By Elio D’Amato, Lincoln

At Lincoln we are not surprised by the quality and strength of the numbers coming through in this profit-reporting season. Following a flat start to the year, the market continues to perform as expected with a rally that has seen the market rise more than 6 per cent this financial year.

A well-published and commonly followed measure is how earnings have tracked relative to consensus estimates. This is often referred to as the market’s view.

To late August, the number of companies that have surprised to the upside outrank the downside disappointments by a ratio of two-to-one (based on consensus analyst forecasts). This varies significantly from history, in which the ratio tends to be more of one-to-one. It provides evidence that global consensus views on corporate earnings expectations were too pessimistic.

Larger companies contributed to this market rally with the S&P/ASX 50 index rising 5.03 per cent in July compared with the S&P/ASX Small Ords index falling minus 0.2 per cent. In contrast, the beginning of the reporting season has seen the roles reversed: the S&P/ASX Small Ords index has risen 5.7 per cent whereas the S&P/ASX 50 has lagged behind, growing by a more modest 2 per cent.

This is typical of a market rally where large-cap shares tend to run first, as they are seen as the quick and easy wins representing a better risk/reward return than the more-volatile small-caps. However, once the larger shares move closer to being fully valued, the quality small-caps start their run. You will know when the market starts to get toppy as it’s completely “risk off” and investors start convincing their neighbours that more risky “fairy-tale investments” will come true.

Leading up to the reporting season, with the backdrop of a doomsday scenario, we thought that the unloved sectors was where deep value was to be had and we expected them to return to favour.. Materials, energy, information technology and industrials which were underperforming the All Ords index over the past 12 months, have turned the tables since August 1, with all outperforming. And vice versa, telecommunications, healthcare and utilities – all outperformers over the previous 12 months – have subsequently underperformed. Investors have hopped off and moved to shares that are running.

Income has its day in the sun

One of the themes leading up to the reporting season was the heavy focus on companies that pay a high yield. Income investing became the “new black”, with many now creeping up close to their valuations.

Although a point of potential concern, it is important to remember that in the case of larger dividend payers, many are at mature stages of their business cycle. For example, the banks and Telstra (TLS) will distribute excess earnings to shareholders rather than invest those funds into other business opportunities.

For income investors concerned about the size of the dividend cheque the good news is that the reporting season has provided some comfort that at the very least; the healthy yields these investors have benefited from in recent times remain.

It may be of interest to income investors to know that the current grossed-up market yield currently sits at around 6.3 per cent. Therefore, if you want to outperform on an income basis, you need to focus on companies that currently pay a higher yield than that.

A quick scan of Lincoln’s Stock Doctor shows there are currently 246, more than enough to choose from despite the recent market bounce.

Company health continues to improve

Corporate balance sheets are looking solid. The flighty debt-laden risks taken on before the onset of the GFC are now a nasty footnote in history. Companies remain profitable and are still, on the whole, generating good levels of operating cash flow. These key ingredients suggest that companies today are better positioned to survive choppy business conditions than when the last crisis of confidence struck in 2008.

But not all companies embrace such prudent practices. The recent high -profile failures of Hastie Group Limited (HST) and Metal Storm Limited (MST) should remind all investors that exposing their portfolios to companies with weaknesses in their financial accounts is, and always will be, extremely risky. It is not as if investors did not have plenty of warning: both HST and MST were financially unhealthy, according to our Lincoln metrics, from the date they were listed, 2005 and 1996 respectively.

Outlook unchanged

Our outlook for the market has not changed from the beginning of this calendar year. We expected the first half of the year to be flat, with a strong rally in the second half of 2012. To date, this has played out as expected.

There are a number of reasons why we believe the Australian market will have a positive run:

1. Shares are cheap, particularly in the sectors that have been unloved in recent times – mining, mining services, energy, IT services and retail.
2. The US economy will continue to improve, although it will be somewhat muted.
3. China will bottom out of its self-imposed slowdown and will look to continue to grow at sustainable rates.
4. Dividend yields are attractive and the differential between them and the official cash rate (currently 3.5 per cent) is large. Historically this is a good sign that the sharemarket will turn.

So although we may not know when it is the bottom of the sharemarket, we will certainly know when we miss it, and there is enough to suggest that it is now safe to go back into the water.

Timely reminder

One last note of caution: beware of predictable outcomes in the market. They rarely happen. For example, leading up to June everyone thought the world would end, when in fact it was a turning point. Everyone thought the latest round of reports would be terrible, when in fact they have been great.

Many now are scrambling, saying the market will go up and turn when the US election is over in November, yet they will probably be wrong. History has shown that the moment anyone believes they can predict the events that will turn the market; inevitably they will be proved wrong.

But don’t be discouraged. The good news is that although the market is not predictable in its movement, it is predictable in its outcome.

If you focus your attention on the most fundamentally superior companies on ASX you will outperform the market under all investment conditions. Invest in companies that are financially healthy, have great management and solid outlooks, and you give yourself the very best chance to outperform over the long run.

By not closing your eyes when investing in the market, you will ensure you do not “miss it” when it comes around next time.

10 companies that have delivered this reporting season

With this current reporting season throwing up many strong results, it is always difficult to limit our selection to a list of the best. We have focused our list of 10 on the ones that have surprised the market and have resulted in valuation upgrades. [Editor’s note: Do not read the ideas below as stock recommendations. Do further research of your own, or talk to your financial adviser before acting on themes in this article.]

Code	Name	Financial health	Return on assets (%)	Return on equity (%)	Earnings per share growth 1yr (%pa)	Forecast earnings per share growth 1yr (%pa)	Dividend yield (%)
IRI	Integrated Research	Strong	22.05%	39.57%	20.36%	19.14%	5.75%
REA	REA Group	Strong	39.37%	47.28%	24.73%	15.68%	2.07%
WEB	Webjet	Strong	35.87%	58.56%	31.17%	19.63%	3.13%
WES	Wesfarmers	Strong	7.46%	12.32%	16.16%	12.24%	4.87%
ARP	ARB Corporation	Strong	28.06%	34.92%	1.70%	16.15%	2.50%
CDD	Cardno	Satisfactory	10.96%	19.14%	10.32%	16.69%	4.21%
CRZ	Carsales.com	Strong	61.27%	77.27%	22.98%	14.89%	3.37%
CWN	Crown	Strong	10.55%	18.37%	56.67%	9.43%	4.07%
DMP	Domino’s Pizza Enterprises	Strong	19.67%	29.46%	20.09%	31.73%	2.73%
IIN	iiNET	Satisfactory	9.28%	24.48%	11.62%	37.27%	3.88%

Source: Lincoln Stock Doctor. Data at August 21, 2012

About the author

Elio D’Amato is chief executive of Lincoln, one of Australia’s premier fundamental analysis research houses and fund managers, offering intelligent sharemarket solutions for the conscientious investor.

From ASX

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