Director's Cut: Reporting wrap

The idea of reporting season delivering a uniformity of results is misplaced. No one asks a weatherman if it’s going to rain, be sunny, or just overcast for the next six months. The question itself fails to make sense.

Were it not for the human desire for (apparent) certainty, one wonders whether the business media would bother with it all. And yet with the gamut of results, the odd kernel of truth emerged from the fog of corporateese, reaffirming existing suspicions and challenging new ones.

The demise of businesses like WOW Light & Sound, Sleep City and Kell and Rigby (and Reed Constructions struggling), suggest unlisted businesses may be struggling to obtain finance. Or perhaps the general weakness in the retail and building sectors is causing problems?

Certainly, companies reliant on Australian discretionary consumption are having a difficult time. The results of JB Hi-Fi, Harvey Norman, Billabong and parts of the Woolworths empire confirmed that. The effects could even be seen in announcements from Coca-Cola Amatil and Reece.

Resources boom

The strong results from the resource sector seemed to confirm the bifurcation (our favourite new word) of the local economy, although as Gaurav Sodhi pointed out on 10 Feb 12 in BHP Billiton turns up the volume (Hold - $37.16), there’s a twist.

Although commodity prices have fallen from previous highs, they remain well above historic levels. The big resource stocks such as BHP, Rio Tinto and Fortescue are relying much more on volume growth than price rises to generate higher profits. As a consequence, prices will, at some stage, start to fall further.

When that happens, only the best, low cost miners will prosper. The rest will once again succumb to the whims of the resources cycle, currently hibernating rather than dead.

Members must therefore be extremely selective in the sector, which is why we’ve long recommended avoiding Rio Tinto, Paladin, Newcrest and Fortescue. Instead, plant your dollars in more fertile ground like the energy sector.

Having argued that the long term trend in oil prices would be up (see The case for oil on 27 Oct 09), the impact of recent oil price increases is starting to feed into company results. Equity prices are now starting to reflect that fact.

Energetic energy sector

Some of our key energy recommendations have performed extremely well recently. Since the start of October, AWE is up 76%, Tap Oil 34% and Cue Energy 30%. Even Carnarvon Petroleum has regained some lost ground (although it still has a long way to get back in the black). Amongst the larger oil stocks, Santos rose 27% and Oil Search 25% over the same period.

These have been great stocks to hold while the rest of the market, including other resource stocks, have gone sideways.

This sector has a bright and prosperous future ahead of it, although selectivity is key. The same cannot be said of electrical retailing, for example, which is facing structural decline.

The resource boom is also keeping the Australian dollar near historical highs, dampening the results from companies with foreign assets (such as QBE Insurance, Sonic Healthcare and Computershare) and exporters like CSL and Cochlear.

It also has also boosted overseas travel. Tight-fisted consumers loosened their wallets sufficiently to take advantage of bargain holidays in Asia, Europe and the US, benefiting the likes of Flight Centre and Webjet.

Profits from the sharper end of this boom are highly cyclical. Members should be acutely aware of the cyclical element in such earnings. Many, if not most, resource stocks would be quickly punished in the event of a resource sector induced currency collapse.

Exposed industries

Industries like travel and mining service would also be severely hit. Take WorleyParsons for example. It listed nine years ago at $1.75 and now trades at over $28 a share on a PER of more than 20, having more than doubled revenue over the past five years. Little wonder that on 23 Jan (see Reflecting on WorleyParsons) we suggested you Sell at $27.70.

On the other hand, with many of Australia's best businesses struggling against a high AUD but reporting good underlying results (see CSL, Cochlear and Fisher & Paykel Healthcare), if the currency headwind changed direction, future profits would likely jump very quickly.

For the most part, the underlying results of our major defensive and high quality recommendations performed well. Spark Infrastructure and Sydney Airport, despite a slight traffic slowdown, have been good recommendations suited to the times, and the latest results showed how.

All up, reporting season delivered a typically convoluted, meteorological picture; there was sun, rain and cloud. This really confirms our approach over the past 18 months; prepare for the worst (hold more cash, seek international exposure and keep to a strict portfolio limit of 10% in bank stocks) but hope for the best.

Performance reporting

The proposed re-jig of our performance report (see Performance report rule changes? from 19 Jan 12) to an internal rate of return (IRR) calculation received plenty of support. That isn’t so surprising; it’s an industry standard and has been used in the calculation of returns from our two model portfolios for years.

Table 1 shows how, under this new methodology, our Long Term Buy, Buy, Buy for Yield, Speculative Buy and Subscribe recommendations have outperformed the market over 10 years. Whilst it’s encouraging to outperform the index by a substantial margin, the new methodology is an improvement without it being perfect.

Remember, though, that the performance report, with 557 buy recommendations over 10 years, isn’t a proxy for a typical members’ portfolio. It does, however, show the universe of our recommendations over the past decade. In the interests of transparency and full disclosure, we feel it’s worthwhile. Combined with the returns from our Growth and Income portfolios, there exists now ample proof of our research and recommendations outperforming the index.

The new performance report using the IRR methodology will be released within the next week or so. We shall also make available a spreadsheet so that members inclined to play around with the numbers can easily do so.

Sell recommendations

One question raised by a member during the consultation process was the performance of our Sell recommendations.

There’s a categorical difference between what one buys and one might sell or avoid, which is why we don’t report on this category. When we recommend a stock that goes up in price, a profit is made. When suggesting a stock is sold or avoided, one avoids a loss. These are two very different things and to compare them is a mistake in itself.

Nevertheless, having asked our analytical team members for their most memorable sell recommendations (see Table 2), the anecdotal evidence is that we haven’t done too badly here, either.

On occasions, we have specifically targeted over priced stocks and these have generally worked out quite well. See Time bombs exposed from 02 Sep 04, Beware these ticking time bombs, published on 19 Jul 06 and Danger UXB from 18 Jun 07.

Generally, though, our role is to offer advice on what stocks to buy. Only where we see a widely-held, over-priced stock, as was recently the case with Rio Tinto and JB Hi-Fi, do we feel compelled to offer an opinion.

Buy and sell strategy

Lastly, a timely reminder of the consequences of the move to a buy and sell strategy in sideways markets, outlined in a Director’s Cut: The buy and sell strategy from 10 Oct 11.

Generally, stocks that were once cheap don’t just return to fair value, as economic theory suggest but, for a whole host of reasons, move beyond it. In more normal markets—and current conditions are very far from normal—it’s tempting to hold a stock until it moves beyond fair value before selling. That’s not something we recommend in this market.

The volatility and capacity for shocks means that holding a stock beyond fair value carries more risk than usual; better to sell it and take advantage of the many under-valued opportunities (see current buy list).

Macquarie Group is a prescient example. Having recommended it as a Strong Buy on 05 Aug 11 (see Chaos amid the storm: The upgrades), the stock price has risen over 30% since its low of $19.94 on 26 Aug 11. It still carries a positive recommendation (see Macquarie Group: An odd conundrum) but if you purchased a large position, it’s probably now an even bigger proportion of your portfolio.

Whilst not suggesting you sell out completely, we do want you to stick to the portfolio limit of 5%. With a substantial and rapid price increase in the past five months, it’s sensible to consider taking some profits off the table now rather than run the risk of round tripping.