Reporting season in Australia was slightly underwhelming this year as a smaller than average proportion of companies beat expectations. This month, we look at the themes that came out of the 2017 Financial Year’s reporting season, and how companies could be priming themselves for future growth.
Reporting season in Australia is over with the overall average result in-line with the consensus, leaving the S&P/ASX 200 index little changed over the past month. The S&P/ASX 200 continues to trade within a tight range as investors continue to search for direction amidst the high valuations relative to history.
While the S&P/ASX 200 remains stuck, the US S&P 500 has pushed to new highs despite Cyclone Harvey and Hurricane Irma, and a further rise in geopolitical tensions with North Korea over the past month. European and Asian equity indices also posted modest gains over the past month as investors continue to exhibit a ‘buy on the dips’ mentality.
Defensive assets also rose during the month, as bond yields continued their downward slide despite risk assets creeping upward, highlighting the disconnect between bond and equity investors, with bond investors are questioning the US Federal Reserve’s timeline of rate hikes as inflation remains weak, while equity investors are focussed on the synchronised economic growth environment.
The US Dollar fell over the month as weather concerns took hold. The Australian Dollar rose above 80 US cents but remains largely unchanged versus the Euro.
Australian employment data continues to show positive signs, with the economy adding 29,200 jobs in July and a whopping 54,200 jobs in August. This continues a positive employment trend over the past six months, however, like the rest of the world, wage growth is still weak, with a meagre 0.5% increase over the last quarter and unemployment still high at 5.6%. Private new capital expenditure also came in higher than expected for the second quarter of 2017, indicating that businesses are finally opening their wallets to invest for future growth. This follows months of strong business confidence indicators and is consistent with the rhetoric from companies throughout the recent reporting season.
While businesses are upbeat, months of poor consumer confidence data continues to be a drag on economy. With wage growth remaining weak, the consumer has kept their wallets closed, with retail sales figures showing no growth and Australian GDP coming in weak at 1.8% for the 2017 financial year.
In the US, consumer sentiment continues to be strong and this has flowed through as retail sales rose higher than forecast in July. Manufacturing and services surveys also indicate continued economic growth in the US economy. However, employment data was disappointing as the US unemployment rate ticked up by 0.1% to 4.4% due to downward revisions of prior months and a weaker than expected figure for August. Wages also disappointed, rising by only 0.1% for the month. The weak wage growth remains a conundrum for the Federal Reserve and the inflation outlook.
Elsewhere, Europe’s economy continues to perform strongly, with inflation figures reaching 1.3% in July and GDP coming in at 0.6% for the second quarter of 2017 or 2.3% for the full year. Manufacturing and services indicators were also strong, indicating that Europe can continue to maintain its current momentum. Chinese data also continues to be positive, with inflation, manufacturing and services indicators all coming in above expectations.
In politics, the US debt ceiling can was kicked a short way down the road from the end of September to December 2017, thanks to Cyclone Harvey. This provides a short-term relief to one of the market’s major worries, but will be set to start up again later in the year.
2017 reporting season
With the end of the 2017 Financial Year reporting season, investors can now focus on the year ahead. The S&P/ASX 200 reported an average earnings growth of 17% over the financial year following the commodity rebound thanks to China’s 2016 stimulus plan. While this may seem high, this was primarily due to the low earnings base for resource companies in 2016. The market recognised this and responded by moving sideways over the month.
Excluding resources, the S&P/ASX 200 reported an average earnings growth of 6%. Guidance for the 2018 Financial Year was more of the same, with the aggregate guidance indicating another year of 6% earnings growth.
Overall, reporting season held little surprises, which is actually a negative for investors. Historically, reporting season earnings tend to slightly surprise to the upside, with the number of companies beating expectations generally higher than the number of companies missing expectations. During this reporting season, the ratio of companies that beat and companies that missed expectations was about even.
There were also several key themes that played out during reporting season:
Little tolerance for disappointments
Investors showed little tolerance for any disappointments, with the likes of Domino’s, Telstra and Healthscope being punished severely. For Domino’s, it was a dial back of growth expectations moving forward. For Healthscope, it was continued margin pressure leading to a weak near-term earnings forecast, while Telstra was punished for biting the bullet and delivering the huge cut to the dividend that the market wholly expected but thought would be implemented on a staggered basis over several years.
Focus on debt management for resources
Resources continued its focus on deleveraging following the 2016 blowout as the rebound in commodity prices provided strong cash flows. The likes of BHP, Origin and Santos announced plans to continue to reduce debt and continued the rhetoric of learning from past mistakes to invest capital more wisely. Investors greeted these moves positively, with resources outperforming as a sector.
Capital expenditure and business investment intentions are rising across the board
Companies also flagged increased capital expenditure intentions for the 2018 Financial Year. This follows strong business confidence figures and is a pleasant reversal after years of focus on cost-cutting and efficiency. Forecast investment plans rose by 17.6%, the biggest increase in seven years. Positively, this was seen across multiple industries, from resource companies like Santos to industrials like Sydney Airports and giants like Telstra. Increased capital expenditure would be a positive for the Australian economy and comes at a time when the construction boom looks to be rolling over. This cuts into profits in the short term but should provide long-term benefit provided the investments are made wisely.
Investing in future growth
The rise in capital expenditure and business investment intentions should be taken as a positive. Whilst higher spending will eat into earnings over the next year, it is important in building the foundations for future returns and earnings. This has a missing ingredient for the Australian economy and the Australian stock market in recent years as companies focussed on cost-cutting initiatives.
Companies achieve future growth through investing in areas like systems, infrastructure and research and development. Without this sort of expenditure, it is difficult for companies to meet growing demand, access other earning opportunities, gain efficiencies in scale or even create a new market.
This expenditure does not just benefit the companies investing, it is a crucial component of economic growth. Provided companies do increase investment, this should flow through to Australia’s GDP figures and help lift the current below average GDP growth. This could flow through to employment and wages as companies hire more research and development personnel, or expanded production.
The key to these positive flow-on effects occurring is that business investment needs to add long-term value to all stakeholders involved. For shareholders, this means that business investment should only be considered if the return on equity (or return on the money spent) exceeds the shareholders’ required risk-adjusted return. In turn, this should result in higher pay for company management, assuming remuneration is appropriately aligned to shareholder interests. Given that return on equity is an estimate of the future and the required risk-adjusted return from shareholders is fickle, the decision of when and what to invest in is a difficult process for management.
History has shown a fair share of poor capital expenditure decisions, most recently seen in the large pools of money piled into oil and gas developments near the peak of the resource boom, culminating in massive destruction of shareholder capital in the form of Origin, Santos and BHP. On the other hand, there have also been many success stories, especially in the research and development side of capital expenditure, with CSL and SEK being some of the companies that have continually achieved positive outcomes through business investment.
At this current stage, it does not seem like an environment where exuberance will lead to poor capital decisions. Indeed, it seems like companies are flagging higher investment intentions on the back of a necessity to meet rising demand driven by synchronised global growth. If so, the sub-par 6% earnings growth guidance (assuming it is where we finish the year at) should be seen as near-term pain for a better future gain.
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