A profit season to be cheerful

A stopped clock tells the right time at least twice a day. And so it is that many of our major investment banks, which for the past three months have been calling for a correction on the Australian market, eventually will be vindicated.

We are now entering the home stretch in the half-year earnings reporting season and so far, while the results haven’t been what you’d call stellar, they certainly have been far from shabby. More importantly, they have far exceeded expectations.

Given the speed and momentum of the rally on the ASX since June last year, this season’s results have assumed far greater significance than in previous years.

In their pre-Christmas forecasts for 2013, the overwhelming sentiment among analysts and forecasters was that 2013 would be a shocker, the Australian equities market was seriously overvalued and the half-year earnings would not justify the surge in equity prices.

That pessimism clearly was overdone and, as each day delivers better than forecast results – however slightly – the psychological impact has washed over a market clamouring for good news. With everyone predicting impending doom, the mere absence of disasters would have been enough to push this market higher.

On the results so far, the top 200 companies now are on track for earnings growth of about 3%. If you eliminate the resources sector from the equation, where earnings have been trashed by slumping commodity prices, then that figure lifts to 7%. And, on current estimates, earnings for the full market are forecast to grow more than 11% in 2014.

Clearly, though, the market is running ahead of itself. It added 5% in January alone and until last week had risen a further 4%, outpacing global markets, which had risen a little over 1%.  Wall Street jitters about a cutback in stimulus knocked it around last week and further worries about the outcome of the Italian election this week reduced February’s climb to 2%.

Gut feeling alone tells you that, given the breakneck speed with which Australian equities have been travelling, a pull-back in the near future is inevitable. But it is clear that earnings momentum, particularly among non-resource stocks, is gathering strength and that a cyclical recovery in earnings is underway.

That tells you that there is a solid basis for the rally and that any correction will be to levels far above previous troughs. In the past week, it has twice fallen to 5,000. Where that once represented a resistance point, it now appears to be a new support level.

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Source: Credit Suisse

Reasons to be cheerful

A couple of general themes have become evident in the reporting season so far.

The first is that the Australian dollar, while still a handbrake on corporate earnings, has become less of a drag. That is because it has stabilised. It is important to remember that it is the change in value that has an impact on earnings rather than the absolute value.

The second feature is the tight focus on cost and inventory controls. Sluggish consumer demand and poor business confidence levels have ensured that variable costs have been pared right back. Debt has also been minimised and investment decisions postponed to preserve cash flow.

Should there be any reversal of the dollar in the next 18 months, or a lift in consumer demand, then revenue will flow almost directly to the bottom line. While analysts are not factoring in these possibilities, it is clear that investors have.

The run on the Australian market has seen price earnings multiples increase and yields drop.

Midway through last year, the domestic market was priced at an attractive 11 times forward earnings. It now sits a little above 14 times forward earnings.

That movement has been cause for alarm among some analysts. But it is around the Australian market’s 20-year average. Official cash rates, by contrast, are at record lows and market interest rates are likely to fall independently of Reserve Bank moves as wholesale funding markets recover.

The median dividend yield is now sitting at 4.5%, again right on its 20-year average.

Unlike previous reporting seasons, the surprises this time around have been mostly positive, frequently resulting in large share price improvements. They’ve also been evident across a broad range of “problem” sectors such as discretionary retail and engineering.

Some of the biggest jumps have been seen by JB Hi-Fi, Bradken, Leighton, Newcrest, Stockland and Downer EDI.

Industrials and financials have been the performing sectors so far this month, with the best performing stocks during the reporting season Downer EDI, BlueScope Steel and Leighton.

As UBS analysts noted the other day: “This has added impetus to the value rally that has been underway for several months.”

But one of the main forces behind the continuing surge on the stockmarket was the Commonwealth Bank’s result, which was much stronger than expected. It was backed up by quarterly results from National Australia Bank and ANZ, both of which showed improved margins in their domestic business.

The banks were the driving forces behind the yield rally that began midway through last year, and all have confounded the sceptics about their ability to maintain earnings momentum.

The consensus now is that earnings per share among the banks are forecast to grow 4.4% this year and 4.7% the next.

Other majors like Wesfarmers and Telstra turned out decent earnings growth and were amply rewarded by investors.

On a sector basis, Citi analysts tip healthcare to have the best earnings per share growth prospects for 2013 followed by IT, industrials, telcos, consumer staples, financials, utilities and property. Consumer discretionary, materials and energy sectors all are forecast to suffer declining earnings.

A trend, however, has emerged during the reporting season of sell-offs around highly rated companies such as Carsales and Cochlear.

Reasons to be fearful

The caution from analysts shouldn’t be dismissed outright.

A recent weighty study by JP Morgan analysts built a forceful case for a serious pullback in the domestic stockmarket. While I disagreed with much of the logic supporting the argument (equity yields falling faster than Australian Government bond yields), it provided some interesting insights into recent trading activity.

JP Morgan noted that foreign inflows had been a significant force driving the Australian market rally. Foreign equity purchases rose sharply in the third quarter of last year, targeting the banks in particular, in the hunt for yield.

Global dividend funds, they argued, were now overweight Australia. Many were content to buy into Australian banks with a 7% yield but were likely to take profits when yields dropped to 6%, particularly when they can buy Canadian banks on lower multiples.

They also argued that Australian industrials had less to gain from a de-risking of global markets, as threats of a European Union implosion recede, than other stocks directly exposed to global cycles.

That may be true. But it ignores the potential gains to be had from Australian industrials when global conditions allow the Australian currency to settle at more natural levels.