Last August’s reporting season gave little signs of earnings growth to support valuations. Six months on and we’ve seen domestic earnings expectations upgraded for the first time in almost four years. Unfortunately, this was almost entirely driven by Resources where continued elevated commodity prices drove a marginal upgrade (1.6%) in expectations for the ASX 200.
While upgrades were largely concentrated in Resources and to a lesser degree the major Banks, reporting season was still generally solid for the remainder of the market (see chart below). However, company-specific factors rather than an improved Australian economic outlook drove the shift.
While earnings growth expectations for the 2017 financial year were upgraded, it’s worth noting ex-Resources growth expectations remained more modest (for about 6% growth). Against this, the valuation of Industrials (ex-Utilities, Banks and Listed Property) has softened over the last nine months, however, generally they are not at levels that look cheap (currently about 19x earnings). Consequently, we remain of the view there’s little margin for error against such modest earnings expectations. As we continue to take a relatively defensive stance in portfolio construction, our Australian Equity weightings remain below target. We do however, look to be opportunistic as we see share price volatility.
Following a period of rising dividend payout ratios, dividends grew at rates closer to that of earnings. However, these dividends were increasingly supplemented by additional forms of shareholder return. A product of both improved cashflows and a lack of attractive investment opportunities saw management at the likes of AGL Energy, CSL, Navitas and QBE look to return excess capital via share buybacks. Conducted prudently, buybacks have the potential to materially enhance returns for long-term investors.
Bank results and trading updates positively surprised. While loan growth remains lacklustre, margin pressures have eased thanks to last year’s mortgage repricing efforts and modestly improved funding costs. Loan write-offs remain well below average levels and credit quality indicators appear sound. However, expectations are for a modest rise in impairments driven in part by pockets of mortgage stress (for example, in mining regions) and a looming oversupply in new residential apartments. Furthermore, we remain watchful for regulatory developments this year as both Australian and global bodies look to agree on a set of (increased) capital requirements.
The recent driver of the broader market has clearly been Resources. Despite fundamentals to the contrary, commodity prices continued to hold elevated levels. With few new projects to invest in, mining companies saw a surge in cashflows. Consistent with our thoughts, BHP believes the current prices for iron ore and coal are unsustainably high, so it was pleasing to see management direct this cash windfall towards the repayment of debt.
Healthcare names continued to provide a set of reliable and strongly growing results. CSL was the standout following a pre-reporting season upgrade, driven by competitor product supply constraints as well as impressive new product launches. Private hospital operator Ramsay saw their share price fall on result day despite a strong set of numbers, owing to the long-standing CEO’s unexpected decision to retire. We believe the market’s reaction to be unwarranted given the quality of Ramsay’s management team and assets and as the CEO indicated, there is incredible demand growth ahead on account of the aging global population.
The aged care industry continued to garner significant media attention as it began to implement previously-announced changes to Government funding, the impacts of which will be progressively spread over the next few years. Longer-term, we continue to believe the private sector will be increasingly relied upon for the provision of services to an ever-aging population. In this context, Government policy will need to be framed to provide sufficient incentives to private operators. Estia’s result was indeed better than the market had feared. New management were impressive, not only presenting a solid medium-term strategy but also exhibiting early signs of improvement in the underlying business.
Our greatest disappointment from reporting season was unfortunately Brambles. Despite undergoing a well-planned transition of CEOs, an unexpected profit warning in January appeared less the result of new management ‘clearing the decks’ and more a confluence of negative industry and customer-specific events in the American pallets business. Pleasingly, management provided greater clarity during their result presentation in February and while the drivers behind the disappointment appear to be short-term in nature, we continue to actively monitor the company’s progress.
Despite the market’s fears, Woolworth’s turnaround strategy-driven price reductions did not see a price war eventuate between the major supermarket retailers. Both Coles (Wesfarmers) and Woolworths continue to operate rationally in a cosy duopoly. While there are some early signs of success in Woolworths’ turnaround, a return to earnings growth remains elusive. In a period where their key competitor materially reduced shelf prices, Coles produced a commendable result.
While NBN-related cashflows continue to support its dividend, Telstra’s result reflected some underlying headwinds within its core businesses. In Mobiles, while continuing to grow customers, recent network outages along with a step-up in competition saw weaker divisional earnings. As expected, the roll-out of NBN is also driving higher competition and lower margins in the Fixed Broadband business (note: Telstra is being compensated via existing agreements with NBN Co). In a post-NBN world, we expect Fixed competition to focus on content – an area Telstra holds a significant advantage, holding both AFL and NRL telecommunication broadcasting rights. We continue to monitor the implications around a potential spin-off of Telstra’s NBN-related cashflows into a separately-listed entity.
Listed property trusts (or REITs) continue to benefit from the low global interest rate environment. However as experienced in November, sell-offs in global bond markets can have an impact on REIT prices. Fundamentally in office, Sydney is gaining most of the focus with below-average vacancy and rising rents while asset values remain supported by continued low interest rates and the ongoing weight of capital from overseas investors. While we expect these dynamics to remain for the next few years, we believe we are nearing a peak in the commercial property cycle and are extremely cognisant of the current valuations in some office REITs.
While pleased to see further positive economic data out of the US, China and Europe, we remain wary of the potential for political factors to interrupt markets, at least over the short-term. While recent domestic growth data appears to have rebounded strongly, the details continue to paint a picture of sub-trend growth. With the Resource investment boom truly in the rear view mirror, a housing market on the East Coast that’s rallied hard, it is hard to find the next avenue of growth for the economy.
While the market maintains its modest upward trajectory with minimal volatility, we feel global political developments during a time of policy normalisation by the US Federal Reserve has the potential to create uncertainty. In such an environment, we must remain vigilant in the construction of portfolios.