The dust has now settled after the reporting season and with most pundits championing that it was a winner. Seasoned investors will know that being so flippant is not the way to establish a view as to whether the recent run in the market is sustainable. Let’s take a moment to revisit the key themes we observed at Lincoln Indicators.
The Health of the Market
Currently, the health of the market reflects the overall elevated risk investors are exposed to. Overall there are only 27% of companies exposed to manageable levels of Financial Risk (Strong and Satisfactory rating), with close to three in four companies exposed to significant stress. Fortunately, we are in an environment where the cost of debt is low, and access to capital comes relatively easy, so unhealthy businesses can continue to trade for as long as they can convince someone to give them money. But, that doesn’t make them immune, as unhealthy stocks; Big Un, WPG Resources, and CrowdSpark reminded us.
Source: Lincoln Indicators
Source: Lincoln Indicators
For most investors focused on the larger end of town, they will find comfort in the much-improved results exhibited in the overall health of the ASX200. With 81% exposed to manageable levels of financial risk as diverse revenue streams and stable cash flow generation supports operations and provide a robust foundation. Investors should be cautious not to generalise that being ‘big’ means their investments are safe. History reminds us this is never the case with examples like Babcock & Brown, Paladin Energy, Gunns, Great Southern Plantation, and Slater & Gordon as ever-present reminders.
Earnings better than expected
From an earnings perspective, most companies delivered this season. When looking at the ASX300, an impressive 77.8% of companies either met or exceeded expectations, which was an improvement on the 75% from 12 months ago.
Source: Lincoln Indicators
Of those that delivered exceptional figures it was those with overseas operations that performed best. This included our Stock Doctor Star Stocks in the hot sectors of healthcare and tech sectors who achieved significant outperformance such as CSL Limited (CSL), Pro Medicus (PME), Wisetech Global (WTC) and Appen (APX). Domestic IT lottery firm Jumbo Interactive (JIN) was also a stand-out. Pleasingly, Stock Doctor Star Growth Stocks maintained their recent trend of achieving above median EPS Growth levels of 24%, higher than that of the broader ASX200 of 9.7%
Despite incessant talk of a stressed Australian consumer with an overstretched personal balance sheet, we witnessed a broad recovery in the retail sector. We prefer to invest in global retailers with a competitive advantage who benefit from better retail conditions abroad such as Star Stocks; Lovisa Holdings Limited (LOV), Breville Group (BRG) and Premier Investments (PMV) – though at the time of writing the latter is yet to report.
One issue hidden amongst the profit beats was cost pressures created by rising raw materials, labour and energy for many capital-intensive businesses, including those in the building materials, packaging, and mining services sectors. While stronger than expected top-line revenue growth was sufficient in most cases to cover the squeeze, ceteris paribus it will be difficult to replicate the same growth levels next year. Therefore, should this trend of rising costs not be arrested, this could be a negative theme later in the year.
It is not only heavy industrials feeling the cost pinch, the banks are echoing a similar sentiment. While Commonwealth Bank of Australia Limited (CBA) was the only one of the Big 4 to report, the others provided an update. Rising funding costs have started to impact on bank margins, and it was unsurprising to see many beginning to raise lending rates out of cycle to maintain breathing space.
In the lead up to the reporting season, several companies had either performed or were commencing asset divestments. Income investors were buoyed by the fact that payout ratios remain at cycle highs as companies chose to return excess capital to shareholders. A trend that is expected to continue over the next year. Pleasingly, our Star Income Stocks achieved a median average of 5.03% dividend yield vs the ASX200 at 3.7%.
While crystal balling is always a challenging game, there was enough from the latest season to give us confidence in the period ahead.
While it is always pleasing to see such strong beats regarding earnings, the market believes growth, though strong will be lower due to starting the year from a higher base. As we now see, the consensus for earnings growth expectations in FY19 sitting around 12%, down 1.5% from prior.
A sector that is expected to do well in terms of growth is Energy as an erupting thirst for Australian LNG from the world’s new largest supply destination, China – sees analysts scrambling up earnings expectations.
Last year’s ‘high PE’ stock will likely continue as the market seeks dynamic growth opportunities, as investors pay a premium price for a quality opportunity. So, it’s not surprising to see the IT sector close to the top of the list. What may come as a surprise to some, mining services is expected to continue positive earnings momentum coming from a low base.
On the negative side no surprises that hyper-competitive telecommunications sector leads the way. Also, utilities and property sectors are expected to have modest growth at best, but this is no surprise for these traditional income paying sectors that are not remembered for their dynamism.
Source: Bloomberg/Lincoln Indicators
What does this mean for our market? On the back of our recent strong performance, the market is currently on a high forward PE around 16x, which is only a slight discount to the current US rate of around 17x. In a potentially rising global rate cycle, this may cause a bit of strain on lofty valuations, and an orderly correction would not come as a surprise.
However, with powerful economic tailwinds supporting robust growth expectations, one would be hard pressed to suggest that a collapse was imminent. Though the actual risks of lofty valuations, tightening margins and the current health of the market are things, investors should be cognizant of.
At these levels the potential for disappointment and savage price reactions is ever-present so being prudent in the management of your portfolio is the best course of action. Remain exposed, don’t be greedy. If you have made a significant amount of money, take the latest reporting period as a chance to rebalance and get re-aligned to your investment strategy.
And don’t be concerned if you are holding cash. While we say investors should be invested now, the Lincoln Australian Growth Fund has the largest cash balance in its history. Not because we are concerned, rather we are waiting for those moments where irrational selling in great businesses will offer an opportunity too good to miss out on. Expect a few of these over the coming year.
Seven Star Stocks to watch this reporting season