Pedestrian result doesn't justify bloated share price

Macquarie Group on Tuesday produced an early taste of what the coming reporting season holds - some glimmers of hope but not enough - which points to a season tinged with disappointment.

This is a stock that over the past six months has undergone a seismic shift upwards, moving ahead by about 50 per cent. As such the investment bank is priced for success. What Tuesday's operational briefing delivered was tantalising but not enough to justify the recent share price run.

Having said that, if the bullish sentiment in the equities markets continues, Macquarie will be a winner. But these gains have yet to be locked in.

Its chief executive, Nicholas Moore, forecast earnings for the year to March 30 would increase by 10 per cent - and this will be a better outcome than most of the top 50 ASX-listed companies that report their half-year earnings over the next few weeks.

But it needs to be better. Investor disappointment was reflected yesterday in the 4 per cent fall in Macquarie's share price as punters concluded that a 10 per cent profit improvement doesn't justify a 50 per cent share price gain. Nor does the profit outlook support a share price multiple in the range of between 12 to 16 times this year's earnings.

The forecast of a 10 per cent profit increase implies a full-year result of a little over $800 million, although analysts were looking for something closer to $840 million.

To the extent of reading between the lines of the profit update and overlaying some degree of conservatism from Macquarie's management, a 10 per cent uplift is probably already in the bag, and barring some kind of market disaster the full-year result would exceed this.

Moore reckons if the improved market conditions persist there is a probability of a stronger result.

Investment banks like Macquarie are highly leveraged to sharemarkets and any signs of a rebound will see their stock prices outperform most other sectors.

We have seen the same hockey stick-shaped share price graphs over the past six months from US investment bank stocks. Citigroup is up 57 per cent since August, Bank of America has risen 58 per cent, while Goldman Sachs has risen 50 per cent.

The quarterly earnings released by these US giants a few weeks back all demonstrate a return to solid earnings growth. Macquarie is simply catching the same wave. And it's also worth noting that the percentage improvements in performance are coming off a pretty low base from a business that lost a large part of its money-making formula when the global financial crisis hit in 2008. Since that time it has been looking for new focus and direction, surviving in part from one-off and opportunistic gains from its diverse operations.

Not surprisingly, its annuity-based operations have been the big contributors to core earnings. If the market continues to recover these will continue to improve, but the more cyclical divisions like Macquarie Capital will produce the real gains that could justify the current earnings multiples. Taking some cost out of the company will help as long as it has been undertaken with surgical precision. Investors appreciate removing excess but won't be happy if the company is not in a position to capitalise on the recovery. All this will be tested more rigorously as the market improves.

Meanwhile, those investors who got into the stock early have already made significant gains. These are the investors who were prepared to take the risk that the early signs of improvements in equity markets represented more than just a breather in a bear market.

The author has shares in Macquarie.