This article appeared in the September 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Elio D'Amato, Lincoln
Reporting season is always an exciting period. When fresh financial accounts are released to the market we get a holistic sense of how the next six months will pan out, which stocks deserve our attention and which should be discarded.
While the sharemarket was meandering its way lower in the lead-up to the reporting season, buoyant reports from a number of key businesses in August reminded us of the importance of bottom-up financial analysis and not listening to negative "noise" in the media and investment community.
Based on recent positive earnings reports, we expect the Australian sharemarket to move higher in the face of tepid global market sentiment.
The positive situation for Australian companies should come as little surprise. Economic conditions are accommodative for growth, and the balance-sheet conservatism of the past five years has placed corporations in a prime position to take advantage of current conditions. In light of this, growth in company earnings and dividends is occurring and investors could be forgiven for being optimistic when looking forward to the second half of this calendar year and beyond.
Despite the positive market situation and the help of economic conditions, investors must continue to be selective and conduct extensive due diligence on stocks. Lincoln's latest Health of the Market report found that more than three-quarters of ASX-listed businesses do not possess acceptable levels of financial risk (largely because of the high number of resource companies yet to report a profit).
In addition, some sectors, such as retail and traditional media, continue to struggle with structural changes and poor growth drivers. Although the sharemarket is generally positive and reports have been promising, the key to investing remains in selecting stocks that assist investors to achieve their investment goals - be that capital growth or the generation of income through dividend yield.
Earnings and dividends: the story so far
Before the start of the reporting season, expectations from a consensus of market analysts and brokers was that corporate earnings were set to grow by around 7.2 per cent, compared to earnings in August last year. So how is the market tracking with expectations?
Taking into account companies that reported up to mid-August, the median growth in earnings was ahead of expectations at almost 9 per cent, perhaps giving some credence to the recent lift in sharemarket sentiment.
Even more encouraging for the market has been the fact that company dividends have been growing, with the median dividend per share (DPS) growth coming in at 7.14 per cent during the first half of August. Based on these earnings per share (EPS) and DPS growth figures, we can conclude that the market is becoming far more efficient in passing on the bulk of earnings growth to shareholders in the form of dividends. This is great news for those seeking income returns and is indicative of the newfound appreciation of corporate leaders for the value of paying fully franked dividends.
As dividends have become a significant focus for investors in recent times of low interest rates, corporate leaders have started taking notice. The yield highlights so far include the 30 cents per share Suncorp Group special dividend and the Telstra Corporation announcement of an off-market share buyback (a useful mechanism for returning excess franking credits to shareholders).
With the Reserve Bank of Australia continuing to ignore inflation, and talk of stable interest rates at lower levels for an extended period, it is clear that a renewed appreciation for the value of dividends and capital management is a theme that will remain strong. Investors would be wise to take note that quite a significant proportion of shareholder returns are now being sourced through capital management initiatives and dividends.
Outlook statements, trading updates and forward expectations
Funnily enough, and despite the wealth of earnings information and audited accounts being presented to the market, the focus of investors and market sentiment is often directed to the future rather than historical earnings.
This August, the scene was set in no uncertain terms. Strong outlook statements or earnings guidance were met with applause, as we saw in the strong share price surges for the Stock Doctor Star Growth Stocks: CSL and Slater & Gordon.
In all these cases, not only was the financial report solid, but the outlook commentary or earnings guidance informed the market to expect continued growth in FY15 and beyond.
From a growth perspective, the market is rewarding those companies that not only show the ability to grow in the coming 12 months, but also those benefitting from a strong industry thematic or trend that underpins longer-term growth.
Of course, the converse is also true and we have seen some disappointing results punished quite heavily by the market. This includes sectors that have been out of favour, such as engineering and construction. When Downer EDI reported weak results it was sold down 4 per cent on the day of report and JB Hi-Fi provided a strong report but a soft trading update and was similarly punished.
Regardless of the sector and regardless of the historical growth, if a company misses the mark, the market is reacting with heavy selling.
Despite the reaction on the day of report, we have seen rational investment to offset this. Quality businesses such as REA Group and Carsales.com may have slightly missed earnings expectations this time around, but the ensuing sell-off was met with opportunistic buying the following day. This shows the market is aware that volatility in quality businesses can create opportunities, and isn't that what the reporting season is all about?
Earnings drive the market
The chart below shows the All Ordinaries index overlaid by earnings per share and this should reinforce the importance and predictability of the fact that growing earnings correlates with a stronger share price, and higher sharemarket.
Remember, while the reporting season may result in the production of complex interpretations and market reactions, investing is best kept simple. Pick the companies that best align with your objectives, either for the production of income and/or the growth of capital.
All Ordinaries index overlaid by price and earnings
Source: Lincoln Indicators, Stock Doctor
Reporting season is building to a crescendo
Of course, the reporting season is not just August, with a series of resources companies to report in September. At this stage, things are looking good for Australian corporate profits. The big end of town is producing strong returns, with blue-chips such as Rio Tinto and Commonwealth Bank of Australia producing record results.
However, investors that pay closer attention to the fundamentals will know this is the time to set up and actively manage your portfolios for the coming six months. With so much fresh primary information to come, there are reasons to be optimistic for the outlook in the Australian sharemarket.
Lincoln highlights five growth and five income stocks that impressed in the latest reporting season:
(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).
Lincoln Star Rating
|SGH||Slater & Gordon||Stock Doctor Star Stock|
|CSL||CSL||Stock Doctor Star Stock|
|CAJ||Capitol Health||Stock Doctor Star Stock|
|DMP||Domino's Pizza Enterprises||Stock Doctor Borderline Star Stock|
|GBT||GBST Holdings||Stock Doctor Star Stock|
Lincoln Star Rating
|SUN||Suncorp Group||Lincoln preferred income stock|
|TLS||Telstra Corporation||Lincoln preferred income stock|
|AAD||Ardent Leisure Group||Lincoln preferred income stock|
|CBA||Commonwealth Bank of Australia||Lincoln preferred income stock|
|BWP||BWP Trust||Lincoln preferred income stock|
About the author
Elio D'Amato is chief executive of Lincoln, a leading Australian share researcher and investor.
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