PORTFOLIO POINT: Corporate profit margins here and in the US are sending important signals to investors. And if the message is right, Australian shares could be on track to close the gap with Wall Street.
Somehow American companies are much better at playing the sharemarket than their Australian counterparts. Firstly, they guide analyst forecasts down, and then they release better-than-expected financial performances. Granted, the US Q1 reporting season still has a long way to go, but at early count more than 70% of companies are “beating” market expectations. If this ratio continues in the weeks ahead, we may experience yet another solid financial performance from corporate USA.
The contrast with what is happening in Australia is there for everyone to see. March quarter production reports by miners and energy producers have been largely disappointing, admittedly on heavy impact from unusually wet weather, but regardless, corporate Australia continues to suffer from downward pressures on earnings forecasts and resources companies remain among the main culprits. Former market darling Woolworths (WOW) has just delivered what may well have been its weakest quarterly performance in more than a decade. Soon, most of the major banks will report their interim results in Australia. Virtually nobody believes any of these results will shoot the lights out.
There is, however, one major difference with the experiences of the past two years. Despite the high number of reporting season "beats" in the US, equities there are no longer rallying and despite continued disappointment in Australia, the local sharemarket has remained remarkably resilient. At face value, one might be inclined to think that other factors are responsible, such as continued slowing in China, continued uncertainty in Europe and disappointment from US economic data, while the RBA in Australia is preparing for yet another cash rate cut. But does all this really explain it?
First of all, both the US and Australia are now approaching an important inflection point, viewed from the perspective of corporate earnings. Part of the reason as to why equities performances in the US and in Australia have diverged so heavily since late 2009 is because earnings growth in the US swiftly moved into acceleration mode and two years later, after accumulated growth in excess of 100%, US corporate earnings are back at all-time record highs. So too are US corporate profit margins; it is entirely possible those margins have never in history been as high as they are today (which partially explains the tepid hiring by US companies).
In Australia, on the other hand, growth is something that has largely remained absent. At first, it was still there for the major banks and for resources, but both sectors are now staring towards low growth, in the case of banks, or towards negative growth, as with the big miners. Average earnings-per-share growth for the ASX200 since the trough in 2009 has not even managed to exceed 12% (2010-2011) and this year running (results in August) is unlikely to add much on top of it. It is therefore unsurprising that Goldman Sachs analysts earlier this year calculated corporate profit margins in Australia to be back at levels last seen in the mid-nineties.
The contrast between the two countries is easily summed up as follows: one is experiencing profit margins at all-time peak levels, while the other is suffering from corporate profit margins near all-time lows. Guess which one now has the better potential?
Has the time finally arrived for Australian equities to start closing the gap with US equities? It may as yet still be too early to make that call, but one would have to conclude that, from the view of the opposing inflection points in both markets, the pendulum is more likely to swing in favour of Australia's profits and growth at some point.
Look at, for example, the insurance companies in Australia. Everyone is talking about how last year was so exceptional in terms of natural disasters, and thus this year simply cannot be as bad. But what had been happening, hidden in the background, is continued downward pressures on profit margins throughout the sector, until margins fell to a low point last year. Assuming the years ahead are likely to see better margins off such a low base, the sector has re-found its favour with investors. As such, insurance companies in Australia might well be the harbinger of things yet to come for other sectors.
Before we all get too excited about Australia's pending reversal of fortune, let's dedicate a few moments to the headwinds that are now awaiting US profits and thus the US sharemarket. As is usually the case at these inflection points, there's a whole army of market experts who will assure us that peak margins need not be a problem for future profits. US companies have become lean, mean and clean (much more energy efficient) in years past and thus profit margins can potentially still rise further, they say. On top of this, the US economy is now improving, as is growth in the rest of the world, and growing revenues should only add to the bullish outlook.
One important counter-argument to this is that history shows a sharp negative correlation between US unemployment and corporate profit margins. In other words: this may well be the clearest case of "investors, beware what you wish for", because if US employers really are adding more staff numbers in substantial fashion – and continue to do so – then history shows their profit margins will come down, and swiftly.
Meanwhile, another reporting season with significantly more beats than misses cannot mask the fact that US profit growth is slowing down, and slowing down fast. Some analysts had lowered their forecasts in the lead-in to this reporting season for no growth, or even negative growth, but this seems to have been too low. Even then, let's assume average growth in earnings per share comes out at something like 6%; this would be substantially above the too-low forecasts, but substantially slower still than the double-digits US investors have become accustomed to in years past.
With many an expert predicting growth in corporate America’s revenues will eventually fall in line with growth in GDP (remember projections for US GDP are mostly "slower-for-longer"), the sustainability of corporate profit margins becomes the all-important question. This is even more so the case since history provides us with a rather gloomy blueprint.
The last time US corporate profit margins peaked was in 2006, one year before the Grand Sell-Off and a new bear market started. Prior to that, it happened in 1998, also one year (give or take a few months) before the Nasdaq peaked and a new bear market descended upon us. Don't get me wrong: I am not predicting the advent of a new bear market in 2013, but it appears to me the pattern that emerges is first denial and expectations of further margin increases, after which realisation follows that peak margins simply is too big a headwind to resist. History seems to suggest this process takes about a year.
Market strategists at UBS recently updated their own analysis on this matter and their conclusions fall in line with the scepticism expressed above. Says UBS: "Peaks in the profit margin cycle are typically followed by several years of lacklustre earning growth".
For Australian investors, the all-important question now is whether the years ahead will bring enough relief for corporate profit margins to improve, following the sharp downtrend since 2007. A second, equally important question for investors (especially those with a longer term horizon) is whether sectors with ultra-low margins today, such as traditional media companies and discretionary retailers, are the right companies to own, given the structural forces impacting on these businesses. Builders and building materials suppliers are equally battling very low margins, but surely their time of more sustainable relief will arrive at some point?
Margins for big miners now seem to be in decline, while the major banks have done a great job of keeping theirs relatively intact. Most service providers to the mining and energy sector have seen strong growth, but with margins merely at historical averages rather than expanding.
Corporate profit margins are not the only factor that matters when assessing the outlook for equities, but they are, as stated in the words of a battle-hardened US funds manager on CNBC recently, simply too big a force to ignore. Let's hope Australian companies can live up to the promise.
For the US market, the worst scenario would be one that sees revenues disappoint on sluggish economic growth, while earnings margins start their decline. A more promising scenario would be one whereby growing revenues compensate for shrinking margins. The best scenario, admittedly with low odds, is one that sees margins expand further while growth in revenues accelerates.
Current consensus expectations in Australia are for average EPS growth for ASX200 companies (corrected for outliers) of 5% this year and 18% next year. Assuming the current downward trend in estimates slices off some potential in the months ahead, most of today's potential, and profit margin optimism, hinges on how much will come off the projected 18% for FY13.
Rudi Filapek-Vandyck is editor of FNArena, an online news and analysis service. (This is an edited version of an article sent to FNArena’s subscribers on Monday, April 23.)