Survive (and thrive) this reporting season

During the February 2019 reporting season, numerous stocks saw drastic moves following their earnings announcements. For example, Altium, Appen, Domain, BWX and Webjet all gained 20-30% intraday on their respective results. In contrast, Capitol Health, Emeco, Blackmores and Pioneer Credit all plunged 20-30% on theirs. Going into this season, the potential for substantial moves seems higher, given the divergence in valuations and earnings growth. 

So in this latest thematic, we look at some ways to prepare for the minefield that lays in wait in the weeks ahead. Tune in as Matthew Kidman hosts Emma Fisher from Airlie Funds Management and Catherine Allfrey from WaveStone Capital, to hear how you can not only survive, but perhaps thrive, this reporting season. 

Transcript

Matthew Kidman:
Hi, my name's Matthew Kidman, and yes, we're about to hit the earnings season again. Twice a year, we have to face up as fund managers, and see companies report and the stock movements are normally enormous, and they've gotten bigger over the years. 10 or 15% in one day is not unusual, and it can be quite nerve-wracking. 

Joining me to talk about it today is Emma Fisher from Airlie Funds Management and Catherine Allfrey from WaveStone. 

Catherine, I'll start with you. It's probably got worse over the years, stocks come in slight negative compared to what everyone expects, down 10%; slight positive, and up 10%. And we've got a pretty low bar I think this time because the general economy hasn't been great, expectations are low. How are you reading it?

Catherine Allfrey:
Well, I think you've got to look at the last June half and look at the backdrop of what we've been through. Domestically, we've been through the election, which actually caused a lot of weakness in the economy. But subsequent to the election, we've had two rate cuts. So what we're looking at the moment is, what are the outlook comments from the companies? What are the CEOs going to tell us about whether or not we're seeing any improvement domestically. And then likewise, offshore, what we've seen is deteriorating economic data, particularly coming out of Europe and China, and more recently, out of the U.S. So we're really looking for some sort of bottoming in that U.S. economy. Unfortunately, we've got no conclusion yet to the trade war between China and the U.S.

Matthew Kidman:
So are you saying that the earnings that do come out and the numbers they print don't matter as much as the forward comments?

Catherine Allfrey:

No. I'm saying, actually, the numbers they print, yes, we'd like to see them coming in line with consensus. But I think the comments going forward, and in some cases, people will look through the last half, because it really was an election impact, and so, therefore, people will really focus on, what is the outlook for FY'20?

Matthew Kidman:
Okay. And under that scenario, that environment, what are some of the opportunities out there going into the reporting season?

Emma Fisher:
Yes, so I think what's interesting, every now and then I like to play this mind game of, what are the most unloved sectors? And if you go back a few years, it was retailers, everyone was very worried about Amazon, and then the banks, and I think most recently it's been anything housing-related. And I think what's interesting at the moment with the market where it is in terms of valuations is there really are no sort of wholesale unloved sectors, and so it can be frustrating in that sense. So I think really it's just stock specific, the opportunities are stock specific. So we think there are some businesses that look that there's attractive absolute valuation and pretty attractive relative valuation. So we'll be looking at some of the large caps. I mean, names that come to mind are Caltex, Suncorp, businesses like that, that have low expectations going into reporting season, and some self-help we think they can be getting on with.

Matthew Kidman:
Okay, so what about some companies, they've got high expectations, try and avoid them? Is that going to be too hard?

Emma Fisher:
Well, I think the thing about high expectations embedded in high valuations is that, that really elevates your risk. So if anything does go wrong or if anything disappoints on the outlook or the quality of the earnings then the downside for a business that's re-rated can be quite substantial. So I think risk's elevated when you're going into reporting seasons with very high expectations and very high multiples versus history. So, some of the names that spring to mind are obviously the tech sector, some of the health care names, I think that the valuations there versus history look quite elevated.

Matthew Kidman:
Okay, Catherine, I'll ask you the same question. Opportunities going in, do you think there are, or is it just try and work your way through it and pick the winners going forward?

Catherine Allfrey:
Number one, avoid the minefields. We don't want to be in anything with earnings risk, because as we've seen that the market will absolutely smack it, but like Emma said, we're very stock-specific, so I agree with what she's saying in terms of historically valuations are very high at the moment for most sectors with probably energy being the only area where there is, historically, some discount there. But we've already had some really good results from Resmed, for example, and the stock bounced very hard on the day. So there are opportunities for some growth stocks that will deliver.

Matthew Kidman:
Okay. So there's a classic example. Couple of things can happen as we talked about before. Stock misses, it gets smashed by the market, it's not down a couple of percent, it's down 15, 20%. Stock beats, Resmed, it goes up and tends to go up for while. So opportunities to buy off the back of better results, and also, on the other side, do you sell if something has beed slightly disappointing?

Catherine Allfrey:
Look, we always go back to our original thesis and actually look at what are the earning drivers of that company, and try and understand what management is telling us. We then also try and verify the story. So we're trying to speak to competitors and speak to suppliers in the market to try and understand what the management, in terms of the downgrade, has told us about their company and try and verify that information. A lot of the time, we try and act rationally and calmly, because at the end of the day, it's only a small position usually in our portfolio, it's not the whole portfolio that's impacted. And so if we see a stock that we fundamentally believe over five years that company will continue to deliver, we're more than likely to step into the market and buy.

Matthew Kidman:
So knee-jerk is not the best response?

Catherine Allfrey:
No, definitely not.

Matthew Kidman:
Okay. Emma, inevitably it's going to happen, you're going to have some stocks that do really well and some stocks that do very poorly. If we concentrate on the ones that do very poorly, how do we manage that emotionally? Very difficult and no matter how time we put the share price out of your mind and look at the company, you can't help but look at it during the day, or the following days after a result.

Emma Fisher:
I think you hit on the key word there, it's emotion. So, if you've got this mentality going into reporting season that there's a lot of noise around reporting season, there's a lot of volatility, and that it will be, twice a year, probably your most psychologically challenging part of the year as an investor, then if you can keep that at the forefront of you mind and just remember that, when you're investing in a business you're buying the long term cash flows of that business, and reporting season gives you every six months, really a snapshot look into how the business is tracking versus your assumptions. So, it's not the be all and everything, and you really have to spend time, and I think a lot of the work actually takes place post reporting season.

Emma Fisher:
As Catherine said, you've got to go out and you've got to test your assumptions, and if you've been a piece of incremental information that maybe implies that you might have been wrong on something that you're assuming, then really making sure that you're doing the work to really embed whether or not something has changed, whether or not your thesis is structurally broken. But I think the general rule is, selling on the day of these huge moves with the market, I think it's unlikely that you're going to add value for your clients by acting that way, when you're sort of caught up in that volatile, psychologically difficult stampede.

Matthew Kidman:
Okay, quick one. Can the Aussie market, which has had a very good run of late, can it move higher on the back of these earnings results?

Emma Fisher:
Maybe, yeah. Maybe. We think about valuation, it doesn't really tell you anything about whether or not your thesis in investing in a company is going to be correct, but valuation tells you sort of the probabilities of the outcomes. So our starting point is when valuations across the market are very high the probability of those outcomes going forward, it's skewed negatively. So maybe the Australian Share Market can move higher, I'm not sure, but the history would suggest that future returns from here when you've just had a plus 20% year for the whole market, future returns should be compromised by that.

Matthew Kidman:
Okay. Catherine, same question. You talked about lower interest rates. We're probably getting even lower here. That's what it feels like. Can the market move higher with a pretty benign, soft, domestic economy and not terrific earnings growth, can it go higher from here?

Catherine Allfrey:
I think so because of the fact you're talking about the interest rate cuts and the market at the moment loves these cash rates supporting the future economic growth, as well as the fact we've got tax cuts coming through this September from the federal government. So we're starting to get fiscal policy stimulus as well, so the combination of monetary and fiscal policy stimulus into the economy will drive the economy higher. So, therefore, you would expect that earnings will follow that economic stimulus.

Matthew Kidman:
We're all very nervous and biting our fingernails but we're cautiously optimistic.