A Window Into How Companies Are Really Feeling

2016 has already been a year of big surprises. It is a year in which we have seen an unexpected majority of British voter’s support an exit of the European Union, terrorist activity has grown in prominence and regularity and there is now a real chance that the previously incomprehensible may in fact become a reality with the US presidential election. Despite all these apparent challenges to global harmony, equity markets around the world have continued to rally. Year-to-date the US S&P500 is up over 6%, Australia’s S&P/ASX200 has returned 7.5% and New Zealand has delivered a whopping 16%. This performance is remarkable given that globally economic growth remains laboured and basic assessments of equity valuations appear stretched.

Compounding the dilemma for investors is that over the past 12-months reported company earnings in general have been disappointing. The Australian market for example, in aggregate, now looks set to report its second consecutive year of negative earnings-per-share growth. Confirmation of this will be made apparent over the next 4-weeks as we embark on the company Reporting Season. This is a time of great interest for investors as listed companies, that have their financial year-end occurring at either the end of December or June, are required to release their operating financial results (note the same obligation also occurs in February of each year). It is also a time when management teams comment on their recent past performance and provide the market with feedback as to their expectations of operating conditions and outcomes looking forward. This same process of disclosure occurs in all developed equity markets including New Zealand.

The reason that this next month will be especially interesting to investors is because stock markets have performed so well.  The key issue that the market will look to get clarity on during August is whether or not the bull-market that is currently being enjoyed is one that is reflective of improving company fundamentals, and is therefore more likely to be sustainable, or is the “rubber band” of valuations simply being stretched too far.

Although economic and business conditions do move in cycles, with each year different from the next, there is typically great value to be found in referencing history to forecast the future. This exercise of reflection can be unsettling for investors who are currently considering local corporate earnings, because over the past couple of years consensus expectations for company profit growth, at the start of each financial year, have been consistently optimistic and wrong. This has resulted in analyst forecasts needing to be revised down as we have progressed through the year.  In Australia this has seen profit growth expectations for the overall market in FY16 already adjusted down by over 15% over the past 12-months. Even if we take out the Resource and Banking sectors from this analysis the Industrial stocks in aggregate have seen their earnings forecasts cut by over 10%. Typically this earnings backdrop would have weighed on market performance but as we highlighted earlier, equities as an asset class has been a great place to be.

Another aspect of the Reporting Season worth noting is the unofficial “Confession Season”.  This is a period prior to the time when companies must report where management teams are obligated to disclose if company results are likely to be more than 10% outside the consensus view. If they are, then companies must make a public cleansing statement. However, in recent weeks that there has pleasingly been a relatively benign level of commentary by management teams. This is a good thing because in an environment which has been characterized by domestic and global uncertainty there was always the risk that such a backdrop would have manifested itself in economic headwinds, beyond what the market had already factored in.

But what will be the most influential information on stock prices during this Reporting Season? It probably won’t be the reported results because they are historical and the market is forward looking. What will have the greater impact will be the comments made by management teams as to their expectations over future performance. 

When we look at Australia, it is important to realise that there are very distinct sectors which make up the aggregate numbers. The Banks are the most prominent at almost 30% of total market capitalisation. As such their operating experience is very relevant to investors and over the past couple of years their business environment has been challenged by increased capital requirements and subdued credit growth. Expectations are that as a group in FY16 they will see almost no earnings-per-share growth but will then recover over the next 12-months to generate profits which will be almost 4% higher. The Resources sector is more volatile with expectations of a 50% fall in FY16 followed by a similar lift in FY17 driven by a recovery in commodity prices. The remaining major sector category, Industrial’s, are expected to generate earnings in FY16 similar to FY15, but are looking forward to the benefits of cost-cutting and a weaker Australian Dollar should help manifest themselves in an earnings improvement of almost 10%. In New Zealand we have a disparate collection of listed companies but in an overall sense, core median earnings growth for FY16 is assumed to be a healthy 7%. Looking forward, domestic confidence is high with analysts forecasting over 10% improvement in corporate earnings over the next 12-months. Many of these performance assumptions look encouraging but as we highlighted earlier, historical experience suggests that often the early optimism shown by analysts needs to be moderated as the year progresses. Management comments over the next 4-weeks will help us in this assessment.

In the current environment it is important for investors to exercise caution. Equity valuations have expanded and we must determine whether prevailing market pricing sufficiently compensates us for the risks that exist. The investing world is fascinating at the moment and at times difficult to understand. It is a world largely defined by low or negative interest rates, massive political change, technological upheaval, and one in which central banks stand at the ready to do whatever they must. Therefore in such times it is critical for investors to focus on what ultimately drives the performance of the companies that they own over the long term and it is these fundamentals that we will get a window into over the next month.

Slade Robertson - Portfolio Manager at Devon