Australian shares to earn their keep as economy returns to normal

Far from being the end of the record market run, the January sell-off and recent volatility may prove to be the chance to get set for higher company profits.

To judge from the market rout in January, the equity outlook had soured and it was time to sell and prepare for a bear market. At the end of a generally strong US reporting season and the cusp of the Australian semi-annual results period, stock markets corrected (down 10pc, peak to trough) as investors appeared to lose faith in the growth story that just weeks earlier had driven indexes to record levels.

“I think the market had these concerns about earnings 12-18 months too early,” says Hasan Tevfik, senior analyst at equities research house MST Marquee.

Whilst it appeared valuations had become somewhat stretched – with the forward price-earnings ratio out to 18.2 times against a long term average of 14.5  – the “January Sales” have restored some value to the market at a time when there are good reasons to believe companies can continue to turn out earnings growth and justify higher share prices.

That thesis remains intact following the dislocation and a fresh market sell-off in late February caused by the Russian invasion of Ukraine.  Tevfik points out that Australian companies have little direct exposure to Russia or Ukraine and any wider impacts such as the oil price will be marginally positive for the earnings of some companies and marginally negative for others.

“It won’t derail the earnings recovery,” Tevfik says.

“Markets tend to overreact to events like this and then settle down. Investors should use this situation as a better entry point for the market.”

The upside of inflation, rates

Tevfik says that earnings expansions usually run in cycles of three to five years and, even with profits at record levels, this cycle is only in its first year. The last one ended in 2020 as lockdowns across the country hit earnings and forced companies to adapt to new ways of doing business. But growth resumed in the first half of 2021 as the effects of massive government stimulus spending washed through results and banks wrote back pandemic-driven provisions, leading to the biggest earnings upgrade on record.

That expansion looks set to continue even as – and in some cases because of – rising inflation and the prospect of increasing official interest rates in the next 12 months, according to Tevfik.

In a note titled “After the January Sales” MST Marquee made the case for investors to again “buy the dip,” but with a bias to value stocks over growth stocks. According to the note, among the cheaper stocks that should be on investors radar are Ampol (ASX: ALD), BHP ASX: BHP), Downer (ASX: DOW), Iluka (ASX: ILU) Nine Entertainment (ASX: NEC), Perpetual (ASX: PPT) and Santos (ASX: STO).

“The outlook for the asset class (ASX 200 stocks) has become more attractive and we are now targeting a 10-15% total return by year-end. Supporting our positive outlook from here is a lower starting valuation, solid EPS momentum and funding markets remaining functional,” Tevfik writes in the report.

“Investors can look forward to a 11% capital gain and (around) 4% boost from dividends to generate a total return of 15% from here,’ the report said.

(It was dated February 2, 2022, in the immediate aftermath of the sell-off)

Earnings upgrades in mid-season

Based on the results announced up to the halfway point of reporting season consensus earnings forecasts have been increased by 1.2 basis points, equivalent to $1.5 billion across the $142 billion earnings pool for the top 200 ASX companies.

“The fact that we are seeing earnings upgrades through the reporting season more or less confirms that we are not at the end,” Tevfik says. “It is a slowdown, but not the end.”

Australia’s two biggest state economies – New South Wales and Victoria - have recently announced a major loosening of COVID restrictions, including an end to work from home and mask mandates, aimed at helping business and economic recovery. Tevfik says the normalization of the economy as Australia learns to live with COVID-19 will be a significant driver as resumption of regular activity – the return to the office, school and university, domestic and international travel and hospitality - offsets the withdrawal of government stimulus.

Higher inflation means higher revenue for businesses, although Tevfik cautions that this applies mainly to “operationally geared” companies – those with high fixed costs that can expand sales at a faster rate than their costs increase. “As long as you are operationally geared you should make more money in a world of 4% inflation than 2%,” Tevfik says. “But it also depends on whether inflation is concentrated on areas that drive price, rather than cost.”

Prices rising ahead of costs for winners

Driven by pandemic-induced supply chain disruptions and closed borders that kept seasonal and skilled workers out of Australia, rising input costs, labour shortages and wages pressures have been factors in the last two reporting seasons. Companies that froze wage increases during the pandemic will face demands for “make good” rises as the economy recovers, while those companies wanting to grow are having to pay up for talent in a tightening labour market.

How those pressures are handled over the next year as the government and the Reserve Bank of Australia bank on driving unemployment to 50-year lows below 4 per cent and sparking higher wages growth - is likely to have a significant influence on the earnings outlook. “Given the balance of the earnings growth will be driven by the “recovery stocks” like casinos, private hospital operators such as Ramsay Healthcare (ASX:RHC), Qantas (ASX:QAN), CSL (ASX:CSL) and energy companies and they are big employers, wages will be a very important part of the story,” Tevfik says

 And rising interest rates can be a positive for the share market. As well as banks – who can expand their net interest margin – and Insurers – who hold large portfolios of bonds against potential claims, the broader market can benefit from the early stages of rising rates as they are an important driver of PE ratios.

Financial stocks – including the big four banks and Macquarie Group ASX: MQG), fund managers such as AMP (ASX:AMP) and real estate investment trusts (REITs) - are in an earnings sweet spot  of strong economic growth driving volumes at a time of still low funding costs.

Tevfik says office and retail REITs may also win support from a return to the office and the higher volumes of traffic and attendance that will bring to central business districts, although he cautions there are risks in lease durations and the possibility of lower rents.

It’s not positive across the board. The so-called “COVID darlings” who benefitted from more health-conscious stay-at-home workers – such as healthcare companies ResMed (ASX:RMD) and Ansell (ASX:ANN), appliance makers Breville (ASX:BRG)  and Fisher & Paykal (ASX:FPH) – or building materials companies that benefited from exemptions for construction activity may face an earnings hump.

“Largely these companies have able to pass on increased costs because demand has been high,” Tevfik says.

“Now, because demand for gloves, ventilators, auto parts is not as strong (as health settings are eased) they are not able to pass those costs on as they had been doing.”

For now, they may be the exceptions to an earnings expansion that stretches well into 2023.