There was a lot to like about the February reporting season. By our estimates, over 30% of large caps beat the market's expectations, and unlike previous seasons, estimates held firm rather than falling away into results. Downgrades and significant misses were largely a non-event and overall management commentary reflected the most buoyant conditions we've seen for a while. We pick apart seven key themes we identified around large cap outperformance, offshore earnings growth, industrials earnings momentum (up slightly), capital management (up), and the resource cycle (maturing).
The market correction in early February saw the market multiple trade as low as 15.2x and doubtless made it easier for companies to meet investor expectations. On the whole, the large caps (ASX50) were the star performers with 30% beating consensus expectations and only 9% missing expectations. Small and mid-caps saw more varied results (25% beating and 19% missing) which is no surprise given the strong price run-up into the start of the year.
Investment strategy remains cautious
The valuations investors are paying for earnings remain elevated by historical standards, and we caution investors expecting higher-than-average returns. Current earnings growth sits well below the long-term average (approximately 9-10%), reflecting below-trend economic growth, while valuations (XJI on approximately 16x forward) appear to be pricing in earnings acceleration that is yet to be delivered.
The market has been prone to over-shooting the actual earnings trajectory in recent years. We think investors should stand ready to buy the dips when the inevitable bouts of market volatility hit, rather than chase expensive stocks higher.
Unearthing compelling value
Market aggregate analysis can mask the fact that plenty of compelling opportunities still exist in companies capable of thriving despite the challenging economy.
The standouts include Telstra (TLS), Macquarie Atlas Roads (MQA) and Australian Finance Group (AFG), which all look 20-25% under-valued at current market prices.
Seven key themes for 2018
We highlight seven themes that we believe will set the tone for 2018:
- Management gives the green light on the economy – The robust business surveys were reflected in the mostly upbeat tone across the results. While results were good, it wasn't hitch-free. The Retail and Telco sectors continue to struggle against structural change and higher payouts continue to be the modus operandi; nonetheless, the economy remains on much further footing than it has for some time.
- Large caps catch a bid – The investment playbook for the goldilocks environment of growth without inflation was to buy growth. Since October the MSCI Growth index has outperformed the Value index by 3% and even more pronounced was the outperformance of small caps over large caps (+8%). With the re-emergence of inflation and better-than-expected large cap results (particularly among Financials and Healthcare), a rotation back towards large caps was inevitable and unlikely to be confined to just a temporary move.
- Offshore growth surprises on the upside – Global growth and favourable changes to the US tax code continue to be a strong source of upside for stocks with exposure to the recovery in US and Europe. The median Earnings Per Share revision for the Morgans basket of offshore earners was +2.4% and a +1.8% price reaction since the result. The strong results reaffirmed our view that offshore cyclicals will continue to perform over the next 12 months.
- Investors still hung up on high PE growth – The large valuation divergence between high PE stocks and low PE stocks closed marginally, and we think this divergence is unlikely to be sustained in the context of stronger growth and rising inflation. We think expensive growth will underperform Growth At a Reasonable Price (GARP) and value over the short term.
- No surprise, capital management still in vogue – Capital management is still preferred over reinvestment. Companies are still unwilling to dial back payout ratios or scale down buyback programs. Dividends were up for 69% of companies that reported in February and some major buybacks were announced including Qantas, Lendlease and Rio Tinto.
- The infrastructure opportunity – The trend remains positive for infrastructure activity in key urban markets. Macromonitor estimates that nearly $16 billion per annum will be spent on transport projects alone over the next three years and will peak in 2020. Results from Downer (DOW), Adelaide Brighton (ABC), Cimic Group (CIM) and Seven Group (SVW) highlight the magnitude of the upcoming pipeline.
- The Resource cycle is maturing – Resource and energy companies largely delivered as expected in February, with higher earnings flowing through into higher dividends and capital management initiatives. Two emerging themes stood out to us around the return of cost inflation and notable growth via M&A rhetoric and/or activity.
Reporting Season – our top stock picks
Our key buy ideas, supported by strong reporting season results, are as follows:
Undemanding/oversold stocks – Telstra (TLS), Kina Securities (KSL), Motorcycle Holdings (MTO) and Aventus Retail Property Fund (AVN).
Best cyclical exposures – BHP Billiton (BHP), Webjet (WEB), Lindsay Australia (LAU) and Emeco Holdings (EHL).
Backing quality results – Wagners Holding Company (WGN), Orora (ORA), Macquarie Atlas Roads (MQA) and Sydney Airport (SYD).
Flying under the radar – Australian Finance Group (AFG), PWR Holdings (PWH), CML Group (CGR), and Noni B (NBL)
Contributed by Andrew Tang from the Morgans Blog: (VIEW LINK)