After a lot of macro-economic uncertainty and market volatility over recent weeks with the shocks of the Brexit vote and a drawn out Federal election result, the market will now turn its attention to the fundamentals of full year reporting season in August.
Reported company profits will be evaluated against elevated market valuations, with the market trading at a 15 per cent premium to its longer term average valuation. Hence the market in general isn’t cheap, with central banks proving to be the antidote for equity markets against a global backdrop of economic, political and social uncertainty.
Growth in corporate earnings will therefore be the key if markets are to further re-rate from this point in time.
Scarcity in earnings growth creates both risks and opportunities
Strong growth in earnings per share remains a scarce commodity among industrial companies with the top 200 industrials growing profits at a modest 3-4pc over the past 12 months.
This scarcity is driving valuations on stocks which have previously reporting strong and consistent earnings growth to extremes levels. Probably one of the best examples of this is Dominos Pizza. Caution is therefore required with regard to these types of stocks, as any disappointment at reporting will be dealt with harshly by the market.
The divergence between the most expensive stocks and cheapest stocks we believe is starting to look extreme. We therefore think this presents opportunities in overlooked segments of the market, such as resources, energy and select industrial stocks, where earnings momentum has finally started turning more positive and we think the propensity for these stocks to surprise positively remains quite high.
Keeping a cool head through volatility – always a good reminder
Market volatility is hardly a new phenomenon, with Australian investors having endured several shocks since the GFC which have been exacerbated by such an abnormal investing environment.
No investor alive today has witnessed central bank monetary settings this low, so it’s not surprising that markets are susceptible to negative surprise. Nonetheless, we remind investors that volatility is simply the price that equity investors pay for the long-term outperformance of shares.
Despite posting a small capital loss in financial year 2016, Australian industrial stocks have delivered compound annual returns of 9.1pc over the last 20 years. We do caution though that investors need to avoid complacency in such a dynamic market, especially with reporting season around the corner.
- Justin Still, Investment Adviser (Authorised Representative: 000279726), Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410
