August 2011 reporting season: 10 top stocks - Lincoln Indicators

Seeing the world through commodity coloured glasses

Never before has the market endured the myriad of events that unfolded over the past 12 months. From floods to cyclones, international debt crises and natural disasters, the furtherance of a two speed economy, the proposition of a carbon tax; the economy did it tough. We provide some insight into how corporate results and the earnings outlook will show that the Australian economy is only rosy when viewed through commodity coloured glasses.

According to Lincoln CEO Elio D'Amato, "With so many macroeconomic influences to digest, many sectors and stocks have been volatile as the market is struggling to accurately predict the upcoming reporting season.” However despite the flux our market finds itself in, such times of nervousness create an opportunity for the savvy investor. “It is this uncertainty that can create opportunities for investors to seek out businesses with strong fundamental qualities that may be poised to beat the tide and report strong financial results.”

Australia has been envied the world over as many major economies struggle to emerge from the global financial crisis. However we believe that the outlook may not be so rosy. "With the rising cost of living and businesses being starved of stimulated consumerism, we have seen many sectors contract”, says D’Amato. “Whilst we are expecting some minor upside from the stronger section of our two-speed economy, the name of the game is stock specific risk in all corners of the market. Never before has it been more important to be actively managing your portfolio to ensure that you have the right mix of investments to meet your financial goals."

Recent events have exposed consumer weakness, and government policy is not likely to assist. Fiscal policy is proving unpredictable, as the Reserve Bank of Australia (RBA) and the government is finding it difficult to control the rampant growth of our miners and strong headline inflation, without heavily bruising the traditional economy in the process.

With the overall economy humming to the sounds of our miners, if you remove the commodity based growth, Australia is suffering from many of the same problems as the rest of the world. Despite the gloom there are many financially healthy companies that are poised to grow earnings in what has been a tough economic environment and are likely to outperform in the 2012 financial year.

Every rose has its thorns: Winners and losers from the August reporting season

They say every rose has its thorns, and if the resources and mining sector of the Australian economy are flowering and flourishing, the retail and manufacturing sectors are the thorns in our side." Retailers are not going to dazzle this time round." says D'Amato. "We are actually expecting some to disappoint an already cautious market as tough trading conditions take their toll".

Despite compensation and deals for a high number of carbon emitters, depressed construction numbers and a strong currency are likely to ensure that building products companies and domestic manufacturers continue to underperform.

There is also a gap in the mitigating compensatory measures introduced with the carbon tax that will likely see airlines continue to feel the pinch. And whilst consumers are unlikely to be shaken by small airfare price increases, continuing inflationary impacts will continue to drive consumer confidence lower. This, coupled with savings rates at historical highs, makes it no surprise that the consumer discretionary sector may prove weak over the next 12 months.

Given that consumers are being more cautious, and the strength of many sectors is being questioned, we expect, and have done so for some time, that the RBA will keep interest rates on hold for the remainder of the year, with a possible downward bias. So whilst times may be tough now, some respite may be in sight for the long-term investor. "Despite the generally negative outlook, there is a brave investment case that businesses trading at depressed levels, and which offer good dividend yields, may provide sturdy longer term investments."

Not all will disappoint this reporting season, with the obvious outperformers likely to be in the resources sector, but the resilience of Australia's mining boom will be tested. "Whilst our miners have suffered some frustrating operational setbacks over the past six months, including floods, cyclones and a growing labour squeeze, there has been evidence that production levels amongst our biggest and brightest will ensure that earnings growth continues."

Many resources producing companies have been aggressively ramping up production levels to make hay while the sun shines, and lock in sales volume at high commodity prices. "Copper is likely to continue to push higher as there is a lack of genuine supply coming onto the market in the short term. Iron ore prices are high and likely to remain high for now, so it makes sense that companies are trying to get as much out of the ground and onto the boat as possible. When you look at the resources and energy sectors, and the strength in these companies, it is easy to forget the troubles being experienced in the broader market."

Those servicing the mining sector have outperformed over recent years, however, as private capital expenditure soars, many companies will have to sacrifice profit margins in order to maintain top line growth. "With significant expansion planned for the mining sector, companies will benefit from a lift in revenues as contracts for construction, contract mining, and associated services are realised. Those that have invested capital to facilitate expansion may be well placed to grow in coming years." This is a sector that, in our view, will continue to grow and outperform.

This earnings season may see some companies experience growing pains in the form of margin contraction due to increasing labour supply constraints. "Picking quality companies that are positioned to benefit from recent capital investment is paramount in a sector that may disappoint high expectations overall."

Aside from the stark contrast between consumer driven businesses and those leveraged to mining and resources, both telecommunications and information technology businesses are expected to post mixed results. "In tough times, good quality, financially healthy IT and telecoms businesses can offer investors pseudo-defensive exposure. In addition, some businesses are currently trading on low earnings multiples and offer relatively high yields at current prices."

Traditional defensives in the health care sector have endured their own setbacks with currency headwinds culminating in depressed growth expectations. Whilst many of the bigger established businesses are, and will remain operationally sound, earnings growth will likely continue to be hindered as we are predicting the Australian dollar to continue to trade around or above the US$1.05 mark.

Consumer staples don't suffer the same symptoms, and are an obvious defensive play that could be unaffected by currency issues. "We are expecting more buoyant results, and perhaps investors have been harsh on the defensive staples in recent times."

Obstacles to be wary of this financial year

One thing that investors can bank on is that the global economy will continue to throw up obstacles in the coming financial year. "Banks are definitely at risk this time round, and it is expected that credit growth will be subdued. Whilst banks may seem attractive as depressed prices often mean higher dividend yields, the financial system is not yet out of the woods. Many investors see banks as a necessary part of their portfolio, but they should be selective in their exposure to both the risk of increased funding costs, and the risk of an increase in bad debt provisions."

Relevant to the prospect of this increased risk, insurers are not tipped to perform this reporting period. “With the unprecedented levels of environmental catastrophe seen during the financial year, insurers have done it as tough as any. We don’t expect to see much in the way of growth this time round from the major insurers due to an increase in claims.”

So whilst it is apparent that the days of easy gains on the sharemarket are unlikely to return this reporting season, selective exposure to quality companies will, as it has done in the past, produce outperformance. “We select financially healthy companies with proven earnings growth based on strict criteria. We have selected a few that we view as possible winners this coming reporting season. Though biased to the mining sector, there are other companies expected to shine despite tough a tough economic climate.”

Lincoln’s ten top stocks from this reporting season

Fortescue Metals Group Limited (FMG)

FMG is Australia’s third biggest iron ore producer. With a growing iron ore production outlook and the company’s expansion plans looking more and more realistic, we are of the view that the current share price undervalues a company that is likely to produce 155mtpa in the medium term.

Silver Lake Resources Limited (SLR)

This company is a growing gold miner and producer with assets and a growing resource base in the Kalgoorlie goldfields. With production levels ramping up over the next few years, SLR is well placed to benefit from strong gold prices. It is projected that production will ramp up to 100,000 – 110,000 ounces of gold produced in FY12.

Western Areas NL (WSA)

WSA is amongst the lowest cost nickel producers worldwide but is operating in a weak nickel environment. The company's last quarterly production report was strong and with a declining nickel price, partial hedging of nickel prices may facilitate a surprise on the upside. With large high grade stockpiles, near term development should not substantially impact production rates.

Ausdrill Limited (ASL)

ASL is a contract mining, drill and blast services supplier to the resources and energy sectors in Australia and Africa. We expect ASL to perform slightly better than guidance and consensus in the FY11 reporting season. Furthermore, we believe FY12 EPS growth of 16% or more is realistic given the expected return to profitability of some previously underperforming divisions (e.g. its coal seam gas rig), full year contribution of acquisitions (Connector Drilling) and additional returns from new invested capital.

Matrix Composites & Engineering Limited (MCE)

MCE manufactures engineered products predominantly for the offshore oil and gas industry. Its new Henderson production facility has made it an industry leader in terms of quality, efficiency, and automated production techniques, which should bring costs benefits in FY12 and beyond. With offshore drilling projected to remain strong in the medium term and additional capacity able to be utilised to expand its existing product mix, we have a positive outlook for MCE.

Mineral Resources Limited (MIN)

This company is a traditional contract mining business, with a strong reputation and customer base that has been expanding into the mining and production of manganese, lithium and iron ore. With a good track record, and stable contract mining business, the iron ore production set to come online in September this year may provide some further upside to any outlook the company provides this August.

Hansen Technologies Limited (HSN)

HSN technology is a provider of billing solutions to a number of sectors. The structure of the industry makes it difficult for clients to leave HSN providing support to the company’s revenue. We expect HSN to perform well as the company is likely to continue to report strong profit margins and add new customers via organic growth as well as targeted acquisitions.

TPG Telecom Limited (TPM)

TPM is an internet service provider (ISP), which also provides data solutions to a wide range of customers including SME’s and corporate and government sectors. With the company in a cost leadership position in Australia, and the shrewd acquisition of Pipe Networks now fully integrated, TPM is likely to report well this August, and is somewhat undervalued at current prices.

RCG Corporation Limited (RCG)

Despite the gloom surrounding retailers some continue to perform well. RCG’s point of differentiation as a retailer of utilitarian shoes somewhat makes them more resilient to changing fashion trends and consumer sentiment. Growth opportunities through Shoe Super Store and the Merrell brands could result in a meaningful upside to earnings and valuation. The company reaffirmed guidance for up to 28% increase in net profit after tax for FY2011.

Flight Centre Limited (FLT)

Flight Centre operates Australia’s largest travel agency, and has recently upgraded profit guidance for the 2011 financial year. Whilst we are expecting the company to report in line with this latest guidance, it is the potential for a strong outlook statement that leads us to believe there is upside to the company’s profits in future periods. The continued strength of the Australian dollar should assist.

So despite the rhetoric from Canberra and the RBA’s outlook that the mining sector will see the Australian economy through muddy waters, investors need to consider their portfolios without the hindrance of commodity coloured glasses. Below are some tips on how to approach the upcoming corporate earnings season.

Keep perspective and develop a strategy for the reporting season

With approximately 2,000 companies listed on the ASX, it is impossible for investors to assess each one individually. However, it is very important to make a critical judgment of each company in your portfolio in light of any new results. To prepare for this, here are some helpful hints:

Review your current portfolio

1. Read the company's latest ASX announcements and visit their website to view any recent investor information.
2. Consider calling your financial advisor or broker to discuss the company’s operations and future potential.
3. Look at the industry in which the company operates. Is the outlook positive or are there any cost pressures, underperforming businesses or negative sentiment?
4. Look at some of the company's major competitors. How does the company rank amongst its peers? Are there opportunities or barriers to growth for the company?
5. Read the latest business news in order to keep up to date with current events, including any information that may require you to reconsider any opinions developed about the company.
6. When the company reports to the market, read the result carefully. Did the company produce a profit? Did it improve its earnings per share (EPS)? Did the level of growth meet your and the market’s expectations?
7. Read the directors' comments that accompany the result. Did the board have its own expectations met? What type of outlook did the directors put forward for the company? What is their opinion on the current and future trading environment?
8. View the Lincoln Analyst comments (if available). Is the result above, in-line or below expectations? What drove the result, and how will it likely perform in the future?
9. View the share price reaction. This can be tricky as often the first few moves will tend to form an over-reaction. Look, however, for a longer term trading pattern to develop.
10. Is this a company that you wish to retain in your portfolio? This is where the decisions are made, and you may which to consult your broker or financial adviser to discuss your decision. What would you replace the company with? Would your portfolio remain correctly weighted from a diversification point of view?

Evaluate potential stocks to add to your portfolio

1. Create a watch list of companies you may be interested in buying but do not currently hold. You could also form a watch list based on stocks that may have been covered in the paper, seen on TV, or had mentioned via other sources.
2. Once a list of potentials is derived, do some background reading. Investigate the industry these companies are in, read recent announcements and develop a firm understanding of how these companies operate. For each company, this will cut down on the decision-making time when the result is released.
3. Once results are released, look at the level of growth achieved. Apply similar criteria as done when re-evaluating your own portfolio, ensuring that growth targets in your watch list stocks were met and that the outlook is positive.
4. Of course, there may be a result from a company that was not on the market's radar originally, but has caught its attention. If this is the case, then you should look behind the headline and go through all the previous steps to determine if interest in this company is justified.

August 2011 reporting season: 10 top stocks - Lincoln Indicators