Will the ASX copy America?
Broker reports editor |
29 October 2013
The recent strength of the US market has shown that corporate profits can be strong even when the economy is weak. In the US, this is in large part because non-finance big companies saw the GFC coming and stashed massive amounts of cash away. They have not started investing, but they have been able to cut costs, especially with such a weak labour market. That has meant big profits, which are running at historically high levels.
A JP Morgan note askes the question 'Can this happen in Australia as the economy moves into its post-mining boom phase?' The answer seems to be "maybe". JP Morgan points out that are not far from their cyclical peaks:
"The difference is how they got there: the US came via a deep recession which pushed up margins by pulling down wage growth, tax and interest rates. That meant a strong burst of earnings recovery. Australia has not strayed far from peak profits, so the upside from here looks like steady profit growth from a high base, not a sharp turn around from a trough."
The Morgan report says the rally of the last 12 moths is more a PE (earnings multiple) expansion event, i.e. the result of more optimistic assessments of stocks, which is not surprising given how low cash rates are. It is not due to greater profitability, as the graph below shows:
"High, stable sreturns justify high PEs," the report says. "The good news is that it makes equities less vulnerable to macro prospects, which we think is likely." The broker points to stocks that have "strong, bottom up drivers of profitability such as cost reduction or eliminating low return businesses." It warns against companies that depend on a macro-economic upswing.
Bottom line? The Australian economy is heading into more perilous waters, and investors need to avoid investments that will be adversely affected. The lesson from the US is to concentrate on profits, not revenues. It is also important to avoid stocks that depend on the economy being strong. JP Morgan argues that investors should use "tweezers not spoons"; it is very company specific:
"Revenue growth for large companies in a mature economy rarely creates a big surprise: most of the volatility in corporate earnings comes from changes in margin. A 5% boost in sales from the base case is a big deal for any company, but arise in NPAT margin from 5% to 5.5% is more powerful – particularly if it lasts, which a cyclical dip or peak in revenue does not."
Here is what has happened to US profitability, which is extraordinarily high given the weakness of the economy: