Why you can’t ignore key financial indicators this reporting season

With central bank policy and record low interest rates no longer propping up corporate earnings, investors will by default, have to place greater emphasis on key fundamentals this reporting season.

While commentary will be king when companies release their full FY22 results next month, investors are expected to take greater care kicking the tyres on key financial indicators - especially the company’s balance sheet – which in recent years have been conveniently overlooked.

With free cash flow likely to be pressured by rising costs, balance sheet issues, which investors previously ‘let-go-the-keeper’ – while all stocks benefitted from upward momentum - will again be front and centre.

Why refocus on fundamentals

For many investors who relied on momentum in years past, a greater focus on fundamentals will go some way to deciphering how much of this year’s pain is already priced-in to stocks - most of which now look decidedly undervalued.

Like it or not, a strong balance sheet is an important predictor of future success, especially now, when companies need the ability to sustain themselves through some tough times.

Key fundamentals to keep an eye on this reporting season include:

Return on equity (ROE) and net-debt to equity, plus qualitative indicators like management capability, earnings sustainability and a company’s competitive advantage, to name a few.

What to expect

Beats typically exceed underperformers at reporting season 60/40, and despite miserable returns on the ASX, local investors may take some solace from US corporate earnings season which is faring a lot better than expected - with consumer spending holding up well.

But in light of recent macro events this year, including a war in Europe, covid-related labour shortages, supply chain issues, and disturbingly high oil prices, August reporting season won’t been seen through rose coloured glasses.

Nevertheless, with a lot of bad news already priced-in, consensus still expects ASX 300 earnings per share (EPS) growth of 10% in FY23.

What’s also more acute this reporting season in the amount of value on offer.

At face value, the Australian market PE ratio "may seem cheap" on 13.3 times 12-month forward earnings, while resources and industrials are trading on 7.5 times and18 times respectively.

Sectors in the crosshairs

While the earnings of health care, staples, REITs, Telcos and utilities sectors are expected to hold up relatively well, that’s not the case for resources with most brokers quick to factor in earnings per share (EPS) falls.

For example, while JP Morgan expects reporting season to be relatively unkind for resources, the sector’s fortunes are expected to improve on the back of China’s re-opening story later this year.

With consumer discretionary spending having held up reasonably well, some stocks in the travel-related sector have the potential to surprise on the upside.

However, when it comes to retail the narrative is quite different.

Discretionary spending could surprise

Analysts at Barrenjoey recently cut their retail outlook on the back of an expected cooling off in discretionary spending.

In light of challenging macro headwinds, Barrenjoey has warned investors to prepare for lower profits from discretionary retailers, especially electrical and furniture categories.

“We’re seeing early indicators of softness in CBA credit & debit card spending data, with discretionary spending on recreation, clothing & footwear, and household furniture & equipment trending slightly down and increased spending on eating & drinking out down from a peak,” the financial services firm noted.

Stock specific

After applying multiple filters to identify which companies within retail represent value at present, Jarden screens generated a positive outcome for Woolworths (ASX: WOW), Flight Centre (ASX: FLT)Domino's Pizza (ASX: DMP), and Accent Group (ASX: AX1).

By comparison, stocks that screened negatively included Harvey Norman (ASX: HVN), JB Hi-Fi (ASX: JBH), Nick Scali (ASX: NCK), Super Retail (ASX: SUL), and Beacon Lighting Group (ASX: BLX).

Given their defensive earnings and ability pass on costs, Barrenjoey’s top picks are supermarkets Woolworths (mentioned above), Coles (ASX: COL) and Metcash (ASX: MTS) in the large cap space, while youth apparel names like Lovisa (ASX: LOV) and Universal Stores (ASX: UNI) are also favoured.

Morgans expects two local stocks within the listed gambling sector: Jumbo Interactive (ASX: JIN) and Tabcorp spin-off The Lottery Corp (ASX: TLC) to report strong growth numbers in August, and strong growth in FY23.

Woolworths is one stock brokers expect to fair well within a lower earnings environment.