Why UBS thinks it's time to take profits

At the headline level, you would be forgiven for thinking that earnings season was pretty good. The consensus was expecting just a 0.5% increase in aggregate profits but instead, the figure went up by 2%. Beats still outnumbered misses and margins are holding up in spite of massive increases to both costs and the cost of capital. 

But look underneath the hood and you will find a hornet's nest of issues. Recent activity levels suggested the consumer is not in as bad a shape as feared, but we have yet to see all of the 400 basis points worth of RBA rate hikes feed through the system. 

Companies have been able to pass on costs to a consumer that can stomach those rising prices - but how long? And for companies that couldn't maintain margins, the news was met with an ugly reaction from the markets. 

Now, as investors put the August earnings season behind them, they look forward to what the rest of 2023 could bring and beyond. To discuss what they saw over the past four weeks - and most importantly, how they plan to play equities into the end of the year - I caught up with UBS' Australian equity strategist Richard Schellbach.

Key insights

• Earnings beats outnumbered misses by a ratio of 5:3
• But... sell-side analyst earnings expectations have been revised heavily with two downgrades for every upgrade
• Guidance downgrades also outnumbered upgrades by 3:2
• The share price reactions were the worst this season since February 2020, including more than a few +/- 10% moves

The high-level insight

After the research note was released to clients, we reached out to Schellbach for an interview. We're delighted he accepted! What follows is a summary of that interview. 

The health of corporate Australia is still a question

In the six months preceding this August reporting season, the economy was still in an unusual situation. Record low unemployment rates, a healthy amount of spending (evidenced by retail sales), and economic activity remained upbeat. But markets always look forward. 

In Schellbach's view, it's this forward view that hasn't changed and is still shrouded in uncertainty. This is the case even if it is likely that Australia won't enter a hard landing/severe recession scenario. 

"Things are holding together and that's a product of the strength of the economy we've seen over the last few years. But the direction we are headed in is where those tailwinds start to fade and it's a more challenging outlook," he added. 

Schellbach adds that his base case is a growth deceleration environment. 

"This August's reporting season has shown that the revenue and earnings trajectory for corporate Australia is now on a decelerating trajectory," he said.

One that rallied too hard (and one that was sold off too hard)

As is the case with every reporting season, there are wild swings in both directions. Companies can be sold off too heavily or see their share prices rise quickly, despite what would otherwise be classified as a disappointing result at the headline level. Schellbach nominated one such case for each scenario, beginning with the stock that was sold off too hard following a good result - Wisetech Global (ASX: WTC).

The Wisetech result, at surface level, was incredibly strong. Recurring revenues, free cash flow, and earnings were all up double digits. Its guidance also pointed to more double-digit gains down the road, but the EBITDA projection disappointed analysts who had been looking for something much stronger. A slew of acquisitions will also continue to hit the company's bottom line until at least fiscal 2026 now.

Nonetheless, Schellbach is undeterred.

"We think that's disproportionate. We understand the reason why some investors were unhappy with the investments and plans that the company has. But we are believers in the business," he added.

UBS currently has a BUY rating on the stock.

For a stock that rallied too hard in spite of what was a disappointing result, Schellbach pointed to Domino's Pizza (ASX: DMP). Domino's full-year earnings dropped more than 23%, with management admitting that "margins and earnings were affected by the decision to increase menu prices to protect the sustainability of franchisees faced with extraordinary inflation". The full-year dividend was also cut by nearly 30% year-on-year to $1.10/share, unfranked.

"We ultimately believe that the guidance the business has provided is unlikely to be met and we remain sellers of that stock," he said.

The cutting and slicing of dividends

Dividend cuts and eliminations are not new, as are companies that reinstate their dividends after periods of absence. While the Australian reliance on dividends may be stronger than in other jurisdictions, Schellbach points out that this period does come in every cycle and that investors should not have been surprised that this was a possibility. 

But Schellbach does acknowledge this time may have been different in one specific sense:

"The share prices might be a little more savaged this time because the perception from the investor base is that companies which are cutting dividends are possibly doing it because they have no other way to deal with the cost inflation that they are currently seeing," he said. 

Schellbach says corporates won't change their behaviour in the future and that dividend eliminations will always remain a risk but... "at the same time, if companies can convince their investors that this is being done for the long-term health of the company, then you are likely to be less savaged," he said. 

As a result, Schellbach argues that it's time for investors to look more closely at companies that can demonstrate consistent DPS (dividend per share) growth. 

"One of the best indicators of a quality company is consistent DPS growth. There are many ways you can screen for quality ... but the fact is that a track record of consistent growth in dividends is as good a measure of overall balance sheet health, earnings quality, and high levels of corporate governance as anything else."

"Companies that can consistently uplift their dividend are all headed in the right direction."

When I asked Schellbach to nominate some companies that are upgrading dividends and are worthy of such investor attention, he points to the insurers. 

"I'd point to QBE Insurance (ASX: QBE) and Suncorp (ASX: SUN). We've identified these as interesting themes because they have some interesting growth channels at the moment but at the same time, are paying a dividend yield that would satisfy any income investor," he said. 

Taking profits on winners (and whether you should be buying straight away)

Finally, Schellbach is encouraging investors to use this time to book in some profits on cyclical exposures in this market. 

As an example, the banks and the retailers were unloved at the start of the year. In about mid-June, that all changed and they started to trend higher. Now those companies have reported earnings, it's time to take the money and go. 

"Those banking and retailing stocks, about six weeks ago, started getting a little bit too optimistic on the economic outlook. The trade leading into that was increasingly pessimistic but then, people thought the RBA was done with its hiking cycle and therefore, the traditional banking and cyclical names are not so threatened. We disagree with that," he said.

UBS' own analysis of such stocks following the end of a rate hiking cycle suggests pain will continue to come through those sectors. A relief rally could be short-lived and they often bottom six months after the last rate hike. Their current forecast is for the RBA to keep rates at the current level until this time next year.