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Monday, March 19, 2012

Should investors look at the small picture?

By Matthew Sherwood, Head of Investment Market Research, Perpetual

This week’s economic data in Australia has confirmed what Australia’s company reporting season has been telling us; there is only modest growth momentum in both the economy and earnings at present. There were low expectations heading into the February 2012 reporting season, but large cap stocks had difficulty clearing even these hurdles, whereas small cap stocks (particularly mining services and consumer discretionary) did much better. Companies exposed to resource volumes and the Capex cycle did reasonably well, whereas the remainder struggled in the wake of soft revenue growth, sticky cost pressures and the high Australian dollar, which culminated in margin pressures being the prominent theme.

The number of positive earnings surprises (64) was similar to the number of negative surprises (62), and overall FY12 earnings per share growth declined to around 2%. However, the downgrades-to-upgrades ratio bottomed (from 0.3x in mid-January 2012) and is now starting to recover (0.8x in late February), which indicates that almost as many stocks are being upgraded as downgraded. This is the best result for a year. Although earnings growth was modest during the season and there was little in the way of capital management (only Westfield and Telecom New Zealand announced notable buybacks plans), the market experienced some very positive price reaction to their respective results. Clearly the market was priced for bad news on many fronts and stock prices rose when the results were a bit better.

Consequently, two smaller themes have become prominent in the prevailing market environment. The first is ‘value’, which allows oversold companies to experience price growth even though the macroeconomic environment may not improve. The second is ‘quality’, with firms that have a good earnings profile, strong balance sheets and that can provide income growth, being highly prized by investors.

A number of headwinds remain for investors. Next Wednesday, the December quarter 2012 national accounts are released and recent data has indicated that the result is likely to be soft, even though current market expectations are for a 0.7% quarterly rise. Recent data on investment, credit, housing and consumer spending, have suggested that the balance of risks to this result is to the downside. However regardless of the result, investors should not be a too perturbed, as any growth weakness likely reflects the exchange rate rising before the mining boom arrives. This is just a timing issue – investment in mining equipment may be a bit soft in Decemeber 2011, but it is expected to rise by 36% in 2012 and by another 36% in 2013. The problem is that it is entirely mining based. Indeed, there are almost no plans to boost Capex outside mining anytime soon and the Reserve Bank recently noted that ‘the import intensity of current mining investment projects is also higher than in earlier years…range of inputs…that have historically been sourced locally are now often being imported.’