Lincoln: 9 star stocks from latest profit-reporting season
Companies that are outperforming in challenging economic conditions.
Reporting season is never short on providing keen market watchers with talking points. Be it either a company producing record results or, on the flip side, those that disappoint.
It is the most important time of the year for a fundamental investor (who studies company information). Companies listed on ASX are required to disclose their financial accounts twice a year. The timing of this release coincides with a company’s financial year-end, and it has two months from then to disclose the numbers.
It is important because we can look inside a company to assess the quality of the accounts and key business drivers, determine whether expectations were met, and learn about long-term prospects. All directly from the horse’s mouth.
Leading into this latest earnings season, the market was quite buoyant. July provided a positive momentum and acted as a tailwind to the latest reports. The momentum was helped by a quiet “confession season” (the month before reporting starts), meaning minimal bad news.
Health of the market
At the start of the reporting season, the health of the market was consistent with recent trends where about 30 per cent of companies were exposed to acceptable levels of risk as identified by Lincoln Indicators’ Financial Health methodology.
Source: Lincoln Indicators
A study of Financial Health measures a company’s ability to absorb shock at an operational or financing level should the unexpected occur. Companies with a Strong rating are likely to display characteristics of earnings stability, often grounded by a solid balance sheet and strong operating cash flows.
While the reporting season is still underway at the time of writing, a pleasing 64 per cent of companies that have reported are currently identified as financially healthy. However, the beginning of the reporting season is often front-ended by quality companies reporting first, with the fundamentally inferior businesses coming later.
Therefore, despite the strong start, we expect a return to more normal levels as the later results come in.
Impressions of the profit season
It has been a strong period. Companies have come in ahead of dovish forecasts and many that were priced at a premium rewarded shareholders with a premium result.
The main theme for this reporting season has been the need to pay a premium price for a quality business.
Many investors may consider value to be the sole determinant for stock selection. Lincoln Indicators focuses on investing in fundamentally healthy businesses, which often means steering clear of the bargain-basement bin.
As the graph above shows, the market is lapping up the season, currently trading at a quite high price-earnings (PE) ratio and above the average over the past decade. This is not worrying as we have been telling clients that, in the current environment, it is prudent to pay a premium to hold great businesses.
As always, there were companies that failed to make the grade and missed expectations. No matter the disappointment, now is not the time to procrastinate. Short-term neglect can result in long-term loss if left unchecked. If the fundamentals of a company change, investors need to make a disciplined and unemotional decision to exit, in the best interests of their objective and portfolio.
Outlook for the year ahead
We believe the reporting season will be a catalyst for continued strong performance in equities for investors capable of identifying great businesses.
From a broader market perspective, earnings growth issues around the large-caps – that is, the banks, Telstra, BHP Billiton and Rio Tinto – will probably mean that if you intend to use the market index as a benchmark for performance, it will probably be a relatively flat period ahead.
From a bottom-up perspective, the outlook for earnings is quite good when you exclude the stocks mentioned above. If we reduce the impact of large-cap stocks in a weighted measure, the median average reported earnings-per-share growth for June 2016 was 7.6 per cent.
This is a reasonable result that contrasts with Lincoln’s Star Growth and Borderline Star Growth stocks. These are the fundamentally healthiest growth stocks on ASX, where we actively seek companies with higher levels of earnings sitting at 12.3 per cent and 16.7 per cent respectively.
On the other hand, dividends were a mixed bag. Among the large-cap income plays, such as Commonwealth Bank and Telstra, dividends are steady. Other large businesses, such as BHP, Rio and (surprisingly) Wesfarmers, cut their dividends in the face of a challenging environment. We expect this stable-to-negative trend to continue among the top 20.
Income investors need not despair, as many smaller companies, Australian Real Estate Investment Trusts (AREITs) and utilities businesses lifted their dividend.
And, with larger businesses, current yields are still very attractive relative to historical bond rates and therefore still represent opportunities for income-seeking investors. This is indicated in the graph below.
Nine stocks that delivered
As always, there were businesses that stepped up to the plate and delivered for investors. Below are nine that not only delivered good results and met the lofty expectations of investors, but are also well positioned to deliver in the year ahead.
1. Bellamy’s Australia: As a Star Growth stock, BAL has demonstrated its ability to capitalise on the growing demand for organic milk formula, especially from Asian markets. We expect the industry's growth dynamic, where the international demand for high-quality, safe and trusted infant food and formula is high, to continue.
2. Bapcor: A Star Growth stock that has grown earnings aggressively over the past couple of years via a number of large acquisitions, most notably Metcash’s auto arm (ANA). Bapcor operates in a relatively defensive industry as demand for automotive after-market parts is generally not materially impacted by macro-economic cycles.
3. Credit Corp: A Borderline Star Growth and Star Income stock that suits both growth and income investors looking for capital appreciation and above-market distributions. The company continues to deliver consistent earnings growth as the market leader in the Purchased Debt Ledger sector. We expect the strong performance to continue in the 2017 financial year.
4. Cochlear: A Star Growth stock that we believe will generate robust earnings growth with its long-term growth prospects. This is supported by further penetration of the largely growing implantable hearing market and investments in product innovation. Cochlear has had a strong earnings recovery following the successful launch of new products.
5. Eclipx Group: A Star Income stock that has an attractive yield with positive growth prospects. Eclipse is a technology-driven financial services organisation, providing fleet leasing and management services. The company is well placed to continue to provide consistent earnings growth and an attractive yield for shareholders in the future.
6. JB Hi-Fi: As both a Star Growth and Star Income stock, JB Hi-Fi suits investors seeking growth and/or income. Aside from continued store rollouts and conversion of old stores to the new HOME format, another potential growth driver is the possible acquisition of The Good Guys.
7. Sealink Travel Group: It has become a dominant player in the marine transportation industry. We believe that, with strong organic growth and recent acquisitions, the company will continue to take advantage of a weaker Australian dollar and increased domestic tourism.
8. Vocus Communications: A Borderline Star Growth stock in the telecommunications networks and services space that offers potential for growth investors seeking capital appreciation. The company has recently undergone a transformation by merging with M2 Group and has a strong earnings outlook.
9. Webjet: Has a good track record and we believe that strong organic growth and well-timed recent acquisitions will prove fruitful for investors. Also, the company's investment in the business-to-business space is set to bear fruit in the coming periods, giving further access to a new high-growth area.
Star Growth and Borderline Star Growth stocks – for growth-seeking investors
|Name||Status||Health||ROA||ROE||Revenue growth||EPS growth|
Star Income stocks – for income-seeking investors
|Name||Status||Health||Annual DPS||Annual EPS||Div yield||Gross Div yield|
|Credit Corp||SIS/BSGS||Strong||50.0 cps||97.0 cps||3.1%||4.36%|
|SIS||Strong||13.25 cps||18.52 cps||3.6%||5.2%|
|SIS/SGS||Strong||100 cps||152.1 cps||3.3%||4.7%|
Legend: SGS = Star Growth Stock. SIS = Star Income Stock. BSGS = Borderline Star Growth Stock. CPS = Cents per share. DPS = Dividend per share. ROA = Return on assets. ROE = Return on equity; EPS = Earnings per share. Div = Dividend.
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