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Australia - The Underperformer

This story was originally published on Wednesday, July 28, 2010. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere.
I must have read somethirty attempts to explain why the Australian share market has underperformed most other markets since March 2009, but none, I believe, has even come close to what I consider to be the key element in this “mystery”.
Earnings growth.
Forget about market size, the Australian dollar, risk appetite, government taxes and whatever else has been lined up to explain what I consider a fairly straightforward story.
European companies are in the process of reporting average growth in earnings per share of around 24% this fiscal year. In the US, the number is much higher, with June quarter numbers alone expected to come out close to 30%.
And what has Australia to offer?
I just updated FNArena's calculations and can now report that Australia's top 200 companies are, less than one week away from entering the August reporting season, projected to report an average advance in earnings per share of... (wait for it).... (just a bit more)... less than 2%.
That's right. Less than 2%. To be more precise, the actual figure currently stands at 1.79%. I hope it now is obvious why Australia has underperformed.
Fund managers allocating client money on a global scale do not have the time, nor much inclination, to dig deeper into all the finer details. I have little doubt that once experts decided the Australian dollar had its run, towards the end of 2009, they decided it was time to seek greener pastures.
With 1.79% on offer against numbers well in excess of 20%, and I am not even including Asian or Latin American markets, who could blame them? It's only Australian commentators who have mostly been too self-oriented, remaining stuck in the “we're so much better than all the rest” mantra, who have been left scratching their heads asking how, why, and then again how, and again why?
As many of you would know, I have kept a close eye on earnings expectations since the beginning of calendar 2010. Post the February interim-results season average earnings per share growth for Australia's top companies was projected at some 6% for FY10.
Since April these projections have come under pressure as global growth had peaked and overall momentum has started slowing down. Australian companies began issuing profit warnings, including the likes of Macquarie ((MQG)), QBE Insurance ((QBE)) and Insurance Australia Group ((IAG)).
Others disappointed, such as Harvey Norman ((HVN)), Woolworths ((WOW)) and Energy Resources of Australia ((ERA)). Plus we had resources analysts cutting back on expectations as it became clear that projections put forward at year-end in 2009 were looking too high.
As a result of all this, the consensus EPS growth projection for the Australian market has dropped from 6% to 1.79%. I don't think we have seen the end of this process yet. Could the number actually end up as a negative? Easily. But I think even without this happening, the decision by global asset managers to allocate more capital elsewhere has already been vindicated. Sometimes not being as rotten as the other apples in the basket can turn out a relative negative. The past eighteen months have provided one such prime example.
I do have good news to report, however. Europe and the US might have offered superior prospects this year, but the outlook for FY11 looks to the advantage of Australia. With EPS growth projected to fall to low double digits in Europe and in the US, Australia will be able to offer a superior growth profile next year.
Current consensus forecasts amount to projected 18.6% EPS growth for FY11 in Australia, down from growth expectations in excess of 20% at the start of March, but well above what is anticipated for companies in the US and in Europe.
Add the fact that most FX forecasters are anticipating a stronger Australian dollar in the year ahead, along the lines of US94c compared with US89c today, and it would seem the Australian share market should once again appear on the radar of global asset managers.
One of the drivers behind present changes in FX expectations is the fact that Fed tightening is being pushed out until early 2012 (at the earliest) at many a Wall Street investment firm, while expectations for further rate hikes in Australia are equally pushed further out (rightfully so), but nowhere near as far.
Two important caveats come with all of the above. Firstly, Australian companies still have to report their FY10 results with accompanying guidance for the year ahead. Given the trend over the past three months, it seems only fair to expect that earnings projections will be cut further. On this account, we will all be a lot wiser by early September.
Secondly, earnings projections in Australia are more dependent on commodity prices than most elsewhere. While this opens up the potential for bigger positive surprises in case of buoyant scenarios for global growth, it also means downside risks are much larger.
This risk is probably best illustrated by the BHP Billiton ((BHP)) experience over the past two years: measured in USD (the company's reporting currency), earnings per share fell by no less than 61% in FY09. If everything goes according to plan, the company will in the third week of August report a gain for FY10 of no less than 115%.
Those with a good feeling for maths already figured out it will take another year before BHP's EPS will again exceed the numbers reported in 2009. On current expectations, FY11 should see another advance in the order of 61%.
Current consensus forecasts could also serve as an indication of when valuation limits start kicking in for the Australian share market. With the ASX200 around 4500, the Price-Earnings ratio for the Australian share market is still at nearly 15.5 for FY10 – well above the long term average of 14-14.5.
However, if we look at consensus calculations for FY11 the PE ratio drops below 13. Applying a multiple of 14 would take the index to 4853, roughly 6.6% above today's index level.
I do note, however, both BHP Billiton ((BHP)) and Rio Tinto ((RIO)) are still 21% and 30% below their respective average price targets. The same applies to all major banks in Australia with CommBank ((CBA)) shares trading at the lowest discount (7.6%) and National Australia Bank ((NAB)) offering the highest potential (16.3%).
As discounts for all major banks and both giant resources companies are larger than the upside suggested by the market's PE ratio, it is possible these six companies can push the index closer to the 5000 mark.
Those readers paying attention to details, will have noticed newspapers and stockbrokers tend to use different numbers than the ones I mention above. I have seen very flattering forecasts for average EPS growth of 8% for FY10, while the widely mentioned corresponding number for FY11 seems to be 24%.
Apart from the fact that some stockbrokers only rely on their own estimates (and newspapers re-print them without asking too many questions about it) I have a suspicion that the differences with FNArena's calculations lie in the fact that we actually “clean” our calculations in order to achieve a much more accurate and market representative tool.
For example, no less than 35 companies (out of the ASX200) are projected to lift their earnings per share in FY11 by at least 100%. These companies range from Aquila Resources ((AQA)), to Eastern Star Gas ((ESG)), to Elders ((ELD)), to iSoft ((ISF)). While these forecasts may well prove correct, it is difficult to argue such big jumps are representative for the Australian market as a whole.
The same goes for the negative side where Sigma Pharmaceuticals ((SIP)) is projected to report a decline in EPS of no less than 48%. If you think that's a lot, consider Biota's ((BTA)) decline should be 93%, Panoramic Resources' ((PAN)) decline should be 73% and Kagara Zinc's ((KZL)) 49%.
At FNArena we tend to remove these exceptions and aberrations to achieve much better representative calculations.
By Rudi Filapek-Vandyck, Editor FNArena