The big margin squeeze facing ASX companies in 2023

Markets were too optimistic ahead of the ASX earnings season, industry experts say, with around half of companies missing earnings expectations.

Margin squeeze was a key theme, and while the full impact of higher interest rates is yet to flow through, cost inflation is already starting to bite. 

^{Around half of the ASX companies to report in February missed expectations. Picture: Getty}

Morningstar’s head of equity research Peter Warnes says the next 12 months are likely to be somewhat more hostile as economic growth halves and household consumption contracts. 

Markets have since sobered up to the outlook, pulling back from lofty earnings growth expectations says small-cap stock picker Katie Hudson, who I spoke with on the sidelines of a Morningstar International Women’s Day event this week. 

Investors should think small

Hudson is a portfolio manager and director at Yarra Capital and manages the gold-rated UBS Australian Small Companies fund.

“On balance, about 50% of companies missed earnings expectations and then their numbers were downgraded,” Hudson says. 

“But clearly it's going to be a challenging environment. What reporting season really told us was that volume growth has been okay, price growth has been strong - largely as people have passed through cost inflation - but margins have been coming under pressure.”

That will create significant headwinds for earnings through 2023, she says, and the winners will be companies that can grow their earnings and generate real cashflow. 

So, where should investors be looking in the small cap space, I asked, which was heavily sold off in 2022. 

“The sector ended down 18% [in 2022], and that's meant there's been a big valuation gap that's opened up between up between small caps and large caps. From that perspective, we think the small cap sector looks really interesting,” Hudson says. 

She says quality growth and technology companies caught up in the wider sector sell-off now present good opportunities. 

“There’s some really interesting companies within those cohorts that we think have maybe had some short term missteps, maybe have been overvalued, but the retracement has created some really good opportunities, particularly in that sort of growth and technology part of the market in the back end reporting season.”

Most sectors remain overvalued

For companies under Morningstar coverage, technology shares also screen as undervalued. Following reporting season, the technology sector’s price-to-fair value ratio sits at 0.84, a discount of 16%, down from 12% in September 2022. 

Despite strong year-to-date gains, Warnes notes energy remains the most undervalued sector, trading at a near 17% discount. 

“Oil and gas counters Beach Energy (BPT), Santos (STO) and Woodside Energy (WDS) are all in four-star territory. Coal miner Whitehaven (WHC) is also in four-star ground,” he says.

Australian equities: Price-to-fair-value by sector

Over the course of February, there were 63 changes to Morningstar’s fair value estimates, Warnes says, including 36 increases and 27 reductions. 

“At the top of the upgrades were Helia (HLI) (ex Genworth), Ardent Leisure (ALG), QBE, and The Lottery Corporation (TLC),” he says. 

“The largest downgrades included ZIP, EML Payments (EML), Southern Cross Media (SXL) and Humm (HUM).”

On the back of their earnings results, more companies recorded a sharp fall in their share price on the back of their earnings result, than those that saw a share price rally. 

“The market reaction to individual company reports had a strong negative bias, whether due to earnings missing expectations or uninspiring guidance for the second half and beyond,” Warnes says. 

Companies that sold off most heavily:

Companies whose shares rose: 

Warnes’ in-depth analysis of the interim reporting season is available to Investor subscribers here.

Read more on the 5 most overvalued companies to avoid at current prices.

The impact of higher interest rates

The RBA this week raised the cash rate for the tenth time in a row, taking it to a 13-year high of 3.6%. 

However, the full impact of these increases will take time to wash through the economy. 

While Hudson says earnings expectations have returned to more realistic levels, Warnes is less optimistic and says further downgrades will be forthcoming. 

“While inflation may have peaked, there is still a pipeline of higher costs yet to filter through, particularly in the services space. Price increases of 14% in Brambles pallets are just an example,” Warnes says. 

On average, there is a three-month lag between each rate hike the time it takes to hit a borrower’s mortgage repayments. 

Interest rate changes can take between one and two years for their maximum effect to unfold on economic activity and inflation. Even assuming a lag effect of only twelve months, the already implemented RBA hikes won’t fully reflect in our economy before early 2024, as shown in the chart below. 

So far, household spending remains surprisingly robust, although the household savings ratio has fallen back below pre-pandemic levels.

As for home loan risks, data from Australia’s largest lender - the Commonwealth Bank (CBA) – suggests mortgage stress remains relatively low.

The bank has identified 5% of home loan balances as being high-risk, but within this group, 65% have a loan-to-value ratio below 80%.