Corporate earnings impressive, time to start bottom fishing?

DNH Financial Ltd. last week said that corporate earnings released so far look impressive but the bourse has not performed compared to strong earnings generation. The broking firm also suggests time is right for investors to go bottom fishing. Here are excerpts from DNH’s Weekly Report:

The Colombo bourse ended the week on a relatively quiet note with the ASPI declining by just 0.14%WoW to close at 6348 while the MPI also ended the week a tad lower at 5662 (-23% WoW).

Notwithstanding several strong 3Q2011 results, investors opted to remain on the sidelines waiting for market valuations to decline even further before stepping in. Reflecting the inertia in the market, weekly turnover declined to Rs. 2.7 b.

Losers outpaced gainers with SMB Leasing(X), People’s Finance (W) and AMF Co Ltd. declining by 12.5%, 11.6% and 10.7% and offsetting gains in Infrastructure, Citizens Development and Agalawatte Plantation, which rose by 171.8%, 20.9% and 20.5% respectively.

Market Performance

Global markets meanwhile traded in positive territory after Europe announced its latest plans to rein in the region’s credit crisis which included a 50% write down on Greek Government debt held by private bondholders and a boost to the EU bailout fund.

What is remarkable to note is that even though the earnings story appears to be getting brighter and brighter, market activity remains relatively constrained. The dichotomy has consequently resulted in a decline in valuations for several fundamentally strong companies.

However, the critical question remains as to what level valuations may need to fall in order to trigger buying interest? We believe that current valuations provide the ideal opportunity for investors to generate above average returns in the medium to longer term taking into consideration our firm belief that the current market PE of16.5X does not fully reflect the valuations of a number of fundamentally strong stocks which are now trading at multiples well below 10X.

With the price of relatively lower quality companies having risen to considerably high levels during the 2009/2010bull run, an opportunity to invest in companies of superior fundamental value now exists with significant upside potential of reversing relative underperformance. And as we move deeper into the third quarter, valuations should continue to decline for such companies thereby justifying our bull case for equities even further.

3Q2011/2Q2012earnings growth exceeds 102%

Even though it has been only a limited number of companies that have released their 3Q2011/2Q2012 earnings, the majority of the results have been exceptionally strong led by the Auto sector.

Both DIMO and United Motors have recorded a 175% and 318% jump in earnings during the quarter in turn driving down their valuations significantly lower. Economic growth in the country appears to be benefiting not just from heightened consumption by the middle class but also by ‘luxury’ consumers who remain undeterred in their spending patterns despite global recessionary woes.

A quick glance at the 2Q2012 corporate results of DIMO(which has the distributorship for Mercedes cars in Sri Lanka) indicates that luxury car sales in Sri Lanka has completely bucked global recessionary woes achieving triple digit revenue growth during 3Q2011 and crossing the Rs. 10 b mark (+102%YoY). While we do contend that global luxury car sales have also been on an upward trajectory spearheaded by growth in Asia, luxury car sales in Sri Lanka has however significantly outperformed.

The story so far is highly encouraging

Top line revenues have 3Q2011/2Q2012 confirming the robustness of the domestic economy and the consumption cycle notwithstanding headwinds in the global markets. Overall earnings are up 102% so far for 3Q2011/2Q2012

Consolidated operating margins have improved by 10% during the quarter on the back of improved operating efficiencies, reduction in financing costs and tax reductions.

On a sector basis, in addition to Autos, we are buyers of other sectors which have a strong domestic theme such as Industrials, Diversified and Banking that will benefit from firm volume growth, pricing power and lower gearing levels enabling the majority of the companies in these sectors to beef up margins, achieve solid earnings growth while generating sustained cash flow.

While we continue to favour leisure stocks on the grounds that the sector now appears to be deriving a considerable portion of its revenues (F&B for instance) from relatively sustainable local guests in addition to strong foreign tourists, we remain underweight on the Telcos which may report only mediocre top line growth owing to likely downward pressure on margins as a result of intense price competition.

Tourist arrivals compete head to head with Maldives

While reputed international hotel chains such as Sheraton, Raffles of Singapore and Double Tree (of the Hilton group) have shown interest in setting up hotels in the country signalling the strong confidence in Sri Lanka’s leisure sector, tourist arrivals to Sri Lanka appear to be on track to hit record levels this year.

Arrivals during the first nine months of the year recorded 598,006 (+34%YTD) and growing at current rates the number could exceed that of the Maldives which has recorded arrivals of 669,172 during the same period.

With traffic expected to continue to surge during the current quarter, we expect tourist numbers to meet (perhaps even exceed) the Government’s full year target of 800,000.

3Q2011/2Q2012 blue chip results will determine market trajectory

While we do agree that the bourse has not performed when compared to its strong earnings generation, the good news is however that the relative fall from grace could be red meat for hungry bottom fishers looking to ride the next rebound. Declining market turnover levels clearly indicate that investors are likely to have depleted their selling spree giving the opportunity for bottom fishers to step forward.

With the majority of the 3Q2011 results yet to be released, we expect the market to trade largely sideways in the immediate term. An upward movement is however expected once the larger blue chips announce strong quarterly results which should exert solid upward pressure on market trajectory.