Reporting season is over and overall it’s been a positive one with a higher percentage of companies that reported a better than expected result than those that disappointed with a lower than expected result. According to UWJ’s figures, we analysed the results of 119 companies that posted their interims. Of those that reported, 52 were a beat, 27 were in-line and 36 missed expectations. That means 70% of results to date were in-line or better which is a remarkable outcome compared to previous periods where the bias has been to the negative. In the previous reporting season only 14% of large caps beat and 25% missed. The results weren’t nearly as bad as feared. Analysts were concerned that the number of earnings downgrades that filtered through early on would continue on throughout reporting season. This didn’t occur, in-fact it was quite the opposite. Most companies were able to meet expectations and a good number went on to surprise on the upside. This boosted the Australian sharemarket and helped it regain almost all of the losses endured during the savage sharemarket rout that occurred at the start of the month due to inflation and interest rate concerns in the US. The Australian share market index started the month on 6090 points, fell to a low of 5786 points and clawed its way back to close on 5999. It’s been a wild ride for investors nonetheless. It was pleasing to see that company dividends were largely in line unlike last reporting season where some of the bigger names surprised on downside by cutting dividends.
Reporting season is always a nervous time for investors, because unexpected fluctuations can have a massive impact on share prices. There are two guidance figures that investors should keep an eye out for. First is the company’s own guidance which is based on its expectations. Second is broker consensus expectations based on their calculations. A company needs to deliver an in line or a beat on both profit expectations. If a company can do that, it is handsomely rewarded and cheered on. Share prices rises. However on the flip side, if a company misses expectations it is severely punished and its share price hammered. Market darlings can become market dogs and small cap juniors can grow into multi billion dollar companies overnight, such as Kogan (KGN). This reporting season was no exception. Companies that beat expectations this time around were greeted with large share price gains, such as A2 Milk (A2M). And on the flip side, companies that missed expectations had their share prices mauled. A good example was Blackmores. According to Deutsche Bank, the average EPS beat saw a 3.6% upside price gain on the results day, while a miss saw a 2.6% fall. Out of this reporting season, the UWJ team put together five trends that have emerged.
- Positive earnings growth. This reporting season was all about earnings growth which was supported by an economy that is doing a lot better than expected. Generally earnings were positive with most companies recording an increase in earnings growth. Some even upgraded forward guidance. The Australian market reported 6.6% earnings per share growth this fiscal year supported by improving global conditions and outlook, rising demand for commodities, a recovering mining and energy sector, increases in business investment and in business confidence. However concerns still remain over weak wages growth, a cooling property market, higher interest rates and household debt, rising inflation and household consumption. Offshore earners did particularly well most benefiting from a stronger US housing cycle and stronger US dollar. It highlights the view that as the Australian dollar falls, owning companies with exposure to faster-growing economies than Australia’s makes sense.
- Retailers surprised on the upside. It was a surprise to many after retails sales fell heavily in December following an increase in November. Concerns around the Amazon effect, the closure of some major Aussie retailers, downgrades from Retail Food Group (RFG), Oroton (ORL) and Shaver Shop (SSG) together with a soft Christmas trading period and a slowdown in consumer spending had most analysts bearish on the sector leading into reporting season. But most retailers bucked the trend and recorded earnings growth. This was especially true for Kogan (KGN), Breville (BRG), Temple & Webster (TPW), Webjet (WEB), Flight Centre (FLT), REA Group (REA), Wesfarmers (WES), Lovisa (LOV) and Corporate Travel Group (CTD). All beating expectations.
- Dividends were in line. One of the highlights this reporting season was that companies recorded strong dividend growth unlike previous periods. According to Macquarie the ratio of companies reporting better-than-forecast dividends to less-than-expected dividends is 1.5 to 1. In other words it was a bit of a cash bonanza for SMSF, retirees and income seeking investors. A rise in dividends is usually a tell-tale sign that cash flows are increasing and the company is bullish on its outlook.
- Mining, resources and energy stocks continue to shine. The resources sector was expected to deliver positive earnings growth and it did. Resources and energy stocks gained from rising commodity prices which helped drive substantial earnings growth. Miners delivered solid earnings numbers with balance sheet repairs largely complete and benefits from cost cutting initiatives now coming through.
- Expensive high PE stocks that disappointed were heavily sold off. This reporting season was once again plagued with high valued stocks that have run well ahead of fundamentals. There isn’t anything wrong with a high valued stock, as long as it delivers. It’s when it fails to deliver, everything comes crashing down. A good example here was BWX. Once a market darling, now not so much.
Whilst most trends are positive, the last one is worrying. To put it plainly, the Australian market is priced for perfection.
The ASX 200 index is trading on a PE of 16.2x which is about 15-20% above the 20 year average (14.5x). The ASX Small Companies Accumulation Index PE is 18.7x and is relatively high compared to history. The US market is at 18.2x about 15% above its average. Some of the biggest losers this reporting season were BWX (-30.4%), Domino’s Pizza (-6%), Bellamy’s (7%), WiseTech (-23%) and Blackmores (-15%). What’s happening here, is that the high growth momentum names are being shaken out, particularly at the small cap end. This means the small cap end is looking more and more vulnerable. Whilst that end of the spectrum has done well, the tide seems to be changing. Large cap stocks with better earnings growth and solid cash flow are starting to recover and are looking more attractive. Towards the latter part of 2017, many investors in Australia took the decision to structurally overweight their portfolios towards the smaller cap end of the market given the underperformance in the large cap end. Many of the big guys performed poorly through 2016-17. Banks underperformed as did Telstra and the big miners. This led investors to target smaller cap stocks to achieve abnormal returns. The Mercer Australian Small Companies survey data shows the median small cap manager has outperformed before fees by 7.32% p.a. over the last 10 years. Small cap fund managers such as Spheria, Lennox, Paradice, Paragon and Pengana have achieved phenomenal returns over the year. However, we think it’s time to be a little cautious.
What we’re saying is that there are now more smaller cap traps than ever before. These traps are smaller cap companies that self-promote themselves, set unrealistic expectations, don’t generate cash and in some cases never will. They’re usually the ones that come undone. When they disappoint, they don’t just fall, they tumble. A good example was GetSwift (GSW) which is down which is down 76% from its February high after it disappointed. Last week Sydney based small caps manager “The Boat Fund” sunk. Literally. The fund manager wound up the fund after it wasn’t able to meet its objective of outperforming the ASX Small Ordinaries Accumulation Index before fees. Its holdings were Freedom Insurance, CML Group, McPhersons and EML payments. High prices valuations for shares are likely to be with us for a while. When inflation and interest rates are low there is a lower expectation of high market returns. But when inflation rises, the prices in the economy rises. This leads investors to demand a higher rate of return to maintain their purchasing power. If they demand a higher rate of return that means the PE must fall. Investors will pay a premium for real growth but not artificial growth caused by inflation. Whilst everything seems to be booming driven higher by Quantitative Easing, low interest rates and high debt, you can’t help but think what happens when the US pushes the Quantitative Tightening button? After this reporting season, you only have to look at stocks in our market that are trading on astronomical valuations, well blown out of proportion. GetSwift recorded revenue of $600k but was valued at $585 million. They very quickly de-rated. Some high PE stocks have become high because there is very little growth in a low interest rate world and investors desperate for any sort of dividend they will take a high PE stock. The Fed has already said it will reduce its balance sheet by slowing the reinvestment of maturing bonds and by raising rates 3 times this year. This has a knock on effect with bond rates, bond proxy securities such as listed property and infrastructure plays and a positive effect on cyclicals geared to higher earnings.
This is why reporting season is one of the great market barometers where everything comes out. High PE stocks that have been inflated by hot air, are popped. Ones that continue to show earnings grow, inflate higher. Clime Investment Management says “it’s tough for companies to maintain a high PE for longer than five years. If there is one stock in the local sharemarket with a high PE that has confounded investors it is Domino’s Pizza Enterprises. The stock floated at just over $2 in May 2005.” It hit a high of $77 trading on a PE of 70x 2016 then downgraded profit and dropped to $40 on a PE of 36x. The rationale for a high P/E is the expectation that the company’s profit will increase beyond today’s levels and that interest rates will remain low. DMP disappointed this expectation and so the story goes. On the flip side, A2 Milk trades on a PE of 62.74x, has a market capitalisation of $8bn, revenue $435m and NPAT $98.5m and it continues to increase earnings and defy expectations. But there will be a point, where its expectations will run far ahead of its actual valuation and it will disappoint. Tech companies are also good examples. They trade on high multiples because their business models, if successful, they generate large levels of growth with low risk. That’s why investors are willing to pay a high PE.
The question then is, when do you hold a company with a very high PE?
In a low interest rate environment, a high PE will continue to be re-rated higher and higher if it continues to grow its earnings and investors see good returns. But as the PE ratio gets higher and higher, it becomes harder to move the needle in growth and so the stock hits a busting point and its PE adjusts lower, shares fall. Ultimately though the PE ratio doesn’t tell you much. It doesn’t take into account earnings growth. When selecting stocks what you want to use is the PEG ratio. This takes into account growth. Because at the end of the day, the market is all about quality and growth and to identify that, the PEG ratio is a better tool.
Here are some high PE stocks that are concerning us: