Stand out performers in a record reporting season

This was a remarkably strong reporting season. Remarkable in that operating conditions for most companies were still very challenging given the stop-start economic activity we saw over the period 1 July 2020 to 31 December 2020. Yet it was one of the strongest in the last decade, with beats significantly exceeding misses by approximately 3x and EPS growth for FY21 now sitting at close to 15%. Better than expected margins, rather than higher revenue, drove the beats. We also saw good cost control across the board – which talks to the uncertainty management faced over the past 6 months. The return of Outlook statements and re-instatement of dividends points to greater confidence in the period ahead.

There were three stand-out categories: 

• Commodities, 
• Banks and 
• 'COVID Winners' 

The latter two which delivered ahead on earnings, dividends and sales. However, we acknowledge that the COVID winners face tougher comps in coming months as they begin to cycle the very strong COVID numbers. The other interesting trend was greater upgrades in Large caps. Driving this was the concentration of Banks and Commodities in large cap, but it also suggests the earnings trends in large companies are stronger, which contrasts with recent years where small caps had stronger earnings. Our sector round up is below.

Financials 

Banks were the highlight of reporting season, reporting significant beats. Main driver was lower impairments (WBC and ANZ wrote back part of their General Provision, NAB held constant and CBA topped up by a small amount), but underlying results were generally better than expected too with a couple of the banks (ANZ and WBC) reporting an increase in margins. This led to material upgrades to bank earnings growth: FY21 earnings growth is now expected to be up close to 25% (from <1% in January), materially outpacing the broader market. Banks outperformed on the back of rising bond yields as it is one of the few sectors that benefit from this, given the ability to re-price their loan book, lifting margins. Another positive was the improved Asset quality. COVID deferrals now only represent <3% of the portfolio across the majors in both housing and SME, although we continue to closely monitor for renewed signs of stress as stimulus policies roll off. 

From a portfolio positioning perspective, we have been reducing our underweight to the Banks over the past 6 months, with increased exposure mainly to CBA, NAB and Macquarie Bank.

Exchanges while holdings like the ASX reported resilient results where increased trading volumes offset lower activity in interest rate derivatives, sentiment was weighed down by the likely ongoing cost reinvestment required to deliver major IT projects such as the CHESS replacement, which extends into 2023. Furthermore, given ASX’s strong infrastructure-like cash flows, valuation have also been impacted by rising forward yield curves. Across the ditch, NZX enjoyed similar themes of stronger than expected trading activity and their growth vectors in ETFs and wealth platform also performed well, albeit requiring further cost investment before these will contribute more meaningfully to earnings.

Turning to the insurance sector, the greatest impact has been COVID business interruption claims after unfavourable test cases imply that insurance policies do indeed provide some pandemic coverage. This has forced large provisions across the sector. While the rear view mirror does not provide much confidence, strong rate cycle momentum has been maintained and we expect the current hardening cycle to be elongated to account for the barrage of recent catastrophes, COVID-19 losses and a structurally lower interest rate environment. Given this backdrop, we have increased our conviction in our IAG holding and see this as a high quality cyclical opportunity to capture outsized risk adjusted returns. Our investment in insurance broker, AUB, delivered a strong set of results, capitalising on both the hardening rate cycle as well as driving margin improvement through IT and cost out initiatives. Outlook for the insurance brokers remains buoyant and AUB remains our preferred exposure.

Wealth platforms demonstrated a return to strong rates of organic FUA growth after some slowdown in client activity amidst the COVID-19 disruptions, and this was also aided by a strong equity market recovery. While the outlook for continued secular growth remains, recent results saw some concern emerging on further margin compression through the repricing of the back book by Netwealth. While we continue to see a strong likelihood of further margin compression, we see the pace of decline moderating and are encouraged by the stable competitive environment and the accelerating inflow momentum.

Property

Dispersion in performance across property sub-sectors continued this reporting season, with investors focusing on different key metrics depending on the impact that COVID has had on the respective businesses. Benefitting from government stimulus and a supportive interest rate environment, residential players such as Cedar Woods was able to deliver as the focus was on the solid uplift in their pre-sales pipeline. Other performers were those within the Industrial and fund managers space such as Goodman Group and Charter Hall, whereby structural demand for improved supply chains continue unabated whilst investors continue to deploy capital benefiting FUM growth. 

Performance in the office sector were generally muted as investors grapple between what looks to be a strong macro recovery versus post pandemic demand trajectory given the WFH phenomenon, although companies like Mirvac managed to demonstrate resilience owing to long term leases whilst able to deliver a slight positive leasing spread. Finally some retail names did indeed outperform despite the longer term structural headwind as domestic restrictions continues to lift, arguably a transitory effect in our view as the market was overly negative around the amount of COVID rental provisions that was required. 

Overall sector performance in the near term will likely remain weak, as rising bond yields acts as a macro headwind.

Mining

For the miners, dividends were in focus with bumper returns to shareholders and commentary that these levels would be sustained in the future driven by continued strength in commodity prices with capex set for the medium term. BHP, RIO and FMG all delivered payout ratios over 70% with BHP and FMG recording their largest dividends. Looking forward, earnings are supported by recovery in global growth and supply side constraints despite some headwinds from currency and cost inflation. 

Valuations are full for base and bulk miners but there is support from macro tailwinds and leverage to global reflation. 

Gold stocks delivered record free cash flows on higher realised prices but stocks have under-performed with gold price weakness attributed to improving real yields. Whilst gold is likely to have peaked this cycle and is a headwind to earnings, there are stocks in the sector that will be able to generate attractive cash flow through the cycle and have production growth optionality.

Industrials

Industrial stocks had a mixed February reporting season with those exposed to domestic cyclical activity seeing a strong bounce in earnings over the past 6 months as the health crisis receded, which is a contrast to companies that are more reliant on offshore markets or a restart of travel, still reporting weak results. For example both Sydney Airport and Auckland International Airport reported sharp declines in earnings due to low volumes of international travel and a disruptive stop-start approach to domestic travel restrictions. The silver lining for the airports were the commencement of COVID-19 vaccinations and strong operating cost control, which should see permanent cost savings even when travel restrictions ease. 

Outside of travel, we have seen the mining services sector report a strong uptick in activity levels over the past 6 months, with Perth based mining service contractor Monadelphous reporting a strong recovery in workforce numbers to pre-COVID levels, as major Iron Ore replacement projects ramp up in the Pilbara. However, this sharp lift in activity levels combined with ongoing movement restrictions in WA has reduced the typical pool of workers available to fill this rising labour demand, driving wage inflation and margin pressure for mining service companies. Finally, offshore earners such as patent firm IPH was impacted by the strengthening Australian dollar, despite managing to grow like-for-like earnings and having successfully navigated through the risks of COVID-19 disruptions to patent filling volumes.

Healthcare

Generally speaking, the Healthcare sector has been classified as “COVID Winners”. However, within our Holdings, we have seen a broad range of outcomes. The key beneficiary of COVID (Fisher and Paykel) did not report in February, however they did upgrade guidance (the 7th upgrade in 18 months) on the back of stronger demand for their respiratory devices demanded by the second wave washing through the US and Europe. Cochlear and Nanosonics saw a solid recovery quarter-on-quarter with new candidate pipeline rebuilding quickly across all age groups, rather than deferrals for Cochlear leading tnuixo upgraded guidance. CSL, although beating market expectations in the 1H (main driver the Seqirus vaccine business) provided a sobering outlook for the 2H as the impact of the lower plasma collection flows through to their core Behring business. 

The other main factor causing a headwind for all our Healthcare holdings was the higher AUD, given they are mostly offshore earners.

Information Technology

High valuations and a rise in bond yields is a headwind to sector performance that we expect can persist in the short term but ultimately given the secular tailwinds over a multi-year period, the sector’s growth appeal will be restored and we expect can out-perform. COVID has been a headwind for the sector broadly with commentary from management teams that decision making had slowed down through this period and weighed on revenue growth across a number of stocks including Altium. 

This is now expected to lead to pent up demand for the sectors services as customers return their focus to improving efficiencies and opening up their capex wallet and will underpin earnings as operating conditions normalise. 

Both Audinate and Megaport management teams talked to industry conditions improving. Altium’s result showed resilience for geographies that were less impacted by COVID and is a positive sign for operating environment when conditions normalise more broadly.

Consumer

COVID-19 pandemic restrictions and fiscal stimulus measures meant that most Retailers enjoyed very strong sales growth. Earnings grew even faster due to robust operating leverage. Online sales growth accelerated and there has been a considerable increase in the proportion of consumers who are purchasing online – a trend that we expect to persist, even as vaccines are rolled out. Looking forward, there are mounting concerns that sales growth is now decelerating and may turn negative as Retailers start to cycle last year’s strong pandemic sales periods. 

Woolworths and Coles expect their supermarkets sales to decline over March to June as they cycle last year’s COVID surge. 

Meanwhile, online furniture and homewares retailer, Temple & Webster, gave a sales update for the first 7 weeks of 2021 which continued to show growth above 100%, supported by the ongoing adoption of online shopping. Consumer companies also reported supply chain disruption such as Wesfarmers and ARB. While most inventory shortages have been resolved, there are still cases where this is persisting, such as auto components. There was evidence of cost pressures in freight, input components and wages. Some companies also complained that it was difficult to hire labour domestically (particularly ARB and Bapcor) but this is expected to be resolved as stimulus measures are wound back. IDP Education’s English language testing and University/College student placement businesses had been heavily impacted by COVID-19 restrictions, but are rebounding faster than expected with English testing levels now back at pre-pandemic levels.

Energy

Earnings and cash flows for the sector were severely impacted by lower oil and gas prices, however this has now turned into a strong tailwind given where commodity prices are trading so we expect a sharp recovery in earnings. With a more constructive outlook, companies have returned their focus to their growth projects which are now back on the agenda and expected to deliver an attractive growth profile for certain stocks in the sector. 

The outlook is also more favourable given the macro backdrop and reflation trade which are supportive drivers of the energy sector. 

Woodside, Santos and Beach Energy all have robust growth projects to execute on which is not reflected in the current stock prices on an un-risked basis.

Telecommunications

Telstra and Spark reported a solid set of results. While both were impacted by lower international mobile roaming revenues, the outlook was slightly improved and both telcos were able to keep their dividends steady. For Telstra, earnings have reached an inflection point as the worst of the NBN disruption has been absorbed and Mobile segment earnings are starting to improve. Two key positive catalysts for the industry are 5G and the opportunity to monetise infrastructure assets, such as mobile towers, through selling down strategic stakes.

Utilities

Not all names under coverage reported however those that did generally delivered to expectations, noting the sector in general has been sold off as viewed generally as proxy to bond prices amidst rising bond yields. Gas pipeline player APA Group delivered a solid result and a slight increase in dividend guidance, with management expressing greater confidence in future growth as they broaden their mandate to invest in a variety of energy related infrastructure including pipelines, firming and storage assets as well as renewables. Over in NZ, electricity gentailer Mercury Energy also outperformed as higher wholesale electricity prices was an offset to low hydro volume, though a delay in their wind farm growth project mired their result. From an outlook perspective, regulatory stance remains either benign, as companies that are beginning to embrace the global push towards net zero emissions are less likely to be impacted longer term from future regulatory imposts. 

Summing it up

Overall, we remain positive on the earnings cycle, with the recent pull back in equity prices and valuations, driven more by bond yield rises than reporting season, was needed given the very strong rally we had year-to-date.

From here, we expect returns to be driven by earnings growth. However, we need to start seeing businesses invest for the future (through capex) and focus less on short term cash burn/profitability. Australia cannot rely on a consumption-led economic recovery for the long term. In fact, a sustained economic recovery in Australia will only be achieved through business investment, job creation and productivity improvement which we hope to see come through over future reporting seasons.

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