US markets continued their summer doziness overnight, doing nothing in particular. But in Australia, we’re right in the middle of reporting season. There’s plenty to discuss.
Before I do that, though, just a heads up that, tonight, we’re removing the 67% discount on an annual subscription to my investment newsletter, Crisis & Opportunity.
Frankly, I’m glad. This is a giveaway price and I was none too happy about agreeing to the discount in the first place. So from midnight tonight, you’ll no longer have the opportunity to take out an annual subscription (with money back guarantee) for less than the price of a decent case of beer or a couple of bottles of good wine.
If you’re interested in signing up before the discount offer expires, go here.
OK, let’s get back to it. I thought today I would review some results and look at the market’s reaction, to give you some insight into how the market actually works. It might help explain why stocks sometimes move counterintuitively to the news they deliver.
For example, on Tuesday, BHP Billiton [ASX:BHP] posted a record full-year loss of US$6.39 billion. Write-downs in the value of its US shale gas assets and a US$1.3 billion provision for the Samarco iron ore mine disaster in Brazil were the main factors behind the headline loss.
But weak commodity prices saw underlying profits fall a massive 80%, to US$1.22 billion.
They are horrendous numbers. Yet over the past 10 days, BHP’s share price is up more than 8%. Since bottoming in January at around $14, the share price has jumped a massive 50%.
The simple answer is that all this bad news was already in the price at the start of the year. The market knew the oil price collapse would have a devastating impact on BHP’s shale assets. It had already factored in the US$7.2 billion asset write-down before the company announced it earlier this year.
The market also knew that weak commodity prices would have a large effect on the underlying performance of the company. In short, everyone who wanted out of the stock got out earlier in the year.
Then the bargain hunters came in and started buying up shares. It was a risky play at the time, but it paid off.
Let’s have a look at the share price performance over the past few years. Two years ago, BHP’s shares traded at around $37. By January 2016, they had fallen to a low of $14. That is a lot of wealth destruction in a short space of time. It reflects not only falling commodity prices, but bad investment decisions made by management during the strong point of the commodity price cycle.
It’s important to understand that the market prices in the future, not the present. So when BHP announced its record loss earlier this week, the market had already priced this in back in January.
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The share price has now partially recovered. The market has already factored in better earnings for BHP in the six months to 31 December 2016.
Where to from here for the share price?
Looking at the chart, you really want to see BHP improve on its April high, at just over $21, before getting excited about further gains. And for that, you need to be bullish on commodity prices, especially iron ore.
The market is clearly betting on this outcome, because, from a valuation perspective, BHP looks expensive at these levels. Based on the consensus of analyst earnings forecasts for the current (FY17) financial year, BHP trades on a price-to-earnings (P/E) ratio of 34. This is more than double the market average. Return on equity is forecast at less than 4%, indicating a very low level of profitability for BHP’s assets.
From an investment perspective, it’s hard to get excited about BHP unless you believe oil and iron ore prices will continue their rallies. I don’t have a lot of conviction on this front.
Let’s look at another stock in a similar situation, oil and gas producer Santos [ASX:STO]. On Monday, it announced a $1.05 billion write-down on its newly built Gladstone LNG plant. This is in addition to the $500 million-plus write-down incurred in February.
Moreover, it suggests the asset will operate below capacity for a number of years, which will impact STO’s profitability. In reaction to this, the share price rose…and kept rising in subsequent trading sessions.
Like BHP, STO has had a rough few years, as you can see in the chart below.
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That’s oil price related. It also reflects the poor decision by STO to commit $18.5 billion to building a new LNG plant at the top of the cycle. That capital spending will get nowhere near the returns initially hoped for, and the falling share price reflects this destruction of shareholder capital.
Like BHP, STO doesn’t look ‘cheap’, despite the significant fall in the share price. It trades on a P/E of 18 times forecast earnings for 2017 (STO operates on a calendar year basis), and that’s assuming a decent pick up in earnings next year.
So it’s hard to get too excited about the story from a fundamental perspective. Looking at the chart, though, the share price is bumping up against resistance at $5. If it breaks through this level, it suggests the rally could continue up to around $7, which looks like the next area of major resistance.
If it can’t do that, STO will continue to trade within the narrow range of $4–$5 per share.
STO reports its half-year results tomorrow. The market always looks ahead, so the response to the earnings (which are more or less known) will be interesting to watch.
But the market doesn’t always get it right. QBE Insurance [ASX:QBE] announced its half-year result yesterday; the big fall in profits surprised the market. Soon after the announcement, the share price had plunged as much as 11%.
It turns out that ultra-low interest rates around the world are having a much greater impact than expected. There are many moving parts to an insurance company’s result. This surprise from QBE will only increase the uncertainty surrounding the company’s ability to deliver earnings growth in a low interest rate world. That should keep a lid on the share price for some time to come.
The message is that the market mostly gets it right. But when it’s wrong, negative ‘surprises’ are dealt with harshly. To make sense of the market’s reaction to earnings reports, remember that the market always looks to the future, while earnings tell a story of the past.
For The Daily Reckoning