Weekly equities note
Written and accurate as at: Mar 14, 2017 Current Stats & Facts
The S&P/ASX 300 gained 0.75% last week, hauled upwards by the banks which gained between 1.2% (Commonwealth Bank (CBA)) and 3.5% (Westpac (WBC)). This largely offset weakness across both the REITs (-2.2%) and also across resources, which followed up February’s decline with another -4.7% loss as key commodity prices softened.
It was a reasonably quiet week in terms of stock-specific newsflow and the market continued to digest the implications of the most recent reporting season. It was a season which displayed less in terms of strong coherent ‘themes’ than has been the case in recent periods, beyond the resurgence of resources as discussed last week. That said, there were three interesting points to note from February:
Theme 1: The Top 20 continues to outperform small caps
Large caps – and, specifically, the Top 20 provided the bulk of earnings upgrades via the ‘Big Four’ banks and the major commodity companies. The junior miners drove upgrades in the ASX 101-200, however it was interesting to note that midcaps lagged behind the rest of the market.
Notwithstanding the banks and miners, the degree of offshore exposure could also be contributing to this divergence between the Top 20 and other parts of the market in terms of earnings momentum. While Australia’s GDP expanded in Q4, it is important to understand that this was largely as a result of the commodity price surge. Demand in other parts of the economy remains sluggish and mining-driven centers continue to feel the hangover effects of the end in the mining capex boom. The US economy is looking stronger, in contrast, and there are a significant proportion of stocks within the Top 20 with US exposure. Top 20 companies which source a larger proportion of their revenue outside of Australia than in it include BHP Billiton (BHP) and Rio Tinto (RIO), CSL (CSL), Amcor (AMC), Woodside Petroleum (WPL), QBE Insurance (QBE), and Westfield (WFD).
This earnings momentum is one of several factors which have seen a recent reversal of an almost five-year trend in the ASX Top 20 underperforming the ASX Midcap 50. We believe that midcaps continue to offer good opportunities for investment and growth. We also reject the often accompanying argument that the Top 20 are somehow structurally moribund and it is impossible to make money in them. The developments of this reporting season serve as a reminder that investors must keep an open mind and not be bound by constricting dogma when assessing their opportunity set.
Theme 2: Companies surprising on capital returns
Dividend capitulation was a key theme of FY 2016 as companies cut payout ratios and abandoned progressive dividends in response to challenged revenues. The first half of FY17 has seen a stark reversal of this trend, with dividends per share growth coming in 2% ahead of expectations.
Again, this is not the result of a broad-based improvement. It was resources-led, with dividend growth 16% larger than expected, and driven by earnings as payout ratios remaining unchanged. Banks were the only other sector with positive dividend surprises. Nevertheless, there was also a slew of companies across the market returning capital in the form of stock buy-backs. QBE used one of its cleanest results in years to announce a 3-year buy back of $1bn, while RIO ($500m buyback), Crown Resorts (CWN) ($500m), AMP (AMP) ($500m), Coca Cola Amatil (CCL) ($350m) and BlueScope Steel (BSL) ($150m) all got in on the act.
There is a cross section of Australian companies which have repaired their balance sheets following a challenging period, either through a sharp cash flow injection, the previous impairment of assets or the sale of others, or a combination of these. That several of these are now returning capital to the shareholder suggests they lack growth opportunities, but on the positive side also implies that there is a degree of confidence in their outlook.
Theme 3: The ‘disrupted’ fight back
In several instances, the surprise of a company’s earnings upgrade was compounded by it having faced challenges, disruption or even ‘near-death experiences’ in the recent past. If we go back to 2014 Qantas (QAN), for example, was arguing for a government bailout in order to keep afloat. BlueScope actually received an assistance package from the NSW government in 2015 in order to keep its Port Kembla furnaces operational. At the same time, many in the industry were forecasting that iron ore miner Fortescue Metals (FMG) would collapse under the weight of plummeting iron ore prices, high costs and a huge debt pile.
Beyond this, Woolworths’ (WOW) recent fall from grace as it maintained excessive profit margin in the face of intensifying competition is well known while JB Hi-Fi (JBH) has also been under pressure in the face of online competition. The banks, too, provide good examples, with the combination of recent revenue pressure and regulatory requirement for increased capital leading to extremely depressed sentiment surrounding the sector.
This shows that some management teams are demonstrating the strategy and ability to react to adverse circumstances and start to reposition their business models. Where a company is able to reduce costs, it shows that the resulting leverage to a cyclical upturn can see a turnaround take place faster than many would expect. It is often the combination of a good management team in a company or industry that has been written off by the market provides some of the best opportunities for alpha.
At the same time, there are still companies which are having to spend more just to stay still in terms of their market position, or who are struggling to rein in costs. As discussed above – the market is increasingly wary of companies displaying these trends. The lesson is that stock selection in this environment is a paramount.
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