Rudi's View | Feb 06 2020
This story features INSURANCE AUSTRALIA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: IAG
Dear time-poor reader: profit warnings fill the pre-results season while T Rowe Price is comfortable with valuations of equities
In this week's Weekly Insights (published in Two Parts):
-February Reports: Global Uncertainties, Profit Warnings, And..?
-Comfortable At Record Highs
-Coronavirus Or Euphoria?
-Get More Out Of Your Subscription
February Reports: Global Uncertainties, Profit Warnings, And..?
By Rudi Filapek-Vandyck, Editor FNArena
Last year, the two major corporate reporting seasons attracted larger than usual numbers of profit warnings in the weeks leading up to February and August. January this year has not generated similarly large numbers, but profit warnings are coming through nevertheless.
With share market indices near an all-time high, the response from nervy investors can be quite unsettling for shareholders owning the shares of companies issuing a warning.
One would have thought with bushfires raging through towns and villages in NSW and Victoria, and with anecdotal evidence signaling consumers stopped spending post Boxing Day, while the Aussie dollar tried to rally above US70c in the meantime, investors would be a little cautious ahead of the upcoming February reporting season, but the start of the new calendar year showed no such restraint.
We can all but wonder where the share market would be without the coronavirus, but the observation remains that profit warnings remain part and parcel of corporate profit seasons in Australia.
Market strategists at JPMorgan have kept track of the numbers, and shared some of their observations. Since mid-December, 17 companies included in the ASX300 have "confessed" their operations are not running in line with market expectations. Of these "profit warnings", discretionary retailers and industrials are responsible for the lion share, with the former sector alone accounting for one-third of all warnings thus far.
In response, one-day share price punishments have been quite severe with the average share price fall -16.5%. JP Morgan strategists observe the average downgrade to forecast earnings has been -15.5%, which is not dissimilar.
It is important to note JP Morgan's research does not include all profit warnings issued, which can be partially explained by a certain discretion about when negative news is a profit warning. I note, for example, insurers Suncorp and QBE Insurance are missing from the report, but Insurance Australia Group ((IAG)) is included. Equally, there is no mentioning of Gentrack Group ((GTN)) or Beacon Lighting ((BLX)).
Equally important, the strategists point out despite these warnings, the broader earnings trend for Australian companies remains positive leading into the February season.
Again, this remains subject to interpretation. On FNArena's observation, earnings estimates are definitely falling, an observation backed by analysts at Macquarie, though we agree with JP Morgan it appears small cap companies are faring worse than large caps.
At least thus far.
What cannot be denied is that multiple companies are enjoying upgrades in earnings forecasts and among those are companies that recently updated on financial performances, including Credit Corp ((CCP)), Afterpay ((APT)), GUD Holdings ((GUD)), ResMed ((RMD)), and Virgin Money UK ((VUK)).
Under "normal" circumstances, one might expect rising earnings forecasts translate into a rising share price, but with coronavirus and other macro-factors hitting investor sentiment, this has now become less of a certainty. Investors should note: this means there will be opportunities with less risk when companies perform well operationally but their share prices are being held back by macro-angst.
My own suggestion would therefore be to look for excellence in performance potentially followed by share price weakness because of macro concerns and herd behaviour. ResMed once again seems to fit the profile.
Looking For Beaten Down Bargains
Investors being investors, and above all: human, the animal instinct will direct many eyes towards the beaten down share prices of companies that disappoint this month. After all, everything has a price, n'est-ce pas?
It depends on one's strategy and horizon. Analysis and observations from past reporting seasons teaches us that shares in companies that surprise to the upside are most likely to outperform, at times up until three months and longer after the event, while share prices in companies that disappoint can continue to oscillate around bargain-basement price level, until the next catalyst arrives, which potentially could be the August reporting season in six months' time.
My personal insight is to watch what happens to analyst forecasts and valuations post reporting. If forecasts rise and valuations are pushed higher, and the share price isn't already trading well above revised valuations and price targets, you have most likely discovered an outperformer who might continue to outperform for longer.
Exactly the same formula works the other way around, unless an extremely cheap valuation triggers take-over speculation, or something similar. Investing in the share market is often said to be all about cashflows and profits, but when it comes to drawing lessons from corporate profit reports investors tend to be best off when they correctly assess the trend in profits and in profit forecasts.
Which is why jumping on cheap-looking stocks post unexpected profit warning is a strategy beset with elevated risk. I suggest, for investors with a longer term horizon it is imperative to assess whether a profit warning has changed the growth outlook for the company beyond the short term.
In many cases it will do exactly that. This means investors need to re-assess what the outlook for this company looks like in the new context. This is not easy, given we are all influenced by the past, not in the least where share prices and valuations have been pre-profit warning.
From a personal perspective, I don't like companies that issue profit warnings. I can understand management teams cannot anticipate everything, and there is always room for an Act of God or an unpredictable setback, but in most cases profit warnings should have alarm bells ringing, and ringing loudly.
Most likely, they reveal not everything is running smoothly inside the organisation. Or management does not have a firm grip on the business, or doesn't understand the risks well, or is too optimistic in its messaging. It is also possible that sector dynamics are very fluid. Or that competition is getting a lot tougher. Or current management is simply not up to the challenge.
None of these reasons make for an attractive longer term investment, irrespective of how deeply a share price falls.
For investors who happen to own shares in companies that heavily disappoint, and that don't look like a great investment anymore within the revised context, I have but one key message: it is never too late to sell. It only takes one look at the share price graph of, say, Slater & Gordon ((SGH)) shares to underpin that statement.
This year's January confession season has impacted on my stable of preferred exposures in the local share market, with Treasury Wine Estates ((TWE)) and Nearmap ((NEA)) both issuing profit warnings. In both cases the share market reaction has been nothing short of savage.
Within my framework of finding All-Weather Performers, and combining my short-list of high quality performers with companies that have longer dated growth trajectories, I had included Treasury Wine under "Prime Growth Stories' and Nearmap under "Emerging New Business Models".
In both cases, the inclusions proved quite prescient for a while as share prices climbed to ever higher levels, but that was then. Now we know that, in Treasury Wine's case, the strategy to develop a new distribution model in North America is in tatters, and new management is looking for answers via an in-depth review.
Meanwhile, the odds seem very much in favour this company might be hit with more negative developments. Not in the least because Chinese cafes and restaurants are operating under the cloud of the spreading coronavirus. In Australia, grapes have been impacted by bushfires and the smoke these fires spread around.
For good measure: coronavirus-related impacts might prove temporary only and a shortage in high quality grapes locally might not have a large impact on the company's production of premium wines short-term, but these are tangible risks that won't go away simply because the share price has tanked.
Last year the Treasury Wine share price had weakened on speculation of hidden inventory build-up among distributors in China. It was a narrative spread around by hedge funds that had gone short the stock. As time went by, it seemed this malicious narrative didn't seem to stack up, and thus the FNArena-Vested Equities All-Weather Model Portfolio added some Treasury Wine shares.
By December, however, upon reading about problems inside the US division, it was decided to offload all those shares and reduce the portfolio's exposure to zero. In hindsight, this proved prescient. Or to use another term: lucky. We had no idea a profit warning was forthcoming only weeks later before the February half-yearly update.
Treasury Wine had been an outstanding performer from mid-2015 as the former division of Foster's finally got rid of its mediocre management-legacy and successfully executed on a strategy of "premiumisation" and increasing market share in China.
Taking a step back from all the positives that have occurred in the years past, of which some will continue in the years ahead, we have to conclude there is now potential for a lot of negative news flow, while risks remain elevated.
If the Model Portfolio hadn't sold all its shares in December, we would have sold post profit warning. Treasury Wine is hereby removed from the selection of Prime Growth Stories on the website. This doesn't mean all hope should be abandoned and this company can never again recover from the damage done.
What this does mean is that the company's overall risk profile doesn't suit the cautious, lower risk approach we prefer for the Portfolio. For similar reasons, we decided to sell the portfolio's remaining small exposure to WiseTech Global ((WTC)) in December. Too many unresolved question marks about the accounting in between subsidiaries and the mother ship need to be addressed with more transparency by the company.
Another grave disappointment was delivered by Nearmap, a company that arguably has everything at its disposal to become an international success story.
On Monday, Citi analysts explained why they remain optimistic longer-term post the January disappointment: Nearmap has a scalable business model, the current market share in North America, which is a large addressable market, remains tiny and there remains plenty of potential to move into additional geographies.
On the flipside, things clearly have not been running smoothly internally, an admission that was explicitly included in the written statement to the ASX. While management is likely to reduce the cash burn, the company is still not profitable and if more bad news were to follow, investors might start speculating about the need for extra capital.
This is probably partially why the share price is where it is today, which is well below targets set forth by stockbroking analysts (even post profit warning). I think the market is now anticipating a slower pace of growth for Nearmap in the years ahead. This might not be bad news in se, as it also reduces the potential for management to stretch itself and the company's resources too far.
But slower growth is slower growth, and if it turns out too slow this in itself can potentially result in more bad news through the share market allocating a lower valuation and, not to be completely dismissed, the company running out of cash before reaching break-even.
One observation that is firmly on my radar is the fact that management at Nearmap has now delivered three disappointments to the market in less than twelve months. This can be a sign of more negative news flow to come. Some of the corporate disaster stories from years gone by, including Slater & Gordon, iSentia ((ISD)) and Eclipx Group ((ECX)), started off with exactly the same pattern of successive disappointments.
Which is why Nearmap now sits in the naughty corner. One more negative piece of news, and we'll probably sell without thinking twice about it. In the meantime, we continue to re-assess, including asking ourselves questions about where to allocate the funds in the portfolio in the best possible manner.
Heavy turnover volumes in Nearmap shares post profit warning is likely an indication some institutional shareholders have now abandoned the register, while others have been waiting for the opportunity to get on board at a heavily discounted price, judging by the rally in the share price on Monday, when broad selling is dominating most ASX-listed entities.
As per always, this is what makes a market. Though not everybody is in it for the longer haul. Always good to keep this in mind.
Investors should know their own risk profile, level of experience, strategy and objectives, and act accordingly.
FNArena is keeping an close watch on the February reporting season: https://www.fnarena.com/index.php/reporting_season/
Part Two on Friday will zoom in on analysts expectations and predictions about likely hits and misses from individual companies.
All-Weather Model Portfolio
Apart from the few minor adjustments in December as explained earlier, no changes were made to the FNArena-Vested Equities Model Portfolio thus far in 2020. Direct impact from slowing growth or the coronavirus on the portfolio should be rather benign, on our assessment, and we already shifted into a more cautionary composition in August last year, as explained at that time.
In January, the Portfolio's performance kept track with the broad share market. For the financial year to date (from July 1st onwards) the performance remains in excess of 4% above the ASX200 Accumulation Index, taking total return ex-costs to near 12.50%.
On our observation, expectations for a general revival of laggards/value stocks in Australia continue to be hampered by obstacles on the ground, while high quality performers continue doing what they do naturally and best.
I intend to conduct a general update on my stock selections post this reporting season in March.
Before we move on to more things financial…
Our democracies are in danger. I know this sounds extremely hyperbolic, but it is not.
Since the middle of the twentieth century we have all become accustomed to the fact societies and political systems have become more open, accessible and accountable. In particular in the West, and in particular after the iron curtain collapsed in the late eighties.
Today we take too many things for granted. We assume bad history won't repeat. And just like the proverbial frog in gradually heating up water, we don't notice or even understand how the parliamentary system, the role of government, and its institutions are being undermined and eroded away. Read The Fifth Risk by Michael Lewis. Read Fascism, A Warning by Madeleine Albright.
There are, of course, many more authors, books and publications that can be read, but the message remains the same: undemocratic forces are on the rise, and they have the momentum on their side. Increasing limitations placed on free and independent media, of which FNArena is a proud member, is but one factor that is easy to identify.
Awareness is the first step to defending our democracies, who have never been flawless, but nevertheless far superior to any of the alternatives history shows us.
Comfortable At Record Highs
Last week, portfolio managers at T Rowe Price organised a series of briefings to share and discuss their views and analysis for global equities and the Australian share market in 2020.
With T Rowe Price's investment methodology centred around quality and growth, the media event I attended proved quite the refreshing exception from the bubbles and overvaluation narrative, and sheer frustration, expressed by your typical value-style investors up until late 2019.
Contrary to many of their value-style oriented peers, the team at T Rowe Price led by Head of Australian Equities, Randal Jenneke does not see equities as egregiously overvalued. Bond yields, inflation, cash rates and global growth numbers are all noticeably below historical averages, and this does need to be taken into account when modeling the valuation for today's equities, argues Jenneke and his team.
This is not to say bond yields cannot rise, or shares cannot have a serious correction, but investing is all about playing probabilities, and such scenarios within the global context as it currently stands are certainly possible, but at a low probability.
For investors trying to get the portfolio correctly aligned, Jenneke suggests it's all about interpreting the earnings trajectory correctly. If the investment team in Australia is on the mark, the local economy should gradually improve this year on the back of a resurgent housing market, with positive flow on impact for building materials, construction companies, and consumer facing businesses.
The only sector that is being treated more cautiously is healthcare with T Rowe Price's own portfolio having moved underweight most heavyweights in the local healthcare sector on the back of a stellar performance in 2019, and an ever widening valuation premium relative to the rest of the share market.
Stocks that have been singled out for a positive performance this year include REA Group ((REA)), JB Hi-Fi ((JBH)), and James Hardie ((JHX)). The team continues to like Aristocrat Leisure ((ALL)) on a solid three year growth outlook, while having sold out of Link Administration ((LNK)) and Star Entertainment Group ((SGR)) after what proved a disappointing 2019 for both companies.
In general terms, the Australian portfolio remains skewed towards higher quality domestic operators and offshore structural growers. Financials remain the largest portfolio underweight, followed by A-REITs and bond proxies in general.
Maybe the most interesting piece of insight was revealed when Jenneke shared that in-house research had revealed that equities are only pricing in bond yields at around 2.50% while the Australian ten year yield is trading well below 1%. (Even in the US, the ten-year benchmark is currently closer to 1.50% than to 2%).
Coronavirus Or Euphoria?
Probably worth highlighting Citi's Panic-Euphoria modeling has market sentiment firmly back into Euphoria territory.
History suggests this is when markets start taking a breather, as is starting to happen on the back of global concerns the economic impact from the coronavirus might prove larger than initially thought.
Get More Out Of Your Subscription
To my knowledge, FNArena is the only service in Australia that closely monitors corporate profit updates. This means investors are not only kept up to date about financial performances released by CommBank, BHP Group, Telstra and the like, but even so about Incitec Pivot, Aristocrat Leisure and TechnologyOne, among numerous others.
Paying subscribers to the service also have access to detailed reports for past seasons going back to August 2013. Make sure you check it out regularly:
(This story was written on Monday 3rd February 2020. 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 will follow 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: firstname.lastname@example.org or via the direct messaging system on the website).
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 $440 (incl GST) for twelve months or $245 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
For more info SHARE ANALYSIS: ALL - ARISTOCRAT LEISURE LIMITED
For more info SHARE ANALYSIS: APT - AFTERPAY LIMITED
For more info SHARE ANALYSIS: BLX - BEACON LIGHTING GROUP LIMITED
For more info SHARE ANALYSIS: CCP - CREDIT CORP GROUP LIMITED
For more info SHARE ANALYSIS: ECX - ECLIPX GROUP LIMITED
For more info SHARE ANALYSIS: GTN - GTN LIMITED
For more info SHARE ANALYSIS: GUD - G.U.D. HOLDINGS LIMITED
For more info SHARE ANALYSIS: IAG - INSURANCE AUSTRALIA GROUP LIMITED
For more info SHARE ANALYSIS: ISD - ISENTIA GROUP LIMITED
For more info SHARE ANALYSIS: JBH - JB HI-FI LIMITED
For more info SHARE ANALYSIS: JHX - JAMES HARDIE INDUSTRIES PLC
For more info SHARE ANALYSIS: LNK - LINK ADMINISTRATION HOLDINGS LIMITED
For more info SHARE ANALYSIS: NEA - NEARMAP LIMITED
For more info SHARE ANALYSIS: REA - REA GROUP LIMITED
For more info SHARE ANALYSIS: RMD - RESMED INC
For more info SHARE ANALYSIS: SGH - SLATER & GORDON LIMITED
For more info SHARE ANALYSIS: SGR - STAR ENTERTAINMENT GROUP LIMITED
For more info SHARE ANALYSIS: TWE - TREASURY WINE ESTATES LIMITED
For more info SHARE ANALYSIS: VUK - VIRGIN MONEY UK PLC
For more info SHARE ANALYSIS: WTC - WISETECH GLOBAL LIMITED