The 5-point earnings results checklist
ASX listed companies report their earnings to the market at least twice a year, typically in August (full year results) and February (half year results). 2020 was a year filled with extreme and extraordinary events with many companies withdrawing their outlook and earnings guidance in response to the COVID-19 pandemic. Unfortunately, history doesn’t repeat but often rhymes with 2021 shaping up to have a few surprises.
Reporting season can see levels of volatility that can be quite difficult for some investors to stomach. In this article, a five-point earnings results checklist has been created to help investors navigate reporting season while we flag three key themes that NAOS Asset Management is keeping an eye on.
“Volatility is a welcome creator of opportunity” - Seth Klarman
1: REALITY VERSUS EXPECTATIONS
The two most common factors that determine market expectations leading into an earnings result are:
1. The previous guidance given by a company prior to the result, and/or
2. The collective research analysts ‘consensus’ for what they believe the result should be.
It is not uncommon for both of these numbers to differ, potentially significantly, from the actual result. Hence the share price reaction on reporting day can at times border on the extreme.
The below chart outlines consensus EPS estimates per year (individual lines) and what was actually delivered (sold green line). As you can see, significant disparity exists in what was expected and what was delivered. The obvious trend here is one that declines as the financial year comes to a close.
Source – Factset
In saying that, the initial share price reaction on the day of an earnings announcement can be driven by a high level of emotion. A stock that is sold off heavily may lead the market into an irrational thought process which can lead to irrational selling.
The below table looks at companies within the S&P/ASX 200 and their most recent FY2020 full year results to see if EPS outperformed (positive earnings surprise) or underperformed (negative earnings surprise) the market’s estimates, along with the subsequent performance on the announcement day. It is evident that while there were 111 companies that delivered a positive earnings surprise, not all had positive performance. In fact, only 68% did. While looking at companies that delivered a negative earnings surprise, 44% actually had positive performance on day 1.
Source – Factset – Note: data for 5 companies was not available.
While the above table recognises the very short-term movement, it’s worth looking at performance over a slightly longer timeframe, e.g. 5 days after the result, which should be enough time for the market to have fully understood the results. In the below table, what is noticeable is that there is quite a bit of movement after the initial day once investors and the market fully comprehended the result.
At NAOS one of our key investment principles is long term investing. We aim to hold companies for 5+ years not 5 days, but at all times it is worth remembering that the stock market can be a very useful tool for transferring wealth from the impatient to the patient. Even great companies will experience periods of underperformance and it is during these times where an opportunity to buy or incrementally add to your existing holding can often present itself.
2: CASHFLOW IS KING
Next, we want to delve into the cashflow. In our view, the best way to read a financial report is back-to-front – i.e. start with the cashflow statement at the back and then work towards the profit and loss statement at the front.
Due to varying revenue recognition policies and accrual accounting, the profit and loss statement will not always give a true indication of what the cash earnings of the business have been during the period. Free cash flow generation can give a better understanding of this.
There is often a misconception that if profits are stronger then the company should be able to meet its financial obligations, however, it is not uncommon for a company to announce a positive profit figure, but the actual cash received paints a very different picture.
3: RESULT QUALITY
Beyond cashflow, we want to know if the company has a strong balance sheet and whether they are growing key financial metrics.
At NAOS we particularly like to focus on metrics associated with returns on capital and returns on equity. Whilst a static metric will give you a snapshot, often it won’t give you the full picture. How does this year’s metrics compare to the last few years? What is potentially of more importance is the trends of these return metrics and whether the company has options available to deploy excess capital at similar rates of return to how they have done in the past.
A company with a relatively high but declining abovementioned return metrics may actually point to a decline in the quality of the business and its competitive positioning. Equally, increasing return metrics may highlight that the business fundamentals are improving. A business which is continually seeing increases to its overall quality of earnings can have significant compounding effects for shareholders over time.
Similarly, we like to see companies that are showing evidence of margin expansion. This is especially powerful for a company that has a fixed cost base. If the cost base can stay relatively static while the top line grows, then that fixed cost leverage will drive the bottom line much faster than the top. If this occurs, you are likely to see multiple expansion and therefore a positive share price re-rate.
4: WHAT HAS PREVIOUSLY BEEN SAID?
If you really want to understand a company, we find a great way to do so is to read company announcements from at least the last few years.
It won’t take as long as you think, and it will give you a very good idea about what management’s strategy looks like and how they have executed it. Remember you are buying a business and not a stock code.
This point particularly relates to capital allocation. Did the company make an acquisition over the past few years that they were excited about at the time, but it has now been swept under the rug? Have they been sticking to their stated strategy or has it changed along the way?
Working out whether the management team has a consistent strategy year-on-year will go a long way to knowing whether you are buying a quality company.
5: WHAT DOES THE OUTLOOK INVOLVE?
Finally, the outlook provides us with detail of what to expect from the company going forward. It is quite customary for market participants to forget a poor year in place of a rosy outlook.
We will often place a healthy level of scepticism on companies providing guidance for future years ahead of the current reporting period unless they have a highly predictable earnings stream. An overconfident management team that sets expectations too high will set themselves up for a poor year of share price performance if they do not deliver. We prefer a conservative management team who are aware that business conditions can change, and the business cycle changes with it.
What we are currently looking for
Every reporting season is different. So while the above checklist provides a useful starting point, there are a few key themes that we will be looking for throughout the August 2021 reporting season.
1: capital management
At NAOS we like to align ourselves with a strong management team that has displayed prudent capital management through various stages of the cycle. So whilst there might be an increased level of uncertainty due to recent lockdowns, there has been a large amount of stimulus flooding the economy and a strong bounce back in earnings. As always, the tough decision on how and where to allocate capital will be front and centre. On the one hand, low interest rates and strong balance sheets could entice management teams to look at expansion projects and/or M&A but these plans may also be kept at bay with increased uncertainty caused by the increase in COVID-19 cases.
Part of the capital allocation equation is the topic of dividends. Something we are always mindful of is the relationship between a company’s earnings and their ability to pay dividends. There is a risk, similar to what we saw at the start of COVID-19, of several companies either cutting or delaying dividends. Thus, we will be on the lookout for commentary around dividends (and other capital management initiatives) as well as commentary on growth and expansion initiatives.
2: Covid-19 related issues
Putting aside the devastating health issues that COVID-19 has caused around the world there is a laundry list of issues that have impacted businesses of all shapes and sizes. Listed below are a few issues that we will be looking out for, and in particular how management teams are addressing them.
(i) Cost of shipping & freight
There are several factors driving the large increase in shipping & freight costs (outlined in the below chart) which include:
- a shortage of shipping containers
- longer wait times due to quarantining and COVID-19 checks
- the increase in demand for goods globally.
Companies with substantial import or export exposures are likely to face issues with delayed revenue or potential large cost increases unless they have strong pricing power. A key focus will be how they manage and mitigate these issues going forward.
Source - Moelis Research; FBX Freightos; VesselsValue; WSJ
(ii) Increased commodity prices
Depending on the company and the industry in question, the substantial price changes outlined in the below graph can either be positive or negative. The key area of focus we will be looking for is whether the company has pricing power. Some companies will benefit from the large increases if their product or service is leveraged to a particular commodity. At the same time, a company that has limited pricing power will potentially see margin compression if they struggle to pass on a large portion of the price increases onto their customers. It will be vital to understand management’s expectation going forward and how they will manage ongoing price moves.
Source: CapitalIQ - Data as at 20/7/21
- Global chip shortage
Everything from new cars to electronics have been delayed as manufacturers around the globe have struggled to source enough supply. It’s not all bad news for companies as some sectors have seen margin expansion given the increased demand for certain products, however there are question marks over whether this can continue and if companies can continue to source enough supply to meet demand.
- Labour shortages
With border closures restricting migration, companies are finding it difficult to source labour, both skilled and unskilled. Not only can this have an impact on delivering projects on time but the second order effects that may eventuate relate to pressure on margins as low unemployment leads to wage pressure.
Given the recent outburst of the COVID-19 delta strain and subsequent lockdowns, some companies have already started to remove guidance for FY22. We expect this trend to continue. While guidance and company outlook statements are seen as important for forecasting future earnings, part of our investment process at NAOS is searching for companies that have an element of predictability in their earnings profile and can show resilience in all conditions. Although the removal of future guidance is a risk, it’s important to understand the drivers of each company and key areas of risk e.g. revenue exposure on the east coast of Australia.
The topics covered in this article are only some of the key aspects of what to look for during reporting season, rather than a comprehensive list. Every investor may have their own approach and areas of focus. With the challenging environment we all find ourselves in, this reporting season will no doubt present plenty of challenges as well as plenty of opportunities. We at NAOS are confident our concentrated, long term investment approach will allow us to take advantage of some of these opportunities.
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Robert Miller is a Portfolio Manager and has been with NAOS since September 2009. Robert has completed his Bachelor’s Degree in Business from the University of Technology Sydney, as well as completing his Masters of Applied Finance from the FSIA.
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