Harbour Views: a seasonal report

The reports are in. Harbour Asset Management director and portfolio manager, Shane Solly, digs through the latest Australasian corporate results looking for trends

NZ market knocks off peak

Last month we highlighted that given the New Zealand equity market is nearing historical peak pricing based on a simple Price to Earnings (PE) measure, the mini company profit reporting season over November would need to at a minimum meet expectations to maintain the current level of NZ market pricing.

The result season with 22 companies reporting, delivered enough to sustain current market valuations. While there were more results below expectations than above expectations, and there were more post result downgrades than upgrades to forecasts (with growth pushed out to later years), outlook statements were relatively balanced with a positive skew.

While revenue results came in slightly better than market expectations, a number of measures were slightly disappointing. Dividends and dividend increases have attracted investors to the NZ equity market. The net negative revision to dividend forecasts post results highlights that dividend pay-out levels may have peaked for this cycle and that further dividend increases are dependent upon earnings increases.

Figure 1. November reporting season summary

Source: Forsyth Barr

While there were company specific disappointments reflective of challenged industry structures, company commentary from the AGM season was similarly relatively balanced with a positive skew.

Post the earnings results and AGM season consensus broker earnings forecasts for the New Zealand market have been have been trimmed for the 2016 financial year (from 9.6% to 9.2%), but increased on a market capitalisation basis for financial years 2017 (from 6.4% to 7.2%), and 2018 (from 5.3% to 5.6%). As a result the expected three year average earnings growth expectation for the New Zealand stock market has increased from 7.1% to 7.3%. This is a lofty target relative to the New Zealand economy growing at 2.5% and highlights the low domestic economic sensitivity of the New Zealand equity market.

Australian Annual General Meeting Season: Cautious

While commentary over the Australian AGM season was cautious, earnings trends were relatively balanced. Companies highlighted that while it is tough to grow top line revenues, productivity and capital management will support profit growth.

Several companies exposed to structural change, including Sims Group (stock price down -31.4%) and Dick Smith (-59.7%) guided earnings to below market expectations which resulted in significant stock price declines. We expect rapid structural change will continue to test returns for many businesses in the resources and traditional industrials sectors. Uncertainty as a result of regulatory reviews in previously high certainty growth sectors may also test returns from some stocks.

Post AGM consensus broker earnings revisions were consistent with historic norms, with a net 20% of companies earnings forecasts downgraded. Consensus earnings growth for the ASX200 is currently -4.0% for the 2016 financial year, 7.5% for the 2017 financial year and 9.2% for the 2018 financial year. While much of this earnings growth expectation is predicated by a recovery in the energy and materials sectors the underlying Australian economy is more resilient, and more conducive to company profitability, than many investors have feared.

Despite the end of the commodities boom and the slowdown in housing, other elements of the economy are steadily picking up the slack. Deutsche Banks’s Profit Pulse, a real-time indicator, has hit a 4-year high, with domestic indicators robust (credit growth, employment, business sentiment) and a reduced drag from commodity prices. Net exports are now expected to contribute 1.5% to GDP, far more than the 1.2% expected. Tourism activity is accelerating buoyed by both strong ongoing inbound tourism and an uplift in domestic tourism with Australians staying home as the AUD weakens.

While we believe the Australian housing market’s cooling from ‘white hot levels’ is healthy for the broader economy, the slowing may test Australian consumer confidence. The ANZ Roy Morgan weekly consumer confidence recently dropped to 112.8 partly due to cooling housing and partly due to concerns over the Paris Attacks. The RP house price data declined 1.5% month-on-month in November, its first monthly decline since May. The December HIA new home sales index declined 3% month on month. Building approvals growth eased to 12.3% year on year in October from 21.4% the previous month.

Outlook – the song remains similar

The Fed vs the world

Inconsistent growth and suppressed inflation are creating a difficult environment for central bank policy makers. These conditions are also creating extremes in capital markets, with capital flowing into a small number of investment pools creating some very ‘crowded trades’.

The US Fed will begin to gradually increase interest rates in the near term, but it will be doing so against a world which needs easy policy settings.

Geopolitics are likely to continue to cloud policy settings and responses for the foreseeable future. The unwinding of the resources spectrum is placing ongoing pressure on emerging economies that are levered to commodities, increasing near term financial event risk. Rapid industry change through new technology development is creating economies that don’t react to traditional policy tools.

For us, ‘the song remains similar’ (with apologies to all you Led Zep fans) going forward. Capital market settings remain in ‘goldilocks’ zone for equities, a ‘not too hot, not too cold’ state, with monetary policy very stimulatory and economic growth showing signs of gradual improvement. But the settings will be less stimulatory than they have been. Given inflated pricing and ‘crowded trades’ in some sectors, particularly bond yield proxies, we believe event risk is high and there is potential for market volatility to spike for short periods of time.

We believe these conditions lend themselves well to value add via stock selection. While we will keep investing in the ‘classics’ we will take advantage of the volatility to invest in companies that have the right characteristics but who may be currently over-priced, while continuing to avoid ‘one hit wonders’.

Right kind of companies for the environment

While the New Zealand equity market remains fully valued versus historical norms we expect global facing companies to continue to benefit from the historic year-on-year sharp decline in the New Zealand dollar. The Australian equity market is priced in line with long run average levels, while earnings growth expectations for Australian non-resource stocks are reasonable. The market capitalisations of the materials and energy sectors have been savaged over the past year and a half, meaning they no longer have the same bearing on the ASX as they used to.

Further cost cutting and capital expenditure reduction have the potential to enhance near term earnings; with the caveat that such policies are positive if they don’t stymie long term growth and reduce corporate competitiveness.

Both markets offer a 5% plus net dividend yield which remains attractive relative to fixed interest investments. Maturing pension pools and low returns on competing assets will support further flows into New Zealand and Australian equities.

Merger and acquisition (M&A) activity is expected to continue to underpin equity market valuation and confirm the underlying investment attraction of New Zealand and Australian companies as being relatively predictable and of an investable quality. Companies that can’t grow organically will continue to use relatively freely available debt to boost short term performance by acquiring assets, including listed companies.

Sustaining and growing revenue and margins will be difficult in this environment. Our focus is on industries, and companies within those industries that are profitably gaining share of the economy. In our view the right kind of companies for the environment include innovative companies with global platform driven growth, taking advantage of massive and rapid technology change. In many cases these businesses are defining new industry groups, neutralising traditional competitors. But it also includes traditional businesses that can use technology to enhance margins, improve capital use and deepen customer relationships.

We also recognise that while higher long term bond yields may slow near term enthusiasm for interest rate sensitive stocks, bond yields are not likely to rise enough to unwind investor thirst for high quality yield. But given the massive valuation multiple expansion such stocks have had from the global fall in interest rates there is very real risk of de-rating for some yield stocks if earnings growth is not sufficient or dividend distribution policies are questionable. Select quality yield stocks with potential to grow earnings remain attractive in this context.

This column does not constitute advice to any person.
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