3rd March 2021: 2020 will always be remembered for the COVID-19 pandemic. It was a year defined by massive uncertainties around our health, the social implications of shutdowns and distancing, and ultimately whether many businesses and sectors would survive at all. What must also be considered when we look back over the past 12-months though, is the manner with which many governments and central banks dealt with the crisis. In a world where lockdowns, masks and hand sanitizers are still the norm, major global economic policy initiatives have generally done their job. In light of record low interest rates and broad fiscal policy, growth has not only stabilised but is now recovering strongly. The International Monetary Fund recently updated their economic forecasts and expect the global economy to grow by 5.5% in 2021 and by a further 4.2% in 2022. Confidence levels across households and businesses continue to improve and asset prices are in many cases at all-time-highs. Equities certainly fall into this camp, with the US S&P500 Index having rallied by almost 50% since 31 March last year and locally, the NZX50 Index and Australia’s ASX200 are up 25% and 34% respectively over the same time period.
These performances across share markets are being driven by a number of powerful forces. Firstly, with interest rate settings where they are, there is little attraction for investors across the fixed income space. This has resulted in a substantial redirection of capital and savings towards stocks, which offer capital growth and are often paying relatively attractive dividends yields. Low interest rates also have a positive impact on company valuations (which discount the value of future cashflows). The other major influence though is the growing confidence that the operating performances of our listed companies will follow the broader economic recovery lead. Over the past six months, investors have begun to look for signs that profits would stabilise and then expand.
This is consistent with market cycles that we have seen in the past. After shares face initial selling pressure due to the emergence of economic challenges, a divergence then typically occurs where stocks rebound despite the economy still facing headwinds. This scenario played out from April last year through until October. Although this confounded many commentators, what it simply reflected is that the share market is forward looking. There was a confidence that through the commitment of policy makers and the determination of governments to develop an effective vaccine to address Covid, in the medium-term the world would repair itself. This leg of the market cycle has now finished. The remaining stage is one where prices will move in concert with the direction of actual earnings and short-term profit forecasts. A window into these drivers has been open during the past month with the February reporting season in full-swing.
And encouragingly the news is good. In fact, in Australia during the past month, it appears that this reporting season is the strongest seen in over 20-years. During the course of result announcements throughout February, actual reported earnings in Australia have exceeded analyst expectations by an astonishing $4.8bn of profitability above what had been forecast. This is particularly positive because over the long-term, the average actual result has historically been below analysts’ forecasts (analysts always tend to be too bullish, it’s just human nature). From this very strong platform, the consensus view is now that corporate earnings in Australia will grow by 15% for the year ending June 2021 and by an additional 10% for the following 12-months to June 2022. This profit recovery is strongly aligned to the economic outcomes which are evident. In recent weeks Employment data has continued to improve with the Australian unemployment rate falling to 6.4% (and in NZ to 4.9%!), and Consumer Sentiment has rebounded to a level 14.2% above pre-pandemic levels.
Of additional importance to our positive assessment of the current earnings season is that in Australia there is a positive spread across the companies which are upgrading. This is across sectors, with Banks and Resources, in particular, both surprising on the upside. Looking back over the past month, there is almost a two-to-one ratio in favour of upgrades to downgrades. Driving many of these positive outcomes has been a very credible performance by management teams in addressing operating costs and the conservative allocation of capital. Profit margins have consequently improved, by 0.1% for Industrial businesses and 0.5% for Commodity Producers. An improved outlook for free cash-flow has also lifted expectations around capital returns with dividend forecasts for the ASX200 lifting by 9.2% for the year to June 2021. If achieved, this would equate to an additional $6.2bn being returned to shareholders.
In New Zealand the overall outcomes have been similarly encouraging. Leveraging off our ability as a country to resume some degree of normal activity (less social distancing than elsewhere) and through a central bank which has determined to provide enough liquidity and support to help navigate the Covid challenges, the operating environment for many of our listed businesses has been much better than had been anticipated during 2020. In essence, the median reported Revenue has exceeded expectations by 1.4% whilst Profit (EBIT - Earnings Before Interest and Tax) is better by 6.2%. In fact, at the time of writing, almost all the of companies that have reported their results have exceeded analyst expectations. Fletcher Building has been a good example of this dynamic. Fletcher’s reported a first-half profit of $323m, 47% higher than the same outcome last year. This was driven by substantial cost-out benefits (~$87m) and leverage to the super-charged New Zealand residential sector. The company has provided guidance for a full-year profit result of $610-$660m but this looks particularly conservative given the ongoing strength of our domestic forward economic indicators. This earnings backdrop is a favourable one for stocks.
After the rapid appreciation of share prices since the latter stages of March 2020, concerns have arisen about valuations within the market. With the Australian ASX200 currently trading at a 12-month forward price-to-earnings ratio of 19-times and the NZX50 at 29-times, these levels are elevated (the long-term average for the ASX200 is 15-times and for the NZX50, it is 17-times). This challenge to the medium-term direction of shares will likely be resolved via one of two channels. Either prices fall or earnings grow to essentially bring the valuation multiple down (a price-to-earnings multiple is a classical way to determine valuations across individual stocks and is calculated by dividing the share price by the relevant earnings). Given the very successful reporting season that we have just completed it is our assessment that many share prices feel reasonably well supported, particularly in out of favour cyclical and “value” stocks. However, as we have written previously, we believe that a significant bubble has formed in the valuation of many “growth” companies and that an upward movement in interest rates could and should result in a sharp correction for those companies that are priced for perfection. In our opinion, Devon is the last remaining “valuation based” investment house in NZ and we believe that the current conditions favour our style.