An analysis of profit trends and surprises in Profile's Results & Earnings shows that fundamental conditions are not yet right for a new bull run in equities. But it could be coming soon writes Nic Oldert of Profile Media.

Investors watching the JSE for the right time to move back into equities should pay attention to company profits and profit expectations.

Notwithstanding the JSE rally over the past six months, investors are not betting strongly on the JSE at the moment. For proof of this statement, look no further than the recent quarterly statistics from the Association of Collective Investments – more than 63% of all assets under management by unit trust companies are in fixed interest and money market funds.

A change in sentiment needs to be supported by company profits. Strong performances are needed in the next few months to maintain the welcome surge in equity prices seen in recent months.

A rising equity market is sustained by strong profits from listed companies and by expectations of higher profits in the future -- especially in the early stages of a bull run. (Near the end of a bull run, the rising market is sustained purely by expectations of rising prices. It is such price-based expectations, devoid of fundamental foundations, that lead to market crashes.)

The lacklustre performance of the JSE over the past two years is not surprising when you look at actual profits declared by listed companies in relation to profit expectations.

Downside Shocks
Downside shocks defeated upside surprises by six to four during the third quarter of 2003. In other words, for every four companies that beat expectations, six disappointed the analysts. The "average" surprise was negative whichever way you look at it.

There are a number of ways of calculating the "average" earnings surprise or shock across a sample of companies. One way is to average the reported HEPS for each company and to compare this with the average of the forecasts for the same sample. But using actual HEPS skews the average in favour of companies with high share prices. ASMANG, with earnings of R57 per share, has considerably more impact on the sample average than AVGOLD, with earnings of 3.8 cents. In fact, if a single high-priced share finds itself alone amongst small caps in a reporting period and it also happens to have produced a major upside surprise, its performance will completely overshadow any other numbers.

Using this method (let’s call it the average earnings method), the 39 companies which reported in the third quarter and which are suitable for trend analysis disappointed analysts by nearly 9%.

Another method is to average the percentages (ie, to average the percentage change of each share’s actual vs forecast variance). This has the opposite problem: it potentially skews the average in favour of a small cap which has produced a major surprise or shock. This is particularly so because there is a small but definite negative correlation between magnitude of shock or surprise and share price (that is, a penny stock is more likely to produce a big percentage difference between actual and forecast than a heavyweight).

Using this method (let’s call it the average percentages method) the companies in Table 1 underperformed analysts’ expectations by 3.6%. Table 1 excludes 29 researched companies that reported during the third quarter which were excluded because of single forecasts or corporate changes. If these are included, the downside shock climbs to about 12% using the average percentages method, and to about 11% using the average earnings method.

All of these figures are based on a comparison of actuals and the last forecasts made before the release of results. If the comparison is made between forecasts of three months earlier and actual reported results, the downside shocks are much worse, rising to 14% for the sample of Table 1, and to 17% including the (more dubious) variances of the excluded companies.

Either way it is clear that companies are not producing the profits that analysts want to see. That means that investors, big and small, are not getting the earnings (and possibly not the dividends) that analysts had suggested they might. If you accept the proposition that, over time, average market P/E values will always tend back to a long-term mean, then, all things being equal, downside profit shocks tend to mean lower share prices.

Of course, one question remains: were analysts just being over-optimistic, or were forecasts for third quarter results realistic?

Using the average earnings method, the answer is no – forecasts were 24% lower than the prior year actuals for the sample of companies in Table 1 if you average the earnings. If you average the percentages, though, it looks like analysts were smoking something strong – using this method, expectations were 48% up on prior year actuals.

But the earnings average method is a better indicator at this point. The average percentages method is skewed by a few special cases, such as Comparex, Frontrange and Avgold, which showed losses in 2002 but returned to profitability this year, giving huge percentage changes on forecasts vs prior year actuals. If these are excluded (along with outlyers Iscor and Panprop), the forecast increase using the average percentages method is around 2%.

Both methods therefore suggest that analysts were not, on average, being overly optimistic, and that the downside shocks mean that SA business is not yet achieving levels of profitability needed to sustain a stock market boom.

Profit Forecasts Decline Again
For the 12th quarter in succession, analysts lowered their profit forecasts in the three months to end September for companies due to report in the next 12 months. Compared with three months previously, profit forecasts dropped 6.9% on average.

Looking at the main sectors, Cyclical Services stands out as the only bright spot with a +7.1% upward re-rating. This small bit of optimism, however, is overshadowed by harshly lowered expectations for Financials (–17.4%), Information Technology (–12.2%) and Basic Industries (–10.8%).

An examination of the sub-sectors reveals the extent of negative sentiment. Steel marked down 45%, mainly due to a 77% downgrade for Hiveld. Specialised Other Finance cut back 71% on a –215% revision for BJM, a –69% for thumbs down for AMB, and –57% frown for Peregrin.

Leisure & Hotels, marked up 32%, are one of the few areas of optimism, mainly due to a massive 146% upside re-rating for Kersaf. Oil & Gas also enjoyed a thumbs up (+11%), mainly due to a 26% upgrade to profit expectation for Energy Africa.

Click here to see the version of this press release published in the Sunday Times Business Times.

EDITORIAL CONTACT

Profile Media
Nic Oldert
(011) 728-5510
njo@profile.co.za 

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