Investors’ responses to the profit reporting season suggest that the market is still rewarding those companies that can produce results in a weak revenue environment, rather than rewarding those investing for the future, according to fund manager Martin Currie’s analysis of market reaction to the results.
Profits in the year to June were up by an average of 19 per cent among S&P/ASX 200 stocks. This was dominated by the rebound in resources stocks, with the rest of the companies in the index improving from flat growth in 2015/16 to 5 per cent growth in 2016/17.
Martin Currie Australia chief investment officer Reece Birtles says: “During the reporting season, the market rewarded cost-out programs, was sensitive to dividend payout changes but did not differentiate between companies upgrading or downgrading capex forecasts.”
Birtles says the most controversial aspect of the reporting season is what happened to forecasts for earnings per share post-results. There were fewer upgrades than usual and more downgrades, making it the worst reporting season for EPS forecasts since 2008.
“However, this analysis masks the high percentage of in-line results, and even more so the relatively low range of EPS revisions (as represented by a low variance of EPS revisions) compared to the previous two years,” Birtles says.
“While the number of upgrades versus downgrades was poor, the market-weighted EPS forecast revisions for the S&P/ASX 200 were in fact bang in line with the last five-year average of a -0.3 per cent revision.”
The drivers of EPS downgrades were negative sales revisions, an increase in forecast capital expenditure and no change to margin forecasts.
Offshore cyclicals, such as Brambles, and defensive industrials, such as Telstra and HealthScope, were the stocks with the worst revision performance. The upgrades came from the less popular cyclicals, such as Qantas, Flight Centre and Lend Lease.
Looking forward, consensus currently expects flat profits for resources and growth of 6 per cent for non-resources, driven by real asset stocks and industrials but restrained by bancassurance stocks.
“We find that the best way to assess earnings quality, and the potential for future profit surprise, is to the look at the ratio of free cash flow to net profit after tax,” Birtles says.
For the S&P/ASX 200 overall that figure was 107 per cent – 143 per cent for resources companies and 82 per cent for industrials (down from 95 per cent a year earlier).
Within the industrials sector, mining services looks strong given the improved spending outlook from miners and strong free cash flow. Cyclical industrials look healthy on a stronger revenue outlook.
More concerning are the defensives, which exhibit slowing revenue growth.
