A tale of two halves: February 2018 reporting season

The February reporting season was, on balance, better than many had anticipated. Australian companies delivered more earnings beats than misses. The primary winners were those able to deliver organic growth, as opposed to prior reporting seasons where companies exceeded expectations through cost-out programs.

Though the market finished broadly flat for the month, with the ASX200 up only 0.36%, the February reporting season was both an active manager’s dream and nightmare. 36% of ASX200 companies delivered upgrades while 34% suffered downgrades; this represented the largest positive difference since 2010. The strong corporate earnings season, increasing company capital expenditure expectations and higher organic growth, suggests the broader economy is witnessing the beginning of an acceleration in growth.

Below we highlight the best and worst performers over the reporting season.

* company announced acquisition

Source: Macquarie analysis, Bloomberg

Key market trends

Behind this top-line result were several noteworthy market trends which are summarised below, and expanded on later in the piece.

  1. Tale of two halves– the flat finish for the month disguised considerable volatility during February. Global macro events dominated markets early in the month, before the focus shifted to the domestic reporting season. The greater performance dispersion (the amount by which company share price performance diverges) typical of reporting season highlights the opportunity available to active managers.
  2. Going for growth– companies that recorded organic growth were rewarded by investors, while those that made acquisitions were subject to greater scrutiny.
  3. Not yielding results– rate-sensitive yield names continued to underperform, reflecting a broader market rotation out of yield; by contrast, offshore earners did particularly well.
  4. Optimising capital allocations– the market remains in a capital expenditure upgrade cycle across all sectors except Consumer Staples; expectations have increased by 0.4% for June 2018. In the area of capital management, a further $500 million of dividend upgrades and $1.7 billion of share buybacks were announced.

1.  Tale of two halves

Following a sell-off in global equity markets early in February, the domestic reporting season moved into focus for Australian investors. Reporting seasons are always an exciting time of year for active managers, as the sheer quantity of new information entering the market means dispersion in prices is at its highest. This creates more opportunities for an active manager to exceed the benchmark. Chart 2 shows dispersion in price performance spiked considerably above typical levels; active managers making the right calls amidst such dispersion can generate significant outperformance.

Chart 2: Levels of market price dispersion across the February reporting season for the ASX300

Source: Macquarie analysis

2.  Going for growth

Many names rewarded by investors this reporting season were those that recorded organic growth. Outperformers were largely concentrated in several high-growth sectors, including education (IDP Education), cloud storage (NEXTDC), Chinese consumer (A2 Milk) and tourism (Flight Centre, Qantas). This contrasts to previous reporting periods where firms largely delivered earnings beats through cost-cutting. Investors viewed inorganic growth (ie growth through acquisition) sceptically, with Super Retail being particularly punished during February.

Our investment approach looks to identify cheap, good quality companies, with strong momentum. Examples of these movements and our analysis are explored below:

  • Insurance Australia Group (IAG, +13.3%)– the largest general insurer in Australia, IAG has delivered several earnings upgrades over the past year. This momentum in earnings (ie serial correlation – when one upgrade occurs, more are expected to follow) has been combined with improving company quality as IAG reduced its insurance risk through reinsurance by Berkshire Hathaway.
  • IDP Education (IEL, +19.9%) – our position in this global student education company is another example of a position driven by quality and sentiment. IEL has a very high return on equity, driven by strong profit margins and a low asset base. The company has gone through a strong period of growth, with earnings upgrades generating strong momentum.
  • Super Retail Group (SUL, -22.4%) – our position in this diversified discretionary retailer is based on Valuation. When the company announced its Macpac acquisition, it was viewed sceptically by investors, given SUL’s poor record acquisitions. However, we believe the market has over-reacted and that SUL remains relatively cheap within its sector.

3.  Not yield results

The market also continued its rotation out of rate-sensitive yield names as investors contemplated the impact of rising interest rates globally. Despite in-line results from Telstra, Transurban and Sydney Airport, such yield-based stocks broadly underperformed this reporting season. This contrasts with the success of offshore earners, particularly those with exposure to the US. Companies in the healthcare and construction industries were the highlights; CSL, Boral, Reliance Worldwide and James Hardie each observed growth in revenues largely driven by organic US earnings growth.

4.  Optimising capital allocations

Capital management was very much on the agenda this reporting season, with $500 million of dividend upgrades and over $1.7 billion in announced share buybacks, most notably by Lend Lease (up to $500 million), Dexus (up to 5% of issued securities), and Qantas (up to $378 million).

The market also remains in a capital expenditure upgrade cycle, impacting all sectors apart from consumer staples, which has seen a slight fall in investment expectations. Overall, expectations increased by 0.4% for June 2018. This increasing spend on business investment supports our view the domestic economy has turned a corner, and domestic growth will continue to improve over coming years.

Conclusion

There are, in our view, many reasons for optimism coming out of this reporting season. Earnings beats outnumbered misses, company capital expenditure expectations are increasing, and organic growth was a feature broadly. However, as small cap variation and the rotation away from yield demonstrate, the characteristics of quality stocks evolve over time, and it remains vital for outperformance to correctly analyse trends within the market; we continue to believe we at Macquarie Investment Management can achieve this outperformance.

 

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