Profit season may rain on your returns

Before writing my first contribution to Eureka Report for 2013 I thought I would have a yarn with Ross Barker, the chief executive of Australia’s largest listed investment company Australian Foundation Investment Company.

In theory Ross should be over the moon. Australian Foundation stock has risen strongly with a gain from it low point of more than 30%. Its shares, at around $5.37, are substantially above the book value per share of $4.27. Yet Ross was apprehensive. And we fanned each other’s sentiments because the way Ross was thinking was very similar to myself.

Australian Foundation Investment Company

Click to enlarge

Source: ASX

As you know, from August/September onwards I have been advocating people increase the equity share of their portfolio, and that is what I have done.

And that strategy has seen some very strong gains, particularly in companies that have yields. In essence, as bank deposits have matured money has been transferred into bank shares, Telstra and other high-income yielding securities.

The forecasts of further interest rate reductions have accelerated that trend, and if those forecasts prove to be correct then the current yields on banks and other high-returning securities still looks high.

But Barker and myself see another side. What the market has been reflecting has been a rerating of equity returns via dividends rather than rises in share prices linked to higher profits. And when the market undertakes such a rerating of dividends it can carry a long-term risk, because if interest rates start to rise and/or profits fall because companies have been too hard on cost cutting and not reinvested in their business then the sharemarket can get some nasty shocks.

Currently, although the market has risen by around 20% over the half-year, earnings in all companies for the year ended June 2013 are expected to fall by around 2-3%.

There is a small fall expected in bank profits, and a more sizeable fall in resource companies. Amongst industrials we could be looking at between a 6-7% rise in profits, but that is a very misleading figure because it covers great variations amongst individual stocks.

The price earnings ratio for non-resource industrial companies is averaging between 14.5 and 15%, which is very high given the lack of growth. Investors are simply valuing the companies on their income return and not on what is taking place in the base business. Longer term that is not a sustainable exercise, although if interest rates keep falling it could go on for some time. The pending interim reporting season will be very important. Those companies that are not able to develop growth momentum – or at least forecast it – may come under pressure as people look for higher returns. The simple fact is that longer term the equity valuations are as much linked to earnings performance as they are to dividend income. To ignore earnings performance and simply value on the basis of dividend payout ability carries dangers.

I must emphasise that neither Ross nor myself are forecasting some cataclysmic fall, but rather that there is a degree of risk to the stockmarket that didn’t exist three months ago and investors need to understand that. It doesn’t mean that they need to go out and sell everything they’ve got. But if your company performs badly in the latest half year and its share price is holding up on the basis of its yield, then it is probably best to invest elsewhere. Dividend yields are much safer where there is profit growth at the same time.

As I talked to businesses during the early weeks of this year, I didn’t find a great deal of enthusiasm. Supermarkets for the most part had a good Christmas but the other parts of retail were very patchy. There was no particular joy in the banking business, and business confidence is low. The NAB November business survey plummeted from minus one to minus nine, which was its weakest reading since April 2009, and some 15 points below the long-run average. We have also seen more recently that the Australian Chamber of Commerce and Industry found that while business conditions had improved slightly in the three months to December, the outlook remained bleak. The climate for investment index fell to 31.1 points, which is its lowest level since the survey began in 1998. Readings below 50 show that sentiment is deteriorating.

In other words, businesses are simply not investing and that trend towards lower investment has been accelerated by the government’s move to drain cash from our larger corporations by making them pay tax monthly. Gradually that will be extended down to middle-ranking companies and it will hold back investment. If companies are not investing then their longer-term earnings potential is reduced and they can get into trouble.

Most of the profit rises that will take place will not come through trading improvement but because costs have been reduced. Where simply hacking out staff has reduced costs, the benefits are not long term. Cost reductions only make long-term sense if there is a different way of conducting the business. My impression is that, for the most part, not enough Australian companies are revamping their business strategies but rather are simply adjusting their staff levels to the lower economic levels.

But the news is not all bad. In the past it has taken between one and two years for the effect of interest rate reductions to flow through into better trading. In particular you will be looking for a rise in in the level of home and general construction in response to interest rates. While at the moment there is no substantial sign of this taking place, that doesn’t mean that it won’t happen. In the past, the Reserve Bank has occasionally raised interest rates too far or cut them too much because they became impatient at the lack of response and did not take into account that stimulatory or economic dampening exercises via interest rates usually taken one to two years to work.

And why are AFI shares trading above asset backing? Ross says that historically this is rare, and normally he is complaining about the discount. Because investors are looking for yield they feel safer in deriving that yield from a portfolio spread like AFI where the managers are looking at the performance of companies rather than an indexed fund or picking their own shares. Nevertheless that premium adds risk in a downturn.