Australia Reporting Season Wrap – ‘Mind the gap’

Analytical review of results and revisions

For us, the reporting season is about unpacking the impact of heightened news flow from companies via their results and our engagements with boards and management on our long-term Valuations.

Every reporting season we use our analysis of the drivers of how company results came in compared to consensus broker expectations (surprise), the extent to which these brokers revised their forecasts for earnings in the next 12 months (revisions), and how stock prices reacted to that news to judge the overall pulse of the market more logically and better understand the real fundamental drivers of the price response.

Earnings results = a passing grade for the first time in some time

Across the S&P/ASX 200 stocks we cover, sales and earnings surprise, or how the actual results came in vs. the prereporting broker consensus forecasts, was line-ball positive this season, with a more positive surprise for dividends.

Sales surprise

EPS surprise

DPS surprise

In terms of revisions by brokers post the announcement of results, we saw a positive skew towards upgrades across each of the sales, earnings and dividend lines. While the earnings skew doesn't look that large on our metrics, as the last five reporting season periods had been skewed well towards the negative, this is a welcome change.

Sales revision

EPS revision

DPS revision

An important note to consider with this data is that we calculate our scorecard on an equal-weighted basis rather than market-cap weighted, to remove the impact that the large index weights, particularly the miners, have on the data. Given falling commodity prices, market-cap weighted results would have been a bit worse. have been a bit worse.

Deep dive on market reaction

Market conditions flipped in February

As an active fundamental manager, we have been looking for signs of a price and earnings re-connect for some time as this would provide more opportunity for us to use our differentiated fundamental insights to generate alpha.

We are able to compare and contrast the efficacy of various market factors and also our fundamental research lenses to better understand what is driving the returns of the market, and this has highlighted that drivers of returns over the reporting month of February were very different to the last 12 months.

• Over the last 12 months, Price Momentum had been the dominant factor, and as such it has been a difficult environment for valuation and income factors (for both our internal MCA lenses and also traditional factors).
  The market had also favoured stocks that are exposed to rising equity markets.
• In the month of February, we saw a full reversal of factors, with valuation and income now doing well, and Momentum doing poorly, and those names exposed to rising equity markets underperforming.

S&P/ASX 200: 12-month risk premium

S&P/ASX 200: 1-month risk premium

Price reaction = different by style and sentiment

When we look specifically at how share prices reacted to results and revisions during February, we also saw a marked change in the market behaviour, making us feel like the momentum-driven, large-cap days might be behind us.

Compared to recent seasons:

• Stocks with increasing level of shorts coming into the season had on average, a positive price reaction relative to the S&P/ASX 200 in the two days post result.
• Typical Value-style stocks saw in-line earnings results, and slightly negative earnings revisions, but a strong price reaction. In contrast, Growth stocks and those with strong momentum/direction coming into the results, delivered more on earnings and had upgrades, but their price reaction was quite poor.
• Bundling this into quintiles, the most expensive stocks on a P/E basis (Q1) did have modest earnings upgrades, but their P/E ratio fell (i.e., price fell more than earnings rose). The cheapest names (Q5) saw earnings downgrades, but they had a stronger P/E improvement (price rose more than earnings fell).

2-day price reaction: by shorted stock level

Average change: by style category

Average change: by P/E quintile

Volatile large caps

Another thing that we noted outside of expectations this period was the volatility of earnings and prices during the results month.

Earnings revisions and prices have tended to be quite volatile around crisis periods like Covid and economic uncertainty. Despite the choppy conditions, the variability in both metrics was relatively normal this season and was not particularly volatile.

However, when we drilled down into it a bit more, we found two things stood out. The volatility was there, it was just hiding in the two-day price reaction, rather than the returns over the full month.

Cross sectional variance of returns and revisions: S&P/ASX 200

2-day price reaction for +/-2% EPS revision

And within that, the largest moves, both up and down, over the two days post result were in the top 50 stocks, not across the whole S&P/ASX 200, with 40% of top 50 stocks having a price reaction of more than +/-6% vs. the index.

As a result, large stocks also generally did poorer than small companies on earnings and price reaction.

2-day price reaction: S&P/ASX Top 50

Special analysis on the growing impact on indexing

Index friction creating mispricing and potential active alpha

Looking at reasons for this, one that stands out as a potential culprit is the growing impact on the Australian market of index related flows, be it passive investing, or superannuation funds focused on Your Future Your Super (YFYS) and hugging the performance test index.

We have recently completed new analysis that measures the percentage of daily stock turnover that can be attributed to index buying. In aggregate, we have calculated that more than 25% of daily turnover for certain stocks is currently related to index/passive/ETFs, compared with less than 15% during the previous decade.

This reporting season, we saw this with National Australia Bank, Goodman Group, CSL and Westpac Banking Corporation who had very minimal earnings downward revisions, i.e., very little incremental information, but had a near -10% two-day price reaction.

While it didn’t have a large two-day price reaction to its results (they were slightly positive), Commonwealth Bank of Australia is another stock that fits in the high index buying bucket, and it did start to fall later in February. We wrote about the danger that unwinding euphoria around the stock could cause to index hugging portfolios in detail in a recent blog article.

For an active manager like us, understanding this kind of inefficiency/friction can create alpha opportunities.

On the theme of index flows above, we are also seeing this change the capital management behaviour of companies, with Light & Wonder looking at redomiciling the majority of its index weight from the US to Australia so they can benefit from increased index flows.

Key fundamental themes from engagement

Less externalities, more internal confidence…

Back to the fundamentals and looking at the broad themes that have come out of management guidance and our meetings and engagements with company management teams, we are seeing a slightly different ‘tone’ to the last few seasons.

Previously, companies seemed to be focussed on how externalities were negatively driving their results. Management now seem more confident to talk about business growth and investing more in their business. Management guidance from companies suggested that the consumer is still finding it tough – they are still bargain hunting and trading down from ‘premium’ to ‘everyday value’ – but companies are now just getting on with it.

What was interesting was what didn’t make the top of the list this season but had been important in the past - labour and energy costs, shortages in supply chains, FX (given the weak AUD), tariffs. We have certainly seen that the labour market pressures have normalised with government big build programs coming to an end and no longer crowding out labour resources.

Cost pressures are now a tailwind. With tariffs, most companies talked about either flexing production on where they produce or making the consumer pay. One other large reaction we saw in Australia to the Trump campaign was the step away from Net Zero and science-based targets. We covered this in more detail in a recent blog article based on a survey we undertook of ASX-listed companies late last year.

In terms of China, there is an overcapacity in steel and China needs to rebalance that market with capacity closures. There is a general concern that this could have a negative impact on demand, pushing out the high-cost producers. Market sentiment towards China will be very positive if the proposed stimulus is significant. In terms of the lithium and rare earth space, demand and production for EVs is still growing strongly, but it is not clear if any positive sentiment is going to translate into material demand improvement for Australia.

…but macro regime may signal a bigger change

Stepping back however, it is impossible to ignore the changes in the macro environment that have seemed to gather influence in the first 50 days since President Trump’s second inauguration and which coincided with the months’ worth of Australian companies’ earnings reports.

1. Evidence of inflation and bond yields staying “higher for longer” has become more widespread;
2. Concern surrounding the impact of higher tariffs on the US consumer has reduced optimism on the outlook for US and global growth; and
3. The reversal of two decades worth of negative equity / bond return correlations.

All of these point to a change in the macro environment that could foreshadow a change which could benefit Value style investing.

Market outlook

Closing the gap between price and earnings: Narrowing valuation spreads

On a valuation basis, the gap (dispersion) between the P/E ratios of the cheapest socks and most expensive stocks in the market has been in extreme territory for some time. Our proprietary ‘MCA Valuation Spread’ measure -- which uses the bottom-up analysis of our team and shows how cheap the stocks that we use to build our MCA Value Equity portfolios (such as the Martin Currie Select Opportunities Fund) are compared to the rest of the market -- is also highlighting that we are facing similar extreme conditions last seen in the Tech bubble, Global Financial crisis and Covid crisis. These spread peaks have all preceded large Value-style return rebounds.

P/E dispersion

MCA Valuation Spread

Value stocks produce significant alpha after elevated spread events

It is very hard for fundamental-focussed Value managers to have strong performance while valuation spreads are widening, as this means that expensive stocks are rising, and cheap stocks are getting cheaper. But they cannot remain at such elevated levels indefinitely.

To us, the factors driving market returns and the sentiment change during February’s reporting season is a sign that prices are reconnecting with earnings and fundamentals and that wide valuation spreads will soon begin to narrow. In fact, in February our MCA Value Equity portfolios (including the Martin Currie Select Opportunities Fund) have already returned significant alpha vs. the S&P/ASX 200 Acc. index.

Of course, one month of good performance does not make a full rebound, and there is still a very large disparity remaining between the price for cheap stocks and expensive stocks in the market. History has shown us that as valuation spreads narrow, they can mark the beginning of extraordinary outperformance for Value investors for the next 12-18 months.

Value stocks should offer a safety net

Growth managers may suggest that enduring high valuation spreads between cheap and expensive names is justified. They refer to the ‘growth scarcity’ in the Australian market, and that in a decelerating profit growth environment, the cheapest part of the market would have weaker earnings growth and the organic structural ‘growers’ will maintain their earnings growth. They would say that investors should pay a premium for that.

However, there is no clear path for the future earnings direction of Australian companies at this point. An acceleration in interest rate cuts would help the consumer, and China stimulus would assist miners. But the US tariff wars are creating a lot of uncertainty which we think would be ‘stagflationary’.

No matter the direction, we believe that the opportunity for Value is twofold. An economic acceleration can be good for Value as this growth scarcity gap would reduce. On the other hand, an economic deterioration can be good as the Value opportunity is concentrated in low-beta and higher-quality names.

What we mean by this is that the lower-risk, low-beta stocks can essentially provide investors both upside potential and downside mitigation. And that can produce great outcomes in times of market volatility. This makes the characteristics of the current extreme valuation spread more akin to the conditions of the Tech bubble than the more-risky crisis conditions of the GFC and Covid.

Strategic positioning for the conditions

High conviction Value

The changing valuation conditions over the recent period have allowed us to be far more active in our Value Equity portfolios (including the Martin Currie Select Opportunities Fund), and we expect this heightened trading activity to continue as higher valued and risky names come back to earth.

We are particularly excited about the quality and diversification of undervalued Australian stocks available today. In these portfolios, we are currently overweight (vs. S&P/ASX 200) what we believe to be the most attractively valued, high-quality defensive businesses including Medibank Private, ANZ Group Holdings, QBE Insurance Group, Aurizon Holdings, and AGL Energy, while maintaining underweight positions in fully valued/expensive names such as Commonwealth Bank of Australia and CSL.

• Medibank Private is a great example of a defensive, attractively valued stock that we have held for some time hold across multiple strategies. This season it reported stronger earnings growth and delivered good results for the period and upgraded its earnings outlook to around 15% p.a.
• We also recently added Woolworths Group to the portfolio, a company with a strong market position in a stable industry. While its stock price has been subdued after it lost ground to Coles, we see it as a defensive Value opportunity. The new management is looking to refocus on its core strategy, which should see it regain its old lustre.

Multiple ways to capitalise on the opportunity

Given the size of the Value opportunity, we believe that all investors who believe in fundamental, valuation-led stock picking can benefit, even those facing strict performance and risk benchmarks or those that have specific Sustainability requirements.

Our high conviction Value Equity portfolios share several key value opportunity overweights, such as Medibank Private, with our more customised strategies:

• Our Active Insights strategy (available via the Martin Currie Active Insights Fund) is a risk-managed strategy combining fundamental analysis with quantitative techniques to capture value opportunities while minimising sector and style risks; and
• Our Sustainable Equity strategy (available via the Martin Currie Sustainable Equity Fund) aims to create long-term value for investors through an actively managed selection of companies which have been assessed using our proprietary approach for understanding sustainability and financial attributes.

A high-quality defensive stock like Medibank Private is also a key holding for our income-focussed strategies due to its attractive franked dividend yield:

• Our Equity Income strategy (available via the Martin Currie Equity Income Fund) aims to meet the income needs of investors such as retirees by providing a consistent and growing income stream through an actively managed selection of high-quality companies, favouring those that are highly franked dividend payers.
• Our Sustainable Income strategy (available via the Martin Currie Sustainable Income Fund) combines this unique approach that aligns with the income needs of retirees with our proprietary approach for understanding sustainability and financial attributes and client ethical values.