Predictability and sustainability of earnings growth the key to success in 2014

Mark Arnold

Mark Arnold

Market sentiment has improved over the past year, and with it investors’ appetite for risk, according to equities specialist Hyperion Asset Management.

Hyperion’s Chief Investment Officer, Mark Arnold, and Portfolio Manager Jason Orthman, said that equity markets in general had performed well over the past year, with many stocks re-rated upward as the lower earnings of the past few years started to pick up.

“Investors are feeling more comfortable taking on more risk, moving back into growth assets such as equities. And when it comes to which stocks are favoured, the companies that can demonstrate the potential to deliver positive future earnings growth have been trading at premium price to earnings (P/E) ratios,” said Mr Arnold.

In addition to P/E ratios, in the current low interest rate environment, dividend stocks were another major focus for investors in 2013. Accordingly, the major banks and Telstra, both of which offer appealing dividends, both rose sharply over the year.
However, Hyperion cautions that this trend may not continue.

“The long-term outlook for credit growth is subdued, and with regulatory requirements for higher capital levels, earnings per share (EPS) growth from the big banks is unlikely to move above the mid-single digit level for the next five years,” said Mr Arnold.

On the other hand, the performance of a number of Hyperion’s holdings over the year looks likely to continue to be strong in 2014. Three investments, REA Group, and Domino’s Pizza Enterprises are cases in point. All delivered strong earnings per share (EPS) growth over the year, up by 26%, 16% and 12% respectively, and were significantly re-rated as a result.

Mr Arnold went on to explain that, over the longer term, earnings and dividend per share growth is the best indicator of long term performance.
“Price to earnings ratios are an important metric, but they are not the best predictor of future value,” he explained. “Long term stock prices should, on average, grow in line with earnings and dividends per share growth, so these are the factors that investors should focus on.”

Mr Orthman predicted that performance in 2014 will be all about delivering in line with expectations, with predictability and sustainability of earnings growth crucial.

In addition to REA, Carsales and Domino’s Pizza, which Hyperion believes will again deliver strong EPS growth in 2014; Mr Orthman also cited examples such as Ramsay Health Care and Twenty-First Century Fox as stocks to watch for 2014.

“We expect that Ramsay Health Care (RHC) and Twenty-First Century Fox (FOX) will deliver solid growth next year. RHC had offered guidance of 12% to 14% growth in FY14 which should be comfortably achieved as it continues to expand its capacity in its existing portfolio of private hospitals. High utilisation rates, rising medical costs and the aging population mean RHC is well positioned to deliver consistent double digit annual EPS growth. FOX should also produce double digit EPS growth over the medium term due to its growing high margin subscription revenue and regular share buybacks. With quality content and high investment in new channels, we expect strong price rises over the medium term,” said Mr Orthman.

While online and health care stocks rate highly in Hyperion’s view for 2014, it is resources and mining related stocks that should be viewed with caution, according to Mr Orthman, who says their predictability will be low next year.

“We are not confident about the consistency and sustainability of their earnings,” he explained. “That’s one of the reasons Hyperion is underweight the mining sector.”

Mr Arnold concluded by saying that the recent spate of successful initial public offerings, such as OzForex Group, and strong share price movement of market sensitive stocks, such as Macquarie Group and Henderson Group, along with a willingness to support early technology plays like Freelancer was a sure sign that investors’ risk appetite is on the rise.

“It’s great to see renewed confidence flowing into the market,” he said. “But for investors looking for long term performance, a focus on strong, predictable earnings growth is still the best guarantee of success.”

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