The article was first published on The Constant Investor.
Julia Lee - Equities Strategist at Bell Direct
Outlook remains largely unchanged
Reporting season is important because it gives an insight into which trends are continuing, which trends have stopped and which ones have reversed. This reporting season has shown some trends continue, such as a positive outlook for mining services, strong cashflow from resource companies and property prices continuing to rise.
Trends that may have reversed are in hospital and private health care where the lack of uptake in private health insurance is not only being felt in the insurance sector but also in hospitals. Medibank Private was the exception coming out with stronger than expected earnings but this was driven by investment income rather than its core business.
The big trend that has reversed is the flat to growing dividend payout ratio from Telstra. From the current financial year, Telstra will no longer be paying out all its underlying earnings as a dividend and hence dividend payments are forecast to drop.
Banks have reported slightly ahead of expectations this season, and resources have reported slightly below expectations but have offset with stronger than expected dividends and capital management.
From a market capitalisation point of view, while reporting season has been mildly disappointing, it hasn’t been enough to significantly change the outlook for the Australian market. The market is still in a cycle of earnings growth and that is a positive backdrop for shares.
Alex Shevelev - Senior analyst at Forager Funds Management
Buying big caps for yield?
Think again Reporting season is drawing to a close and big positive surprises have been few and far between. While good results and disappointments have been roughly matched by number, some reactions on the downside have been extreme. Small slip-ups relative to expectations, weak guidance statements and reduced dividends have been met with sharp share price declines.
Results delivered during reporting season serve as a litmus test for dividends. Some large cap stocks are failing that test. This reporting season has seen operational issues and high payout ratios put a strain on their ability to generate the dividends investors have come to expect.
Telstra headlined this trend. After paying 31 cents in dividends last year, and paying out up to 98% of earnings over the past 5 years, Australia’s largest telco bit the bullet and lowered dividend expectations. It expects just 22 cents in dividends this year, leaving the business more cash to deploy on further capital expenditure over the next few years. Telstra stock fell 11% on the day the result was announced.
QBE was another to disappoint on the dividend front. Results in emerging markets were weak and growth in gross written premium is likely to be modest this year. Dividend expectations for the full year fell by 11%. Sure, BHP’s dividend rose, but it is still markedly lower than just a few years ago. The Commonwealth Bank, the sole big bank reporting results for June year-end, delivered a dividend just 2% higher than last year.
The top 20 stocks on the ASX have a yield of about 5%. This sounds great in the context of a 1.5% cash rate, especially when taking imputation credits into account. Yet we must not forget that these dividends are dependent on the financial performance of operating businesses and subject to risk. Dividends from large caps, on a steady increase since the GFC depressed levels of 2009, peaked in 2015. Expectations for dividend growth next year are just 2%. Based on the current reporting season investors will have to rethink their reliance on dividends from some of Australia’s largest listed businesses.
Julian Beaumont - Investment Director at Bennelong Australian Equity Partners
Housing and retailing results have guided to better than feared outlooks
The market had probably got a little ahead of itself. Growth is still sluggish, as it has been for years, but the market had hoped things were picking up. Earnings expectations for 2018 have drifted back slightly, but that is normal, and they still indicate fairly decent positive growth.
In a new development, an increasing number of companies are beginning to invest for growth, and as growth orientated investors, this is encouraging in terms of potential new stock ideas. Perhaps this is business confidence flowing through into action, with positive implications for the broader economy down the line. Otherwise, genuine growth remains within a relatively narrow bunch of stocks.
The miners are going the other way. The change is that they have stopped investing for growth, and have become cash conscious and more shareholder friendly, with significantly higher dividend payouts. Some investors are even thinking of the miners as dividend plays, notwithstanding their potential generosity is dependent on ever-cyclical commodity prices.
Some of the defensive, more mature sectors saw added weakness, including telecoms, supermarkets , domestic healthcare companies and insurers. A part of this owes itself to increased competition, which is manifesting in limited pricing power and the necessity to spend more back on the business.
Two sectors of concern to the market – housing and retailing – reported strong results and guided to better than feared outlooks. Housing construction looks like it might be able to glide lower, and any slack might be taken up by infrastructure and other construction work, for which the pipeline looks very healthy. While we had thought a weak consumer outlook and the Amazon threat will unfairly hang over the retail sector for some time, there was evidence (at least in respect of non-housing-exposed retailers) that strong execution and strong results would actually be rewarded by the market.
Jun Bei Liu - Deputy portfolio manager at Tribeca Investment Partners
The market has irrationally chased growth
This reporting season is shaping up to be one of the worst reporting seasons in recent years with so far four times as many downgrades versus upgrades to FY18 earnings. Top line softness and margin disappointment are the two key drags, particularly observed in the “high growth” names. Overly optimistic analyst forecasts have proven to be very difficult to match and most businesses cited the need to reinvest to drive revenue growth.
This reaffirmed our thesis that the market had been too optimistic and irrational in chasing growth. We saw meaningful downside risks to the price as some of the growth companies expanded their earnings multiple. We hope this important reality check will see investors reassess their expectations, especially for the previous market darlings. Further, we could see the market begin to rotate into the cyclical and value sectors as the growth names disappoint. This would put further selling pressure on those sectors.
John Murray - Managing Director at Perennial Value
Key themes reinforced
This current reporting season hasn’t so much changed my thinking about the market, rather it has reinforced some of my thinking on three key themes:
Share prices have been unceremoniously belted across a range of stocks, reinforcing the immediate influence of short sellers. This continues the trend of often disproportionately adverse reactions to disappointing news. This seems to have been accentuated during this current period for reasons that aren’t clear to me. However, for a longer term investor such as Perennial Value, this can present valuable buying opportunities.
The big miners ie. BHP, RIO and, increasingly Fortescue, are in fantastic financial shape. Their very significant and ongoing internal efficiency programmes, combined with a sustained robust iron ore price, are resulting in big increases in free cash flow, enabling them to both pay down significant chunks of debt (which are now generally at very low levels) and increase dividends to shareholders. Perennial Value has core holdings in BHP and RIO.
The market continues to punish companies which are choosing to reinvest some of their profits into growth options as opposed to passing it all back to shareholders in the form of either dividends or share buybacks. In some cases, AMP being a case in point, I feel that the market has been too harsh in taking this view. No business can shrink to greatness and, over the longer term, they must reinvest in order for the business to prosper for the long term.
Steven Semczyszyn - Head of Portfolio Management JCP Investment Partners
Favourable market for active managers
With reporting season coming to a close, we have observed a general trend of earnings weakness emerging. This has been particularly pronounced for industrial stocks, which are coming under pressure from a lack of national income growth. FY18 earnings for this cohort have been downgraded by 3% across those that have reported – a higher number than usual, with lower margins featuring as the main culprit. Companies with leverage to the housing sector, however, have generally fared better versus companies that rely on income driven consumption patterns.
In terms of my thoughts on the market from this reporting season – there are three observations I would highlight:
- Companies are exploiting aggressive accounting techniques to grow earnings: I have been surprised at the number of companies that have been increasingly creative on what they capitalise and the extent of non-reoccurring items taken below the line. In a world being shaped by online industry leaders such as Amazon, Google and Apple, expenditure on online and digital should now unquestioningly be part of a company’s operating expense. To remain relevant in todays (and more importantly tomorrow’s) world, companies will need to invest in this each year, not treat it as a one off expense to be capitalised and amortised over a number of years, which conveniently has the effect of overstating profits.
- The rise of machine based trading: Falling liquidity in the market and the rise of machine based trading has meant small upgrades or downgrades are having an exaggerated impact on stock prices. We have seen stock price reactions over exaggerated on day one as machines look to trade on the same signals, with prices often retracing several days later. The market is not properly quantifying the impact of earnings changes, nor is it appropriately analysing the sustainability of the beats or misses.
- Rising electricity prices: Profit growth is starting to be impeded by the impact of rising electricity prices and this pressure is likely to accelerate into next year. Examples of companies calling out this pressure include Adelaide Brighton, Sydney Airports, Ingham’s, Coca Cola and Asaleo.
From my perspective, the market remains favourable for active managers prepared to look beyond the short term.
Stephen Kench - Head of Direct Equities at Perpetual Private
The glass is half-full
Company reporting season reactions are all about results versus expectations. Our expectations were not high going into this period and we expected reasonably benign outcomes in aggregate. This has predominantly come to pass as we saw positive, albeit low, profit growth in the mid-single digit levels and outlook commentary focussed on reinvestment for growth.
Thus, it was a glass half-full reporting season for Perpetual Private whereas others may say half-empty and cite disappointment. We expected, and witnessed, an increasing willingness by management to invest for future growth. This meant short term profits were not quite as high as they could have been stretched. CSL is a great example where R&D expenditure will increase from 7.5% to ~11% of sales revenue from FY18 to pursue new product sale streams over the next 1-3 years. We view this as positive and would take sustainability of future profits and dividends over short term profit manipulation any day of the week.
The benign nature of corporate Australia’s earnings report card over the last month is reflected in a very tightly traded market since May, within a 100 point range. Since earlier this year we have seen greater confidence by management buoyed by a relatively stable operating environment and revenue
predictability. This is providing a better balance between cost efficiency (vs cost-out), capital management and reinvestment for future growth. Essentially a return to a more normal operating position.
Chad Slater - Joint CIO at and Executive Director at Morphic Asset Management
Is it better to travel than arrive?
Because for some stocks, like Woolworths, travelling (going from 21 to 27) was better than arriving at good sales results.
For coke, travelling wasn’t much fun- it’s down a lot in the last 12 months- and arriving with poor results still sent the stock lower.
We can add Telstra to the mix: the old saying is “a dividend cut is never in the price”. And the old saw proved true again on dividends- travelling and arriving weren’t much fun. A lot of locals didn’t short the stock into the result on the assumption that it was already in the price. It’s never all in the price.
On the other hand BHP showed that traveling can help- cleaning up the business and time in purgatory may lead to heaven. Though heavens knows why it took a foreign activist to point out what local fundies should have done years ago. An indictment on the local closeted industry.
So our thinking on the local market post reporting season is that defensives show signs of fatigue but cyclicals, particularly miners, may be the better bet for the rest of 2017.
David Sokulsky - CIO at Crestone Wealth Management
The period of chasing ‘growth darlings’ is over
The reporting season has not changed our thinking about the Australian market. We were underweight Australian equities heading into reporting season and there has been nothing in the results to change our positioning. However, one of the key things to come out of the results is that the period of blindly chasing ‘growth darlings’ in companies such as Domino’s and REA has likely come to an end. Investors punished them for poor results when expectations were extremely high.
Other interesting things to come out of the results so far have been:
- Large caps have outperformed small caps
- Defensives have performed poorly (Transurban, Telstra)
- Resources companies have generally performed well (Woodside, Origin)