Macro and Australian equity strategist, Macro Strategy Advisors

Shane Lee

Macro and Australian equity strategist

Macro Strategy Advisors

Thematic (Sector/Industry)

It's not too late to jump on board the Growth train. One of our key calls for 2018 is that Growth will again outperform Value (Aussie Equities 2018: In a Sweet Spot), despite Value reaching distressed levels that normally trigger out-performance.  We argue that sustainable stock rerating requires an earnings turnaround, but the PE de-rating is concentrated in areas under structural or cyclical pressures such as bricks and mortar retail, <a href="https://www.smartkarma.com/entities/690" target="_blank" data-smartkarma-citation="entities:690:1">Telstra Corp Ltd (TLS AU)</a> and the interest rate sensitive sectors.  In absence of an earnings turnaround, the best way to achieve outperformance is to buy excess earnings backed by earnings certainty without the need for PE multiple expansion.Avoiding an earnings landmine is key. Buying growth in a market that has been expanding for 9 years and trading on a relatively high PE multiple requires conviction about the earnings outlook.  In this note, we take a two-pronged approach to scanning for earnings landmines.  Firstly, we calculate earnings quality for each Growth stock in the ASX200 (ex-financials).  Secondly, we then look at the PE multiples being paid for these stocks based on longer-term earnings growth and earnings certainty.High earnings quality doesn't mean high PE multiples. We assume that earnings quality can only be assessed over the longer-term and calculate it for the ASX200 (ex-financials) over the past 10 years.  Top of the class is dominated by service-orientated Consumer Discretionary stocks such as <a href="https://www.smartkarma.com/entities/8118" target="_blank" data-smartkarma-citation="entities:8118:1">Corporate Travel Management (CTD AU)</a>, <a href="https://www.smartkarma.com/entities/1099" target="_blank" data-smartkarma-citation="entities:1099:1">Navitas Ltd (NVT AU)</a>, <a href="https://www.smartkarma.com/entities/9044" target="_blank" data-smartkarma-citation="entities:9044:1">Invocare Ltd (IVC AU)</a>, and <a href="https://www.smartkarma.com/entities/14615" target="_blank" data-smartkarma-citation="entities:14615:1">Tatts Group Ltd (TTS AU)</a> and Tech stocks such as <a href="https://www.smartkarma.com/entities/679" target="_blank" data-smartkarma-citation="entities:679:1">Computershare Ltd (CPU AU)</a> , <a href="https://www.smartkarma.com/entities/15342" target="_blank" data-smartkarma-citation="entities:15342:1">Iress Ltd (IRE AU)</a>, and <a href="https://www.smartkarma.com/entities/1070" target="_blank" data-smartkarma-citation="entities:1070:1">Technology One Ltd (TNE AU)</a> that have a relatively small fixed asset base and lower depreciation, but trade on high PE multiples.  Junior Miners such as <a href="https://www.smartkarma.com/entities/13914" target="_blank" data-smartkarma-citation="entities:13914:1">Galaxy Resources Ltd (GXY AU)</a> , <a href="https://www.smartkarma.com/entities/3572" target="_blank" data-smartkarma-citation="entities:3572:1">Orocobre Ltd (ORE AU)</a>, <a href="https://www.smartkarma.com/entities/20106" target="_blank" data-smartkarma-citation="entities:20106:1">Regis Resources Ltd (RRL AU)</a> , and <a href="https://www.smartkarma.com/entities/4243" target="_blank" data-smartkarma-citation="entities:4243:1">Northern Star Resources Ltd (NST AU)</a> bring up the rear along with Industrials such as <a href="https://www.smartkarma.com/entities/958" target="_blank" data-smartkarma-citation="entities:958:1">Qube Holdings Ltd (QUB AU)</a>, <a href="https://www.smartkarma.com/entities/14430" target="_blank" data-smartkarma-citation="entities:14430:1">Macquarie Atlas Roads Group (MQA AU)</a>, <a href="https://www.smartkarma.com/entities/19063" target="_blank" data-smartkarma-citation="entities:19063:1">Sydney Airport (SYD AU)</a>, <a href="https://www.smartkarma.com/entities/20030" target="_blank" data-smartkarma-citation="entities:20030:1">CIMIC Group Ltd (CIM AU)</a> , and <a href="https://www.smartkarma.com/entities/14351" target="_blank" data-smartkarma-citation="entities:14351:1">ALS Ltd (ALQ AU)</a> .Don't fear paying for sustainable, strong and certain EPS. While earnings quality might not be reflected in valuations, longer-term EPS growth, and EPS growth volatility certainly is.  On average around 50% of the PE multiple of stocks in the ASX 200 is explained by EPS growth and EPS growth volatility over the next 5 years.  Growth stocks such as Costa Group Holdings Ltd (CGC AU), <a href="https://www.smartkarma.com/entities/917" target="_blank" data-smartkarma-citation="entities:917:1">CSL Ltd (CSL AU)</a>, CWY, <a href="https://www.smartkarma.com/entities/700" target="_blank" data-smartkarma-citation="entities:700:1">Domino's Pizza Enterprises Ltd. (DMP AU)</a> , <a href="https://www.smartkarma.com/entities/9044" target="_blank" data-smartkarma-citation="entities:9044:1">Invocare Ltd (IVC AU)</a>, <a href="https://www.smartkarma.com/entities/970" target="_blank" data-smartkarma-citation="entities:970:1">Link Administration Holdings Ltd (LNK AU)</a> , <a href="https://www.smartkarma.com/entities/16042" target="_blank" data-smartkarma-citation="entities:16042:1">Orora Ltd (ORA AU)</a>, <a href="https://www.smartkarma.com/entities/699" target="_blank" data-smartkarma-citation="entities:699:1">REA Group Ltd (REA AU)</a> , <a href="https://www.smartkarma.com/entities/673" target="_blank" data-smartkarma-citation="entities:673:1">Ramsay Health Care Ltd (RHC AU)</a> , <a href="https://www.smartkarma.com/entities/22690" target="_blank" data-smartkarma-citation="entities:22690:1">Reliance Worldwide Corp Ltd (RWC AU)</a> ,   <a href="https://www.smartkarma.com/entities/1070" target="_blank" data-smartkarma-citation="entities:1070:1">Technology One Ltd (TNE AU)</a>, and<a href="https://www.smartkarma.com/entities/593" target="_blank" data-smartkarma-citation="entities:593:1">Transurban Group (TCL AU)</a>  all trade on growth PE multiples, with above-average EPS growth and EPS certainty over this period.  In contrast, Growth investors should be wary of <a href="https://www.smartkarma.com/entities/1345" target="_blank" data-smartkarma-citation="entities:1345:1">Aconex Ltd (ACX AU)</a>, <a href="https://www.smartkarma.com/entities/10303" target="_blank" data-smartkarma-citation="entities:10303:1">Aristocrat Leisure Ltd (ALL AU)</a>,  <a href="https://www.smartkarma.com/entities/8118" target="_blank" data-smartkarma-citation="entities:8118:1">Corporate Travel Management (CTD AU)</a> and  <a href="https://www.smartkarma.com/entities/4243" target="_blank" data-smartkarma-citation="entities:4243:1">Northern Star Resources Ltd (NST AU)</a>.  These stocks trade on Growth PE multiples, have above-average EPS growth expectations, but have higher EPS uncertainty.The list of convincing Value candidates is relatively small.  While we think Growth will generally outperform, there are some key Value stocks that could buck the trend.  Junior resource and energy producers such as<a href="https://www.smartkarma.com/entities/18363" target="_blank" data-smartkarma-citation="entities:18363:1">Evolution Mining Ltd (EVN AU)</a>, <a href="https://www.smartkarma.com/entities/15103" target="_blank" data-smartkarma-citation="entities:15103:1">Mineral Resources Ltd (MIN AU)</a>, and <a href="https://www.smartkarma.com/entities/2415" target="_blank" data-smartkarma-citation="entities:2415:1">Saracen Mineral Holdings Limited (SAR AU)</a>  have cyclical Value with elevated earnings uncertainty holding back a proper PE rerating.  <a href="https://www.smartkarma.com/entities/13914" target="_blank" data-smartkarma-citation="entities:13914:1">Galaxy Resources Ltd (GXY AU)</a> fits into this group but is more fully valued with high earnings uncertainty attached to its strong EPS growth outlook.  Value hunters should see <a href="https://www.smartkarma.com/entities/14253" target="_blank" data-smartkarma-citation="entities:14253:1">Whitehaven Coal Ltd (WHC AU)</a> as a clear value trap.

It's not too late to jump on board the Growth train. One of our key calls for 2018 is that Growth will again outperform Value (Aussie Equities 2018: In a Sweet Spot), despite Value reaching distressed levels that normally trigger out-performance.  We argue that sustainable stock rerating requires an earnings turnaround, but the PE de-rating is concentrated in areas under structural or cyclical pressures such as bricks and mortar retail, Telstra Corp Ltd (TLS AU) and the interest rate sensitive sectors.  In absence of an earnings turnaround, the best way to achieve outperformance is to buy excess earnings backed by earnings certainty without the need for PE multiple expansion.Avoiding an earnings landmine is key. Buying growth in a market that has been expanding for 9 years and trading on a relatively high PE multiple requires conviction about the earnings outlook.  In this note, we take a two-pronged approach to scanning for earnings landmines.  Firstly, we calculate earnings quality for each Growth stock in the ASX200 (ex-financials).  Secondly, we then look at the PE multiples being paid for these stocks based on longer-term earnings growth and earnings certainty.High earnings quality doesn't mean high PE multiples. We assume that earnings quality can only be assessed over the longer-term and calculate it for the ASX200 (ex-financials) over the past 10 years.  Top of the class is dominated by service-orientated Consumer Discretionary stocks such as Corporate Travel Management (CTD AU), Navitas Ltd (NVT AU), Invocare Ltd (IVC AU), and Tatts Group Ltd (TTS AU) and Tech stocks such as Computershare Ltd (CPU AU) , Iress Ltd (IRE AU), and Technology One Ltd (TNE AU) that have a relatively small fixed asset base and lower depreciation, but trade on high PE multiples.  Junior Miners such as Galaxy Resources Ltd (GXY AU) , Orocobre Ltd (ORE AU), Regis Resources Ltd (RRL AU) , and Northern Star Resources Ltd (NST AU) bring up the rear along with Industrials such as Qube Holdings Ltd (QUB AU), Macquarie Atlas Roads Group (MQA AU), Sydney Airport (SYD AU), CIMIC Group Ltd (CIM AU) , and ALS Ltd (ALQ AU) .Don't fear paying for sustainable, strong and certain EPS. While earnings quality might not be reflected in valuations, longer-term EPS growth, and EPS growth volatility certainly is.  On average around 50% of the PE multiple of stocks in the ASX 200 is explained by EPS growth and EPS growth volatility over the next 5 years.  Growth stocks such as Costa Group Holdings Ltd (CGC AU), CSL Ltd (CSL AU), CWY, Domino's Pizza Enterprises Ltd. (DMP AU) , Invocare Ltd (IVC AU), Link Administration Holdings Ltd (LNK AU) , Orora Ltd (ORA AU), REA Group Ltd (REA AU) , Ramsay Health Care Ltd (RHC AU) , Reliance Worldwide Corp Ltd (RWC AU) ,   Technology One Ltd (TNE AU), andTransurban Group (TCL AU)  all trade on growth PE multiples, with above-average EPS growth and EPS certainty over this period.  In contrast, Growth investors should be wary of Aconex Ltd (ACX AU), Aristocrat Leisure Ltd (ALL AU),  Corporate Travel Management (CTD AU) and  Northern Star Resources Ltd (NST AU).  These stocks trade on Growth PE multiples, have above-average EPS growth expectations, but have higher EPS uncertainty.The list of convincing Value candidates is relatively small.  While we think Growth will generally outperform, there are some key Value stocks that could buck the trend.  Junior resource and energy producers such asEvolution Mining Ltd (EVN AU), Mineral Resources Ltd (MIN AU), and Saracen Mineral Holdings Limited (SAR AU)  have cyclical Value with elevated earnings uncertainty holding back a proper PE rerating.  Galaxy Resources Ltd (GXY AU) fits into this group but is more fully valued with high earnings uncertainty attached to its strong EPS growth outlook.  Value hunters should see Whitehaven Coal Ltd (WHC AU) as a clear value trap.

Putting Aussie Earnings Under the Microscope