Earnings growth: The answer to elevated valuations?

Articles 4/03/2021
Earnings growth: The answer to elevated valuations?

2020 was truly a year for the ages in many respects!  In terms of markets, following the short sharp fall early in the year, equity markets made a stunning comeback, quickly recovering their pre-COVID levels and in some countries moving even higher.  With valuations reaching increasingly elevated levels, this February's reporting season was going to be a true test for markets.  Would companies deliver the earnings growth needed to sustain such valuations or would they be punished for failing to deliver?


As it eventuated, we've just experienced arguably the best reporting season in years with a number of companies exceeding the market's expectations.  Over the reporting period Macquarie Equities' estimate for the broader ASX market's earnings per share growth for the 2021 financial year doubled to nearly 15%.  However, we are wary that these results continue to be impacted by distortions that remain in the economy.  JobKeeper remained a notable contributor in the back half of 2020 while support also came from the Reserve Bank's record low cash rate and quantitative easing (bond buying) program.  Further, households' spending habits remain heavily weighted to domestic 

goods while much of the services economy (think air travel and eating out) 

remained under heavy restrictions.


Below are the key themes we took away from the last month:


  1. True global defensives and healthcare continued to deliver.


Global food and beverage packager Amcor and consumer goods pallet provider Brambles, again demonstrated their ability to deliver in all conditions.  State-based activity restrictions continue to drive consumption online, further illustrating the quality of Qube's core infrastructure and logistics assets.  Meanwhile, Sonic Healthcare's labs, at the coal face of the pandemic, were working overtime to deliver timely COVID test results.  Interestingly, their labs' serology testing will play an equally important role during the rollout of vaccines, testing and reporting that immunity in the population is being delivered.


Notably, each of these companies were amongst the few that had the confidence in their business models to provide forward-looking earnings guidance.


  1. Recovery plays are showing signs of life.


While international travel remains a 2022 story, traffic data from both Sydney Airport and toll road owner Transurban confirmed that when given clear air, domestic travel can recover quickly.  With the majority of state borders open and experiencing limited social restrictions, November provided us a glimpse of domestic life after the rollout of vaccines with Transurban (below) reporting solid growth in their east coast roads' traffic volumes.



In the financial sector, the major banks confirmed mortgagees are rolling off their loan deferrals quicker than expected as the economy progressively re-opens.  This saw the market bring forward the banks' expected earnings recovery.


  1. Depending on the asset class, returns from the property sector diverged heavily.


Shopping centres bore the brunt of the pandemic as retailers were forced to shut.  Landlord rent collections were consequently impacted however similar to airports and toll roads, foot traffic returned strongly once restrictions were eased.  While promising, the sector continues to digest the impact of rent relief to tenants.


Office and industrial property owners Dexus and GPT experienced better-than-expected outcomes.  Within office, debate remains between the counteracting forces of the increased acceptance of working from home against employers' increased space needs in the office environment (driven by a focus on social distancing and increased area for collaboration).  Meanwhile, industrial assets were clear beneficiaries from the pandemic as the shifting retail landscape to online drove incredible demand for warehouse space from retailers and logistics operators.


  1. Bulk resource companies are swimming in cash while the shift to 'new energy' is well and truly here.


With the major miners' balance sheets in strong health heading into the pandemic and commodity prices (particularly iron ore) hitting multi-year highs over the second half of 2020, strong shareholder returns were expected.  BHP didn't disappoint, declaring a handsome dividend with the prospect of more if current commodity prices sustain. 


Global engineering consultant Worley proved it will play a central role in the new energy economy as their traditional oil & gas and mining clients transition their assets to meet the environmental and regulatory requirements of operating in a low carbon world.  These projects, growing at an accelerating rate, are now almost 20% of their workbook.


  1. Housing-exposed stocks haven't skipped a beat.


Whether you're operating in Australia or the US, if you're exposed to the construction of new housing, you've enjoyed 2020.  Spurred by record low interest rates and incredibly lucrative government stimulus, demand for new housing continues to soar. 


Australia's largest residential developer Stockland reported its strongest net sales in 4 years, with more expected in the coming year despite the roll-off of government stimulus.  Meanwhile, demand for James Hardie's exterior cladding continues to soar as it reported double-digit growth in volumes, market share gains and a special dividend to shareholders.


  1. Discretionary retailers remain major beneficiaries while international travel remains restricted.


While travel abroad remains off the cards, it seems Australians are taking the opportunity to load-up the family car and discover more of their own country.  Sales numbers for 4WD accessory manufacturer ARB and aftermarket auto parts retailer Bapcor were exceptional.  Judging by Bunnings' (Wesfarmers) result, it also seems more of us are finally tending to that 'to-do' list around home.  However, we believe these results are bringing forward future years' demand and we're very cautious of extrapolating recent trends over the medium-term.  Consequently, we've been comfortable trimming into share price strength.


While we remain wary of the elevated valuations evident in today's markets, a notable correction would require at least one of the following major threats to eventuate:

  1. Failure of the COVID vaccination programs to achieve herd immunity, perhaps as a result of the virus' mutation;
  2. Rising real interest rates, notwithstanding short-sharp spikes similar to the experience in late February; and/or
  3. Further deterioration in US-China relations. 


Without such events, we feel equities are likely to remain supported.  There remains significant stimulus in both the financial system and real economies.  Infection trends in the US and Europe continue to improve, partly on the back of vaccination programs, and as such these countries continue to progressively release themselves from social restrictions.  Finally, as evidenced through the February reporting period, corporate earnings growth momentum remains solid. 


Balancing the above, our growth allocations remain modestly below their neutral targets.  We continue to retain sufficient cash and liquidity, ready to deploy when individual opportunities present.


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