareholders after a challenging period. Ultimately, of course, savvy investors will be weighing up whether any of it is sustainable, and whether it is worth staying on the register regardless.
Here it is worth mentioning international research has identified companies buying back their own shares as most likely to outperform. A recent report by JP Morgan put the average outperformance vis-a-vis the broader market index at 4%-plus per annum in both Europe and the US.
While it is true that shareholders in the likes of BHP Group ((BHP)) and CSL have been well-rewarded on the back of buy backs in the past, it is also my observation that not all share buy backs have the same positive impact. What I would refer to as a "defensive buyback", when the board announces a buy back amidst lots of challenges and bad news, often helps with stabilising the share price, but it fails to also generate outperformance.
In the absence of much in terms of actual growth in profits, it is likely capital management will once again become one of the defining features of the upcoming reporting season. Also because challenged business models are being restructured and streamlined through divestments of non-core assets (Graincorp ((GNC)), Woolworths ((WOW)), EclipX Group ((ECX)), etc).
Lastly, but certainly not least, expectations for FY19 might be low, and most companies might be able to meet or even beat them in August, most experts locally are convinced market expectations for 8% growth in earnings per share on average for FY20 seem way too optimistic.
This happens in most years in Australia. Once FY19 is behind us, and analysts start looking towards FY20 in more detail, also with the latest input included, forecasts tend to trend downwards. See this year's trend as Exhibit B.
For investors the Big Question is whether such downgrades need to happen as soon as August, alongside company guidance for the year ahead, or whether this remains a gradual process that mostly affects other companies not held in the portfolio.
Analysts will be looking more closely in the weeks ahead whether they can find any candidates that appear most likely to disappoint, either on actual performance numbers or through management's guidance. Getting this right is notoriously difficult, but investors might want to take on board that "surprising to the upside" or "disappointing" during reporting season can lead to outperformance and underperformance respectively of up to three months (and sometimes longer) after the results release.
As happens prior to every reporting season, investors are nervous about whether highly valued share prices might be due a correction once the financial results have been released. This is quite normal and on my observation nothing but a twice annually recurring ritual.
Within this context, one observation from the February reporting season is worth highlighting. In February, for no obvious reason or common denominator, a number of the Quality, Highly Valued names on the Australian stock exchange could not enthuse investors and their performances, seen as "disappointing", were met with investors selling out, putting share prices under pressure.
Think CSL, REA Group, ResMed ((RMD)), Carsales ((CAR)), among numerous others. Look up any of these price charts and one can clearly see the "correction" that occurred in February (late January for ResMed) but here we are, five months further and all those share prices have regained the losses, paid out dividends, and rallied to new highs.
Herein might lay the opportunity for those who as yet have not jumped on board any of these long term, structural, Australian success stories.
Most teams of analysts and market strategists are yet to release their previews and recommendations ahead of August.
Macquarie analysts suggest buying Fortescue Metals ((FMG)), Charter Hall ((CHC)) and WorleyParsons ((WOR)) into their respective results releases still makes sense. Macquarie sees all three as major candidates to beat market consensus. a2 Milk ((A2M)) is also seen as a prime candidate for upside surprise.
Analysts at Morgans are habitually concerned stocks trading on elevated price-earnings (PE) multiples are at risk for disappointment and subsequent capital punishment. Stocks with the potential to beat expectations include, according to Morgans, a2 Milk, AP Eagers ((APE)), Medibank Private ((MPL)), Megaport ((MP1)), Australian Finance Group ((AFG)), as well as IPH ltd ((IPH)).
Stocks best avoided, according to the stockbroker, due to risk of reporting season disappointment, include Nanosonics ((NAN)), Bellamy's ((BAL)), NextDC ((NXT)), Carsales, Flight Centre ((FLT)), Coca-Cola Amatil ((CCL)), CSL, REA Group, AGL Energy ((AGL)) and Woodside Petroleum ((WPL)).
As has now become tradition, FNArena will keep a daily eye on corporate releases and the respective responses from stockbroking analysts via the dedicated Corporate Results Monitor on the website. See drop down menu starting from Analysis & Data.
See also "Dividends, Quality And Australian Banks" in Part Two of this week's Weekly Insights.
Next week I shall be attending the National Conference of the Australian Investors Association (AIA) on the Gold Coast. Weekly Insights shall resume with ongoing focus on the local reporting season from the following week onwards.
Audio interview from Wednesday last week:
Rudi On Tour In 2019
-AIA National Conference, Gold Coast, Qld, 28-31 July
-AIA and ASA, Perth, WA, October 1
-ASA Hunter Region, near Newcastle, May 25
(This story was written on Monday and Tuesday 22nd & 23rd July 2019. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website. Part two follows 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: email@example.com or via the direct messaging system on the website).
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(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.)