What do Australian company results reveal about prospects for the Australian sharemarket?
The February reporting season was relatively strong, indicating our corporate sector is in reasonable shape. A total of 142 ASX 200 companies reported their half-year results to 31 December 2016, and 94 per cent made an aggregated increase in profits of 37 per cent1, with 125 companies electing to pay dividends. Of the 28 companies reporting full-year earnings, 25 delivered profits and 26 paid dividends, while across all reporting companies the combined cash level increased by 11 per cent to over $110 billion2.
This broad-based earnings increase for ASX 200 companies is a change from recent years
Given the absence of any significant increase in earnings for the past few years, sharemarket returns have instead been driven by an expansion in valuation multiples.
With earnings growth returning, the price/earnings valuation (the ratio for valuing a company that measures its current share price relative to its per-share earnings) of the broader ASX 200 has in fact reduced, meaning the market has become (on average) less expensive. But it does remain materially above the long-term average and, as such, we believe the case for greater exposure to Australian shares within portfolios appears premature – particularly given that we see more attractive valuations in other markets and asset classes.
While increasing earnings are considered positive, historically, a primary driver of future returns is entry valuations and, at current levels, they appear higher than otherwise warranted.
Several factors driving the stronger reporting season may not be sustainable long term
One of the most significant influencers driving stronger profits was rising commodity prices. In particular, BHP Billiton capitalised on the strong price of iron ore to bounce back from its US$5.7 billion loss during the last reporting period. Posting a US$3.45 billion profit with a declared interim dividend increase of 150 per cent, it’s important to consider that while its results have generated headlines, BHP Billiton came off a relatively low base (factoring in a painful period of lowering costs, decreasing debt and improving productivity) and the price of iron ore has been unusually high.
There are many contradictory views regarding the outlook of commodity prices
In particular, a lot of analysts are increasingly concerned that iron ore is set for a correction in the second half of this year due to new supply, high inventories and insufficient demand. We predict the influx of iron ore supply during 2017 will suppress prices and, ultimately, the share prices of companies directly linked to iron ore. As such, we recommend that investors consider reviewing their exposure to the sector.
Further, companies tied to the price movements of iron ore, coal and oil may continue to experience volatile earnings in the coming reporting periods should underlying commodity prices continue to fluctuate. This should be factored in when considering valuation levels based off the most recent earnings releases.
It’s prudent to maintain a healthy level of caution when reviewing your portfolio
Of course, commodity prices are not the only influence on the market – global geopolitical and economic events will continue to have an impact on the Australian sharemarket this year, whether positive or negative. Of note, Europe faces a challenging period with several upcoming elections in which anti-establishment parties are promising to leave the common currency, thereby increasing global uncertainty.
And although global markets have rallied since the election of President Trump, speculation he’ll provide fiscal stimulus through tax cuts and infrastructure spending are still yet to be formalised, and Trump’s heralded address to Congress was light on detail. Further, the US Federal Reserve appears set to continue to raise rates over time, which has typically led to a reduction in valuations in the US equity market.
We believe Australian companies should invest for the future but this does not seem to be the case
Balance sheets for ASX 200 companies in Australia largely appear to be relatively healthy, dividends are strong and companies are holding a lot of cash, but their capital expenditure numbers and future plans remain relatively weak, which may impinge on future earnings.
A large number of companies in the Australian market are leveraged to the health of Australian households (e.g. banks are dependent on borrowers continuing to make their mortgage repayments and our large retailers are reliant on consumption growth). However, with Australia holding the third highest level of household debt-to-GDP in the world, modest wage growth and recent GDP growth driven significantly by property debt, the question of sustainability remains.
As such, our opinion remains that it may be timely to review any overweight exposures to Australian shares.
This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.