Reporting season is over!
The reporting season is over. What have we learnt and what are the emerging trends?
The reporting season for the first half of the 2017 financial year was dominated by company specific issues rather than a consistent macro theme. The exception was for resource companies who benefited from stronger commodity prices and, therefore, upgraded earnings both into and post reporting.
Overall, companies’ earnings had a positive skew to upgrades but this was heavily influenced by a number of factors, including upgrades to miners, healthcare, consumer staples and banks. Given the market heavyweights belong to these sectors, there was also a bias to large cap stocks.
After most reporting seasons, we witness a decrease in forward growth expectations among analysts. Interestingly, however, this year was the first in many years where we saw increases to earnings growth expectations by analysts.
Increased earnings expectations
Not only did the bigger companies perform better from an earnings perspective, but they also experienced the biggest earnings upgrades going forward. These upgrades were for the miners and banks, making the top 20 stocks influence the earnings upgrade bias.
The smallest upgrades were in the small ordinaries 100-300 stocks.
The Australian share market is now forecasting growth of 18 per cent for 2017 and 6 per cent for 2018, but small caps are only expected to grow at 4 per cent.
Importantly, given that analysts have been upgrading earnings for the first time in many years post reporting season, it is possible that we are potentially at the start of an earnings upgrade cycle (which historically have lasted on average 5 years). This is the first one we have seen in an extended period of time.
The other trend witnessed within the market was capital returns, whether via buybacks or increased dividend payments. This was especially the case for the miners in spite of general consensus that the miners would retain capital. Dividends per share upgrades came from the likes BHP Billiton, Rio Tinto, Fortescue, Crown, and National Australia Bank, though defensive stocks lacked upgrades.
Share price reactions have always seemed to be rather volatile at reporting time, and this year was no different. This is really a result of how investors were positioned, share valuations and perceived quality of the result post announcement. Share price reactions, both positive and negative, were often in excess of the underlying earnings change and as a result were not a true reflection of the stock’s outlook, quality of earnings or actual results.
Digging a little deeper into the sectors
Financials: The Big 4 banks showed solid results with margins maintained in spite of funding pressures and capital requirements. The regional banks disappointed, given the fact they have less levers to pull and more funding pressure. Overall there was limited deterioration to asset quality and better bad debt provisions as the environment for the troublesome areas improved, especially in mining and dairy. The insurance sector was better as premium income improved, though AMP disappointed following major restructuring costs. The fund managers experienced mixed fund flows, and performance fees were hard to come by as a volatile 2016 proved a difficult environment to outperform in.
Miners: As previously mentioned, miners delivered better earnings, as expected. That said, dividends surprised on the upside as companies delivered strong cash flows. We can foresee earnings upgrades going forward, when spot commodity prices are factored into valuations.
Consumer Staples: Interestingly, in spite of offshore competition and expected increased domestic competition as well as margin pressure, we witnessed rational competition between Coles and Woolworths and margins actually stabilise. Overall the staples were better than expected, highlighting the defensive nature of these shares.
Consumer Discretionary: This sector was a little more hit and miss with those areas exposed to housing-related spending, such as JB Hi-Fi, Harvey Norman, doing better. JB Hi-Fi benefited from the lack of a former competitor (Dick Smith), while the balance of the sector struggled.
Gaming in general disappointed, driven by weak VIP revenue as the high rollers stayed away after the gambling crackdown in Macau. The mass market gaming was a little below trend but this was a good result given the disruption occurring at many casinos as they look to spend money on upgrading their facilities. As a trend, weaker wagering continues as competitors continue to enter the domestic market and take market share and squeeze margins.
REIT’s and Infrastructure: Results for this sector were steady but the retail landlords witnessed softer retail conditions, which is consistent with Consumer Discretionary spending, but probably driven by the poor wage growth we have seen over the last year or so. The REIT sector is interesting looking forward as all the tail winds are becoming headwinds as rates rise, capitalisation rates bottom and rents potentially ease.
Healthcare: In general, this sector offered updates that were better than expected but it appears that the poorer quality companies disappointed relative to the more established, higher quality well diversified businesses. This justifies the view to buy quality.
Telco and Media: Results were disappointing as the industries face structural headwinds as a result of weaker advertising spend, changing communications trends and changing legislation for telcos and the NBN.
The outlook from companies remained a little constrained, with expectations of slim revenue improvements but no real commitment to future investment from companies as they continue to cut costs which are becoming increasingly difficult to execute and will potentially drift higher. Not surprisingly CEOs who disappointed were quick to blame it on Brexit, Trump or Turnbull, but few were very committed given the potential risks on the horizon especially macro and political. CEOs though remain focused on creating shareholder value.
Overall valuations remain slightly elevated (see chart below) with sectors trading just above long term average price to earnings ratios. However in a supportive low interest rate environment, and with companies experiencing earnings upgrades post results, we believe it remains justifiable. Furthermore the cost cutting executed over multiple years should enable companies to leverage earnings at any sign of top line growth.
While the local environment is set to improve for the Australian market, it is subject to negative outside influences which provide an element of risk. These risks are dominated by the political environment within Europe in particular and the elevated valuations across some global markets, especially the US. Arguably the end of the secular bull trend in interest rates may also impact local valuations over the year ahead.