Financial year 2018: The good, the bad and the oddly
Confession season was eerily quiet leading into reporting season unlike the noise from the Royal Commission and the incredible events out of Canberra where another Prime Minister didn’t reach their full term.
Confession season was eerily quiet leading into reporting season unlike the noise from the Royal Commission and the incredible events out of Canberra where another Prime Minister didn’t reach their full term.
The global equity backdrop was in a state of flux with the ongoing Trump-induced trade debate/war raging, mixed signals from Beijing regarding a policy/stimulus response, and the incredible divergence of performance between growth over value was surely due a retracement.
Result day volatility was remarkable for some, and the median stock deviation of 3.5 per cent was much larger then we have seen over the past five years. High growth, high PE names were squeezed higher, often on poor results and outlook.
The heavily shorted stocks outperformed during the month driven by better than feared results and M&A activity – particularly at TPG Telecom (ASX: TPM) and Santos (ASX: STO).
The AUD weakness, retracing some 11.4 per cent from year highs and down 7.7 per cent since mid-April 2018, creates an earnings tailwind for the many stocks that are leveraged to a falling AUD.
Nikko AM has been overweight offshore earners for a while, given the attractive valuation to a number of the companies. The lower AUD is positive for the economy and increases the competitiveness of export industries such as education, agriculture and tourism.
According to Deutsch Bank, 52 per cent of companies beat their forecasts, which is in line with the 5-year average (Chart 1), whereas only 39 per cent of companies upgraded, which is below the 5-year average. Morgan Stanley calculated that earnings beats were rewarded by a day 1 move of +2.7 per cent and misses fell by -1.9 per cent.
Chart 1: Changes to Deutsch Bank earnings during reporting season
Source: Deutsche Bank, company data
The 2018 fiscal reporting season has seen growth take a further incredible step up, particularly against value. The top PE quintile stocks expanding their one-year forward PE by a further 4.2pts (or 10 per cent), despite earnings falling by 2 to 3 per cent.
This contrasted with the bottom two P/E quintiles that were largely flat over the month (Chart 2). One of the poster children of this move is Domino’s Pizza, which released a result that was materially below guidance and market expectations. After initially falling 13 per cent, it finished the month 5 per cent (including dividends) above the price it was prior to the result. A retracement of this bubble-like trend must be a high probability given the extreme levels.
Chart 2: P/E expansion by quintile
Source: JP Morgan
Key takeaways from reporting season FY18
Cost inflation within the US has impacted a number of Australian companies, including James Hardie Industries (ASX: JHX), Brambles Limited (ASX: BXB), Amcor Limited (ASX: AMC) and Ansell Limited (ASX: ANN).
Some of the companies have the ability to pass on the costs via pass-through arrangements, but often with a lag. These ongoing cost pressures warrant a close eye given some are stock-specific raw material costs whereas others, such as rising freight and energy costs, are market-wide.
Cost pressures are emerging within Australia after years of cost out initiatives.
Electricity prices, labour costs (particularly in the resources space in Western Australia) were called out. However, in aggregate they still remain quite benign, with little evidence of domestic wage pressure outside of construction and mining.
Bank results and trading updates showed little sign of deteriorating asset quality and bad debts remain at extremely low levels.
Mortgage loan growth continues to slow, as expected, with little sign of life in business lending. Net interest margins are under pressure, but recent out-of-cycle rate rises alleviate this concern. Given the Royal Commission, the ongoing increase in compliance costs shows no sign of abating.
The earnings outlook remains strong at 9.8 per cent NPAT growth for FY19 despite a moderation during reporting season (-1.9 per cent).
The modest downward revision is not surprising given the high expectations going into results season. The breadth of the positive earnings growth is surprisingly high with only mining, transport and telcos in negative territory (Chart 3)
Chart 3: FY19 NPAT vs PCP
Source: Company data, Deutsche Bank
Capital management is an ongoing theme driven by the combination of strong balance sheets and modest capex plans together with management being acutely aware of shareholder claims on profit.
The capital has been delivered by a combination of on-market buybacks and special dividends. Payout ratios were a little higher than expected during the results, albeit continue to moderate after breaching historic highs.
The higher likelihood of a Labor government may incentivise companies to accelerate the distribution of excess franking credits.
What changed this reporting season?
Reporting season was largely a non-event from the perspective of the actual underlying earnings, with few actual material surprises in either the results or outlook.
The surprises came from the market reactions, which at times were just plain inexplicable. Expensive, high PE stocks re-rated further on modest outcomes taking the divergence between the top and bottom PE quintile to levels not seen since the tech bubble of 1999/2000. The top quartile PE stocks now trade on 30x earnings on average versus the 20year average of 19.7x.
Nikko AM Australia values companies based on their sustainable earnings capacity. That is, we determine the intrinsic value by capitalising the sustainable or mid-cycle earnings of every stock under coverage. Using these valuations in conjunction with our forecast dividends and franking credits for each stock, we can then compute an expected return for each company under coverage. This provides us with strong signals as to where the best opportunities are in the market.
It is apparent that some of the price moves preceding and during reporting season are not supported by fundamentals. Historically, such periods of irrationality have not been sustained and stock prices have ultimately reverted to valuations supported by fundamentals.
While our recent relative performance is hampered by the current market conditions, we are confident that our proven and disciplined process, which enables us to take advantage of the market mis-pricing, will deliver excess returns to our investors in the long term.
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Brad Potter is head of Australian equities, Nikko Asset Management. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.
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