10 star stocks after reporting season

Photo of Elio D’Amato By Elio D’Amato

min read

As the February 2016 reporting season draws to a close we examine some of the trends and themes that have emerged and how investors should be positioning their portfolios.

Lincoln Indicators believes financial health should be central to managing portfolios and, given recent sharemarket volatility, this has never been more evident. Investors should focus on fundamentals, only invest in quality companies and ensure those stocks are aligned to their investment objectives.

We have identified 10 financially healthy growth and income stocks (below) that are well-placed in the current environment and might be worth investigating for inclusion in portfolios.

(Editor’s note: Do not read the following ideas as stock or sector recommendations. Do further research of your own or talk to a licensed financial adviser before acting on the themes in this story).

Reporting season shows a divergence between companies and sectors
In terms of reporting season trends, there has been generally moderate earnings per share (EPS) growth. However, there has been a divergence in the performance of individual companies and sectors. That was before many of the larger mining and energy companies reported. This sector is where we continue to see the most pressure on earnings and an expected decline for the period.

This was shown by a weak result from iron ore giant Rio Tinto; underlying earnings fell by more than 50 per cent and the company abandoned its progressive dividend policy.

Earnings growth for financial services stocks have faced more headwinds, but dividends remain strong. There is no better example than Commonwealth Bank of Australia, currently rated by Lincoln as a Star Income Stock*. The outlook, however, is clouded for many fund managers, given ongoing market volatility, although quality businesses such as Star Growth Stock* Magellan Financial Group continue to experience strong net flows.

Dividends lag earnings
From an income perspective, we have seen dividends per share (DPS) growth lag earnings, which probably reflects more caution from boards. Similar to Rio Tinto, diversified miner BHP Billiton is expected to move away from its progressive dividend policy (Editor’s note: At the time of publishing BHP had announced a change to its dividend policy).

There have been slightly lower dividend payout ratios from general insurers, such as Suncorp Group.

Apart from a few sectors, dividends have remained largely intact and continued to grow on the previous year.

As far as themes go, we have largely seen a continuation from 2015. The weaker Australian dollar has contributed to growth for companies with overseas earnings exposure. For companies in coverage this was evident with Cochlear’s result. We have also seen a number of companies, such as Domino’s Pizza Enterprises, benefit from further expansion into overseas markets.

For other companies, given the slow top-line growth there has been a continued focus on managing costs and looking to improve efficiency.

Sectors with increased momentum
Sectors where there has been better earnings momentum include healthcare, telecommunications, information technology and consumer discretionary. Star Growth Stocks such as REA Group and CSL continue to deliver solid earnings growth as they expand through acquisitions and new product launches, while maintaining strong market positions.

As always, investors need to use discretion and focus on the fundamentals. For example, electronics retailer JB Hi-fi delivered a solid result, benefiting from low interest rates and a buoyant property market. In contrast, the demise of financially unhealthy competitor Dick Smith highlights the need to pay attention to fundamentals rather than look at sector exposure.

In this instance, poor operating cash flow meant Lincoln had downgraded Dick Smith’s Financial Health rating (explained in further detail below) to Marginal before the announcement that it was going into voluntary administration.

Find the gems in a pile of rubble
Lincoln takes a bottom-up approach to investing as we go digging for opportunities. Put simply, we let the fundamentals dictate which companies and sectors to invest in. However, that doesn’t mean seeking the cheapest opportunities at all cost.

For example, given the substantial decline in commodity prices, we currently have no Star Stock ratings from the mining or energy sectors. Although some of these companies look “cheap”, there is every chance they may get cheaper. Overall, the clouded earnings outlook and risks to dividends means that in our view these sectors are best avoided for the time being. This also applies to any related services businesses in this area.

Yet while growth has been more challenging for the financial services and real estate investment trusts (A-REITs), looking closer we still see good opportunities for income investors.

The banking sector continues to face a number of earnings headwinds and regulatory uncertainty. However, at this stage the reality is that it doesn’t look likely that dividends will be cut substantially and attractive gross dividend yields are expected.

Where are the opportunities?
There continues to be sectors where the majority of businesses face earnings challenges, but there are opportunities for the savvy to invest in quality companies.

Businesses with dynamic growth prospects have been prized by investors, who have aggressively bought them to satisfy an insatiable thirst for earnings growth. But it has highlighted the need for investors to apply discretion within any environment macro headwinds that may prevail.

The flip side is that it creates an opportunity for the unloved businesses, such as the banks, which have been sold off on concerns of falling dividends, rising capital requirements and bad debt provisions. Yet we have so far failed to see these materialise in any significant form, creating an opportunity for these stellar dividend payers to be snapped up by savvy income-seeking investors as the gap between interest rates and equity yields sit at record levels.

Focus on Financial Health
Based on the academic research of Dr Merv Lincoln, our Financial Health rating involves analysing the true fundamental quality of companies through looking at key balance sheet, profitability and cash flow ratios. We believe this should form the foundation of all successful investment decisions; without Financial Health, you are speculating and seriously risking loss.

To highlight the importance of this, at the start of this year only around 26 per cent of 2000 ASX-listed companies were rated as being in a Strong or Satisfactory position of Financial Health. Once you have used Financial Health as an initial filter, you should look at the company fundamentals and whether a company meets your portfolio objectives, be that from a growth or income perspective.

Review your stock holdings and remain disciplined
Investors need to remain disciplined in their investment approach. Reporting season is a great opportunity to review the stocks in your portfolio with a wealth of information provided through the financial statements, presentations and management commentary. We encourage removal of stocks that are not financially healthy or fundamentally sound, while looking to add high-quality companies that will meet growth and/or income objectives.

  • Star Stocks are identified by Lincoln as fundamentally superior businesses that exhibit the Financial Health qualities investors should consider core to their selection process. Yielding strong returns over the long term, they represent possible opportunities for both growth-focused and income-focused investors.

10 financially healthy stocks Lincoln believes will shine in 2016

Code Company Lincoln Rating * Financial Health
BAP Burson Group Borderline Star Growth Stock Strong
CAR Carsales.com Borderline Star Growth Stock Strong
CBA Commonwealth Bank of Australia Star Income Stock Strong
COH Cochlear Star Growth Stock Strong
JBH JB Hi-fi Star Income Stock Strong
NTC Netcomm Wireless Borderline Star Growth Stock Strong
REA REA Group Star Growth Stock Strong
SRX Sirtex Star Growth Stock Strong
SKC SkyCity Entertainment Star Growth Stock Strong
TLS Telstra Corporation Star Income Stock Strong

Source: Lincoln

About the author

Elio D’Amato is chief executive of Lincoln, a leading Australian share researcher and investor @LIStockDoctor

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