Top insights from earnings season

In this odd market, investors are pricing stocks for perfection – and really punishing those that disappoint.

At face value the latest earnings season has been no different to its predecessors. Overall it modestly disappointed relative to market expectations, as reporting seasons tend to do. It does need to be seen in context, however, and the context isn’t normal.

It’s an odd market, driven by the historically peculiar negligible-to-negative official interest rate environment prevailing in the major jurisdictions, which has driven financial asset prices to unusually inflated levels and which has placed a premium on income over risk.

It is also a nervous environment, where disappointment – as occurred when the market responded, not to CSL’s guidance, which it met, but to its not out-performing it – creates an exaggerated response. CSL has lost more than $3 billion of market capitalisation since it met its own guidance for 2015-16.

As Credit Suisse’s Australian equity strategist, Hasan Tevfik astutely points out, the failure of company profits to meet analyst expectations isn’t a new phenomenon. It happens every reporting season.

Towards the end of the results period, he says, the ASX 200’s EPS outcomes disappointed by only about 1.2 per cent, a similar outcome to last year. That may be because the first half produced the worst outcome, relative to expectations, since the financial crisis, where the profits of the top 200 undershot expectations by 3.5 per cent.

There are elements of both fundamentals and market psychology inherent in the way the market responds to earnings reports.

The first half disappointed mainly because the big commodity producers produced worse than expected results. That lowered expectations for the second half, where the companies – BHP, Rio, Fortescue et al – produced results and forward-looking statements that were better than the market, having significantly downgraded their prospects, anticipated.

Tevfik’s assessment was similar to that of Goldman Sachs, whose bottom line towards the end of the season was that there was no more bad news than normal, but fewer positive surprises. Less than 20 per cent of the companies reporting beat consensus expectations, it said, compared to the long-run average of 36 per cent.

The core of the market – the big banks, Telstra, the big miners and healthcare stocks – didn’t have a great year and the banks in particular have a tough outlook. For the big resource companies the outlook, and their share prices, obviously depends on whether the bounce in commodity prices, particularly iron ore, can be sustained. For BHP, oil prices could be a major influence.

The iron ore price probably explains the positive impact that the resource company results had on the market. No-one really saw the big second-half surge in the price coming after a disastrous final quarter of 2015.

There have been some stellar results, which have been rewarded by the market. JB Hi-Fi, Orora, Ansell, Treasury Wine Estates and Amcor were among them, as were those with an exposure to the housing cycle. The big insurers – QBE, IAG, AMP and Medibank – were disappointing and their share prices reflected that.

For some companies, like Woolworths, the resolution of known challenges – in Woolworths’ case, a resolution of the festering and bleeding sore that was its Masters home improvement business – was regarded of greater significance than the well-signalled poverty of its underlying performance (although the market did seize on the glimmer of hope it saw in the fourth-quarter arresting of its longer term sales decline).

There were a lot of impairments and significant items within this reporting season, Woolworths and Wesfarmers being major culprits. They had, of course, foreshadowed their likely impairments, in some detail, separately and earlier and ensured they were incorporated into market expectations.

The exaggerated sharemarket responses to better-than-expected and worse-than-expected outcomes tell us something about the context in which the companies were reporting.

If investors are paying 18 times those 2016 earnings, which is the biggest multiple since the financial crisis, they really punish those that disappoint – they are pricing stocks for perfection relative to expectation.

The prospective price-earnings ratio for the top 200 companies is about 16.5 times but, historically – as we’ve seen this time around – analysts start the financial year overly-optimistic and subsequently are forced to trim 10 to 15 per cent of their forecasts. The forward PE ratio might actually be somewhat higher than that 16.5 times, which is disconcerting.

The hunt for income in an ultra-low rate environment, and the ever-spiralling cost of acquiring it, explains why forecasts of dividends-per-share have tended to be more accurate than the forecasts for the ASX200’s earnings per share, which is now a longer-term trend. Companies are reluctant to cut dividends because they understand they under-pin their share prices and shareholder expectations.

Curiously, even though analysts appear very bullish about the prospects for the bigger companies in the market for 2016-17, witness the prospective PE ratio, payouts are forecast to reduce from the 75 per cent or so level experienced this season (a dramatic increase on the levels that prevailed only five or six years ago, when the average ratio was closer to 50 per cent).

That does, of course, pre-suppose that the consensus forecasts of double-digit EPS growth this financial year are met. If, as usual, the results don’t meet the initial expectations and the consensus forecasts start being lowered, the payout ratios would automatically rise.

One suspects that they will remain at their recent elevated levels and that companies will struggle to generate double-digit EPS growth in what is a low-growth, volatile and risk-laden global economic environment. The first half of 2016-17 may well be as disappointing, relative to expectations, as the same period last year.