CEOs behaving badly weigh on company profits, investor outlook
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Issues around company stewardship were prominent during the most recent earnings season, as some blue-chip stocks reported results at the same time as news headlines swirled about issues of CEO misconduct.
While QBE Insurance (ASX: QBE) and Seven Group Holdings (ASX: SVW) were at opposite ends of the spectrum in terms of their half-yearly earnings--QBE reported a $898-million net profit while Seven Group is $42 million in the red--their senior executive teams were united in both facing relationship scandals.
Seven's issues surrounding Seven West (ASX: SWM) CEO Tim Worner's inter-office affair with former staffer Amber Harrison has been widely reported in recent months, and were again raised in its results briefing with analysts and media last month. (Seven Group holds a 41 per cent stake in Seven West.)
In the case of QBE CEO John Neal, news of his "unacceptable" relationship with a personal assistant to his executive team emerged at the same time as it reported its results--somewhat overshadowing its strongest profits in several years.
John Murray, managing director of fund manager Perennial, referred to this in a media briefing last week.
"As value investors, the disconnect [in the correlation between underlying profits and share price] is where the share price falls way below where we think the earnings should be, and that can occur for a whole host of reasons. One of those can be the whole stewardship issue, and I think Seven West and QBE are good examples of that," he says.
Murray highlights the position Perennial holds in terms of the correlation between company earnings reporting and its broader outlook on company performance.
"I think the biggest issue is around expectations. If we as analysts are anticipating a company is going to make a profit of $100 this year, and the company announces $110, the share price will rerate very sharply."
Deliver, or else
Murray points to a basket of Australian stocks that have some of the highest PE ratios.
"While up until six months ago, these stocks continued to outperform, we never understood that. But of course, the problem is, when a stock becomes priced to perfection, it doesn't take much to go wrong, and suddenly share prices can get not just hit, but hammered," he says.
"Whilst it hurt us for a while not being invested in those stocks, it's now sort of coming to pass ... yes, they've come off a long way.
"If earnings comes out at $80, the share price is hammered…that's where that group of stocks there, the high PE ones, every six months they've got to continue to optimise earnings because the expectations of a high rate of earnings growth are just so high."
He emphasises the value of taking a more contrarian approach, because "generally, short-term earnings disappoint for short-term reasons ... therefore, you have to have a long-term outlook."
"If we're clever about this, and on top of it leading into profit results, we can move quite quickly," Murray says.
Centralised control of companies is another stewardship issue of which he is mindful.
"As a minority shareholder, we've always got to consider the pluses and minuses of investing in companies that are centrally controlled ... so when you think of Westfield (ASX: WFD) with the Lowy family, or Premier (ASX: PMV) with Solomon Lew, and Crown's another one, one of the questions you've got to ask yourself is, 'How aligned are our clients' interests with those of the major holder?'" Murray says.
"The conclusion we've come to with those recent management changes, and this restructuring [at Crown Resorts] ... I think the minority alignment with Packer [has] the sort of focus we like to see with companies, to maximise shareholder return, core dividends ... all those things I think have intensified.
"I think the move to bring John Alexander in will prove to be a very positive thing. We see a lot more upside in Crown Resorts (ASX: CWN) over the next couple of years," he says.
Are we nearing an inflection point?
In watching the outcomes of several consecutive earnings seasons, Perennial has observed a trend of companies paying out higher dividends to investors.
As at the end of the first half of fiscal 2017, aggregate dividends rose by 6 per cent year on year, according to CommSec research. It also found 89 per cent of companies (120 of 135) paid a dividend, and of these, 69 per cent increased dividends.
"Dividend flows are continuing, and that's fantastic for shareholders, but there's always the issue of how much does a company pay out as opposed to reinvesting," says Murray. He questions whether this trend may be about to reverse.
Perennial portfolio manager Stephen Bruce says: "Over the long term, companies that have paid out more often tend to end up with better return outcomes than companies that don't, which is somewhat counterintuitive."
"When you're reinvesting every cent that you earn, you're often reinvesting it poorly. So companies that have a bit of discipline around paying out a reasonably large part of their earnings, they by definition reinvest in better quality areas."
He suggests an inflection point could be emerging, as the changing interest rate environment and other factors combine to encourage a change of tack from management teams.
"Over this period, where there hasn't been a lot of need for reinvestment because company top lines have been soft, they've been paying out a lot of dividends and buybacks, but I wonder if we are getting to the point where companies are going to need to start reinvesting to grow.
"Will the market in fact start to put more investment into projects instead of just handing back the cash? I think that will come in handy, should interest rates start rising ... will the market start asking for companies to reinvest again?"
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Glenn Freeman is Morningstar's senior editor.
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