Brad Potter
Due to continuous disclosure, reporting season is chiefly an opportunity for companies to relay their outlook to the market. Having said this, the level of detail provided by management is often greater than at other times, while the sheer volume of company newsflow also lends itself to instinct-driven price reactions. Reporting season for a long-term investor such as Nikko AM Australia can therefore be quite volatile at times, while also creating opportunities.
But while dodging bullets from stock-specific noise can be difficult, this reporting season also saw global macro bombs being lobbed into the mix, which made sifting through the immense amount of information even more difficult. The S&P/ASX 200 Index fell 8.64% in August 2015, which was the worst month since May 2008. The S&P/ASX 200 Accumulation Index was down 7.79%.
The devaluation of the yuan caught markets by surprise and resulted in even greater volatility than normal. Eventually, the market perceived this move as an attempt by the Chinese authorities to boost exports to help the weakening economy. China is driving commodity markets as never before and prices continue to respond sharply to volatility in Chinese equity and foreign exchange markets, amid concerns over underlying growth.
Underneath the macro noise, Australian stocks were reacting to results, guidance and changing commodity prices, with the ASX 200 Energy sector down 13.8%, as the oil price fell 27% to a seven-and-a-half year low, before recovering to be up for the month. According to Bloomberg, 50% of companies beat analyst expectations, 48.7% missed expectations and 1.3% were in line. By sector, Materials, Industrials and Utilities had more positive reactions to results, whereas Consumer Discretionary, IT and Telecommunications were negative.
However, it was difficult to determine how the market was responding to some results given the spike in volatility. The worst sector was Energy, followed by Financials ex-REITs (-10.6%) & Telcos (-8.3%). The sectors that outperformed should not surprise in a risk-off market, with Utilities (-0.2%), Consumer Staples (-4.1%) & REITs (-4.1%) all outperforming the broader index.
Post reporting season, consensus market earnings were revised down 150 basis points (bps) in fiscal year 2015 (FY15) and 80 bps for FY16. Resources were again the largest contributor. The outlook for FY16 saw soft guidance, resulting in 45% of firms cutting FY16 earnings per share (EPS), and downgrades outnumbered upgrades by 2.7 times, which is well above the 1.6 times five-year average.
Nikko AM Australia likes to enter reporting season holding a little more cash than usual, as we do find opportunities when the typical fear, greed and trader emotions of the market overreact. This strategy, combined with being underweight Energy and the Banks, helped all three flagship Nikko AM Australian Equities Funds outperform during August. There were also a number of stock-specific outperformers across the Funds, with Sims Metal Management (+21%) and BlueScope Steel (+18.7%) standing out.
One of the key takeaways from reporting season included dividends growing faster than earnings, which continues to be a global theme. Dividend payout ratios continue to drift higher, although this is largely because resources earnings are falling – rather than dividends increasing. Both BHP Billiton and Rio Tinto have unhelpful and poorly conceived progressive dividend policies that have no place in a cyclical company. There are concerns that the high payout ratios may be stifling capex and thus future growth. Over the long-term, this may be an issue – particularly given many companies are cutting capex to pay dividends. BHP is forecast to payout over 100% of earnings over the next five years.
The two-speed economy story also appears to be running its course. Companies with greater exposure to New South Wales and Victoria have generally performed better than those with Western Australian and Queensland operations. This is reflective of the much better retail sales, employment and house price growth in NSW and Victoria, as well as the obvious mining downturn in WA and Queensland.
Cost-out and efficiency programmes are helping to lift earnings before interest and taxes (EBIT) margins, despite top-line growth generally remaining weak. At the margin, some companies are starting to increase costs and capex in order to drive growth. However, despite these initiatives, downbeat guidance was a big driver of negative share price reactions during August. These negative outlook statements appear mainly to have been driven by sluggish global demand and higher reinvestment costs. Weak domestic conditions have been less of a driver – perhaps because there were low expectations.
From a sector perspective, banks have recently raised AUD 8 billion of capital, which helped to contribute to an 11.7% fall for the month. Overall earnings trends were broadly in line with expectations, although uncertainty remains on the horizon regarding Basel 4 changes, notwithstanding the recent capital raisings. The quarterly updates revealed subdued revenue growth due to seasonally weak markets despite loan growth remaining solid. Bad and doubtful debt charges are still at very low levels despite some emerging stress in specific areas such as retail lending to resource-exposed geographies, business portfolios exposed to mining, as well as some agricultural portfolios. Nikko AM Australia has been underweight banks for 12-18 months, due to the dilutionary impact from the capital raisings in our forecasts, resulting in lower EPS, dividend per share (DPS), return on equity (ROE) and ultimately valuations.
Despite the recent falls in commodity prices, the miners posted decent results. Cost cutting and lower capex are helping offset the lower prices but this can’t fully compensate against the price impact. The higher cost producers, often with poor quality assets, have been in constant downgrade mode throughout the year, with EPS now at half of what they were. But low interest rates are arguably keeping many alive for the moment.
Industrial earnings were solid with a combination of some domestic earnings doing well, together with the positive tailwind provided by the falling Australian dollar for offshore earners. It was interesting that in a number of cases, housing-related stocks that had strong results were met with a subdued reaction, suggesting there is concern that trading conditions cannot last for these companies.
As in all global markets, the outlook for Australian equities remains dominated by macro issues that appear to be concentrated around global growth expectations. Management guidance again seemed cautious about the outlook and this was consistent with companies increasing dividends, reducing investment and maintaining cost-out programmes. The sub-trend top line growth across most sectors, combined with cheap funding is likely to lead to increased M&A. On this point, the lower Australian dollar has also made Australia a target for offshore corporates.
The market correction has brought the aggregate market back to reasonable value and we are seeing pockets of extreme value, which represent a buying opportunity. We are cautiously moving into these names.
By Brad Potter, Head of Australian Equities at Nikko Asset Management
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