Reporting Season preview: Resilient earnings amid economic challenges

July 22, 2024
By Derek Bilney

Corporate earnings have shown remarkable resilience against higher interest rates and a slowing economy, propelling the Australian equity market to record highs. The upcoming August 2024 reporting season will further test this resilience, however, the lack of negative company updates in recent months suggests that many companies may continue to navigate these challenging conditions successfully.

Key takeaways

• A quiet ‘confession season’: Few companies have lowered earnings guidance – a positive sign for upcoming reporting season.
• Market dynamics: Despite record highs, gains have been relatively concentrated, with most stocks more than 10% off 52-week highs, providing a buffer against earnings disappointment.
• Valuations: Although valuations are elevated, investors are looking past current earning dips, anticipating higher future earnings.

Reporting Season is a pivotal period for the market, where most S&P/ASX 300 companies report either full-year or half-yearly profit results in August. For companies, this season is akin to end-of-year exams for students – a time to prove their performance to investors. The market can be unforgiving, a ‘harsh marker’, with companies that fail to meet expectations often experiencing sharp declines in share prices.

We believe this is especially true given current market conditions.

Since October 2023, the S&P/ASX 300 Accumulation Index is up almost 20%, reaching record highs. Whilst ‘market highs’ are common and do not necessarily predict future underperformance, they can increase pressure on stocks that have excelled in the lead up to the reporting season to deliver. However, a closer examination reveals that the market's record high does not imply universal peak performance across all stocks (see Figure 1).

As at 30 June 2024, 191 stocks were more than 10% below their 52-week high, compared to 103 that were at or within 10% of their 52-week high, with an average decline of nearly 20%. The recent robust performance has been concentrated in sectors like IT and Financials, with sectors such as Materials lagging – which could mitigate the impact of any earnings disappointment.

Figure 1: No. of S&P/ASX 300 Companies relative to 52 week high (as at 30 June 2024)

Source: ASX. N.B: At the stock level, 52-week highs have been used to avoid complications of company and capital restructurings that can impact longer term price comparisons.

Valuations

Strong market performance has also impacted valuations. Using a simple 12-month forward Price/Earnings multiple as a measure, current valuations appear relatively full compared to historical standards. Nevertheless, the market is optimistic, looking past the current earnings trough and anticipating higher earnings in FY25. Although valuation is not a reliable short-term market performance indicator, elevated valuations can reduce the buffer for any earnings disappointment. Stocks that are ‘priced for perfection’ are at most risk – particularly stocks that temper strong growth ambitions via lowered earnings guidance.

Figure 2: S&P/ASX 300: 12-month Forward Price/Earnings

‘Confession Season’ – No news is good news…

The period from May to July is typically when companies adjust previously issued guidance to align with updated financials. Encouragingly, there has only been a smattering this year, predominantly in the retail sector where consumers are increasingly feeling the pinch, suggesting that results may broadly meet market expectations. But, as always, there are two parts to reporting results: the actual profit result and the outlook statement on FY25 expectations. Whilst there is moderate confidence on the results, outlook statements are harder to predict, leading to potential volatility in share prices.

Reporting Season August 2024: Key themes to watch

Against this market backdrop, different themes will permeate through company results. These will likely include:

1. Artificial Intelligence (AI): going mainstream
To date, investors have rewarded the immediate beneficiaries of AI demand: take for example, chip makers (Nvidia) and data centres (NextDC, Goodman Group). But, investors are also eager to see how AI is being utilised to increase efficiencies, cut costs and boost margins. Service-based industries, such as banks, insurers, gas/ electricity, and telecommunications providers, are poised to benefit from AI adoption. Although it is still early days in the AI revolution, we expect companies that highlight progress in AI implementation are likely to be rewarded by investors.

2. REITs: property valuations
Real Estate Investment Trusts (REITs) will be under the microscope, especially regarding updated property valuations in the office and industrial sectors (Goodman Group, Dexus, GPT and Charter Hall Group). The sector faces a pivotal moment as recent increases in physical asset transactions provide more data for market valuations, which unfortunately for office-focused REITs, has led to downward valuations of property. We expect investors will likely focus on valuations, gearing, supply/demand imbalances and any rotations away from the working-from-home thematic.

3. Wealth effect: ‘Have nots’ vs ‘Have yachts'
The impact of interest rates and cost of living expenses on households has been significant. However, the wealth effect – rising housing prices, share markets at record highs, increasing rental income, higher interest income for savers, and strong superannuation balances – has created winners and losers across the economy. We believe that companies exposed to the positive wealth effects, such as those in travel and essential retail sectors, are better positioned than those more reliant on discretionary spending.

4. Operational (de)-leveraging: better build a better moat
The combination of strong demand, rising prices (outpacing costs) and an increasing population has created a favourable environment for many companies, but as demand slows, passing on rising costs to consumers becomes more challenging. Operational leveraging becomes operational de-leveraging and lower-quality companies that lack effective cost management strategies are likely to deliver disappointing results. Sectors such as healthcare (private hospitals and medical imaging) and media have already felt the strain, and the ripple effects may extend to retailers and service providers, where profit margins may come under pressure.

5. Resources: costs and capex
The market will focus on costs, labour supply and capital expenditure plans. Dividend announcements from companies benefitting from strong commodity prices (such as gold producers) will be closely monitored. Due to daily visibility of spot-prices, the information content of profit results is less than other non-resource companies.

6. Capital management: more income for investors
Dividends and buybacks are always in the spotlight during reporting season. With off-market buybacks no longer prominent, capital management options are reduced. Income investors will be closely watching dividend announcements from traditionally high-yield companies. Companies that surprise positively or negatively on dividend announcements will be closely scrutinised. On-market buybacks have become a bigger feature of the Australian market and provide companies with greater flexibility to turn on/off the buyback as opportunities emerge or cash needs to be preserved.

7. Factor performance
Momentum has been a strong signal in 2024. Although there is significant variation from year-to-year, companies with strong earnings momentum typically report solid results and often outperform. While large-caps have generally outperformed small-caps, if there are strong results from small-caps we could see this trend reversed for the remainder of the year. However, stock specific influences tend to dominate during reporting season due to the detailed nature of company results.

Reporting season can be dramatic - noisy headlines and price volatility. But for the Macquarie Systematic Equities team, our disciplined approach to investing remains unchanged. Our systems continue to process vast amounts of data to update signal scores, seeking to identify alpha opportunities in the Australian market. These alpha signals, balanced against risk measures, help us construct what we believe to be robust portfolios designed to perform well under various market conditions. This disciplined approach underscores the benefits of focusing on consistent market drivers, contributing to the historic consistent outperformance of many of our strategies over the long term.

Despite pessimistic views on corporate earnings amid higher rates and a slowing economy, companies have shown strong earnings resilience. The lack of negative updates in the past three months suggests that corporate Australia may continue to navigate this challenging period effectively.

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