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Putting Aussie Earnings Under the Microscope

• 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, TLS 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 under our coverage universe (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 CTD, NVT, IVC, and TTS and Tech stocks such as CPU, IRE, and TNE that have a relatively small fixed asset base and lower depreciation, but trade on high PE multiples.  Junior Miners such as GXY, ORE, RRL, and NST bring up the rear along with Industrials such as QUB, MQA, SYD, CIM, and ALQ.
• 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 CGC, CSL, CWY, DMP, IVC, LNK, ORA, REA, RHC, RWC, TNE, and TCL 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 ACX, ALL, CTD and NXT.  These stocks trade on Growth PE multiples, have above-average EPS growth expectations, but with 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 EVN, MIN, SAR have cyclical Value with elevated earnings uncertainty holding back a proper PE rerating.  GXY fits into this group, but is more fully valued with high earnings uncertainty attached to its strong EPS growth outlook.  Value hunters should see WHC as a clear value trap.