Investment Matters

A high market P/E to start reporting season

All listed companies (with a June or December financial year end) must release their results by the end of August. 

(A summary of Suncorp's results will be provided in next week's Investment Matters, with the bulk of the Equity portfolio holdings releasing results in the week commencing 15-Aug.)

Of note as we enter this reporting season is the high market P/E.  A high P/E can be a pointer to a correction.  But not always.

Firstly, some background

The following chart from the RBA shows that markets, both the Australian ASX200 and markets globally, are trading at quite elevated P/E levels.

In fact, Australia's (ASX200) forward P/E is 16.5x.  This means an investor needs to pay $16.50 in order to receive $1 of earnings in the coming year (and the growth in those earnings in future years).  The historical average is ~14.5x (depending on the time frame selected).

Therefore, the market needs to fall?

A high market P/E is certainly a sign for caution (just as it is for a company).   The market is at a higher risk of falling when the ratio is higher - although markets can persist above (or below) their average for long periods of time.

We usually focus on Price, but there is a second element to P/E - Earnings.  An increase in Earnings will act to bring the P/E down, thus making the market less expensive.

Thus, we should also take into account what could happen to Earnings.  The upcoming reporting season will be particularly interesting - to see what is happening to underlying earnings at a market level, and, more importantly, to get a better understanding in relation to the outlook for earnings.

Let us consider two sectors in particular: resources and banking.  These sectors have a major influence on Australia's overall market.

Resources

Resource companies are trading on a forward P/E around 22x.  Commodity prices have recovered off their post-boom lows, as you can see from the uptick in the graph from the RBA below.  There is a lag between price increases, and associated reported revenue and profit increases.   Thus we expect to see benefits from higher prices start to flow though in earnest from FY-17.

Goldman Sachs are predicting EPS (Earnings Per Share) increases of 33%, 13%, 80% and 46% for mining, energy, gold and steel companies respectively for FY-17.  This is built into the forward P/E of ~16x.  Therefore, if earnings growth exceeds this, the market P/E would benefit.  There is the contrary risk also though.

Banking

The banks are trading on a forward P/E of around 12x, with flat earnings expected.

Earnings could surprise to the upside, for example, if:

  1. the Basel 4 impact is less (or implementation timeframe is greater) than anticipated;
  2. bad debt blowout is less than predicted;
  3. margin pressure from competition / financing costs is less than expected; and /or
  4. other reasons.

Should this happen, earnings would be higher than analyst consensus, and the P/E of the banks would fall.  Considering they make up approximately 25% of the market's capitalisation, the flow on impact to the market would be meaningful.

In summary...

There is always a correction coming in the market.  When, and the degree, is unknown.  A high P/E does mark a higher probability of a correction. 

However, as noted above, the oft forgotten P/E denominator should be considered.  Earnings outlooks are important, with commodity exposed companies and the banks of particular note in Australia's context.  Given we enter reporting season with a high market P/E, company earnings (including outlooks) will be of particular note as we proceed through August.

Reporting season, P/E and First Samuel's clients' equity portfolios

The P/E of First Samuel's clients' Australian equity portfolios is 11.9x; considerably lower than the market's.

This implies market participants have lower expectations of the companies in our clients' portfolios in relation to their earnings - a view we don't share!  Pleasingly, in most years our companies have at least met if not exceeded our financial expectations, and exceeded market expectations. 

This has flowed through to share price performance.  In fact, of the last eight years, in all but one the average of clients shares' portfolios have outperformed the market.  This is summarised in the following table.

                        
 First Samuel 
XAOAI
    Aug-15 -0.95% -7.30%
Aug-14 3.22% 0.72%
Aug-13 4.77% 2.78%
Aug-12 3.89% 2.12%
Aug-11 -2.41% -2.00%
Aug-10 4.27% -0.71%
Aug-09 11.99% 6.47%
Aug-08 5.81% 4.02%