THIS week’s business headlines were focused on brokerage reports for the recently concluded third quarter (Q3) results season as the reporting window for quarterly period ended Sept 30 just ended the previous Friday.
One conclusion we can make for the quarterly period was that Corporate Malaysia’s results were clearly a surprise – not to the upside, but hugely to the downside.
This was the quarterly period where Malaysians enjoyed two months of tax holiday due to the abolishment of the Goods and Services Tax (GST) and one month into the introduction of the Sales and Service Tax (SST), which came into effect on Sept 1. It was at a time where Malaysia’s Consumer Sentiment Index posted a reading of 107.5 and although down steeply from the euphoria generated from Pakatan Harapan’s victory at the polls, it is still in an expansion mode as the reading was well above 100.
In addition, despite the country’s GDP expanding by 4.4% year-on-year (y-o-y) during the quarter, which was below expectations mainly due to the supply shock in the commodity sector, quarterly earnings came in way off the line.
Forget about the one-off reasons why earnings were significantly higher or lower for companies like Telekom Malaysia, Genting or even FGV, but just looking at the core earnings and as pooled by the research houses, Q3 earnings, on average, dropped on all counts. Third quarter earnings fell by 6.2% q-o-q and 8.3% y-o-y respectively. Worse, the Q3 performance was so bad that net earnings growth for the first nine months of 2018 has now turned negative 1.9% y-o-y.
Are we still surprised that the market is not doing as well as we think it should?
Third quarter earnings season came in at a time where most companies would already have the half-year report card in the bag and hence the Q3 period would see much better accuracy in terms of whether the company’s earnings met expectations or otherwise.
But, alas, it was not the case, yet again, as the number of companies that disappointed the market was 2.9 times more than those which surprised the market. This is the average among the eight brokers that was tabulated and taking into consideration only normalised earnings.
As a result, downward revisions in earnings growth were inevitable as net earnings for the markets were slashed by 3.1 percentage points (pps) for 2018 to just 0.5% while earnings for 2019 was reduced by 2.5 pps to 5.1%. Again, this is the average among the eight research houses but interestingly three research houses were already looking at negative earnings for 2018 while for 2019, earnings growth for one research house is only at 1.5%.
The hard part in any post quarterly results season is the changes in the market call, especially with respect to FBM KLCI targets, taking into consideration the earnings momentum as well as relative values of the market vis-à-vis the region.
With just a little over three weeks to go before year-end, research houses have placed a closing FBM KLCI value at between 1,704 and 1,750 points or at an average of 1,735 points, which is an upside of 3% from Thursday’s close of 1,683. At 1,735 points, the FBM KLCI is valued at about 16.9x 2018 PER multiple based on research houses’ average estimate, which is indeed very rich for a market that expected to experience earnings growth of just 0.5% on average this year.
For 2019, based on research house estimates, the FBM KLCI’s fair value is between 1,674 and 1,830 or an average of 1,774 based on forward PER ranging between 15.4x and 17.4x. Is this fair value a fair assessment of the market when earnings growth is now projected at only 5.1% on average?
This is obviously by no means a herculean task for companies to report given that earnings growth over the past five years coming in, at most, at about 0.7x GDP growth. Hence, with the GDP in 2019 expected at about 4.9%, taking this 0.7x multiple, the projected earnings growth in 2019 is probably in the region of just 3.4%, which is a third lower than the market is presently expecting for next year.
It is likely, as it had been happening over the past five years, research houses will begin to trim their expectations after the release of Q1 and Q2 earnings in 2019 and along with it, the fair value for the FBM KLCI.
But interestingly, the market doesn’t wait for research houses to cut their estimates as the market would probably react much earlier as how it has behaved over the past few months, especially after some major index-linked stocks reported poor quarterly earnings.
Let’s face the fact, our market is not cheap, judging by the current PER multiple it is trading at. Worse, if we were to compare with other Asian ex-Japan bourses, the FBM KLCI is trading at a significant premium. At 1,683 points, according to Bloomberg estimates, the FBM KLCI is already trading at 16.7x for 2018 earnings and at a premium of 20% to the region’s simple average PER of 13.9x.
With earnings momentum likely to be just 3%-4% in 2019 at best, is the current year’s 16.7x multiple justified?
Historically, the premium that the FBM KLCI has enjoyed over the regional peers is 5%-15% and if we were to take a premium of 10%, the appropriate multiple for FBM KLCI’s 12-month forward earnings is about 15.3x forward PER. At this multiple, the FBM KLCI should be fairly valued at 1,540 points for this year and implying earnings growth of about 3.4% in 2019, the FBM KLCI’s fair value 12 months forward should be about 1,600 points. There is indeed a 5% downside risk for the market in 2019.
With the current market volatility and concern of potential recession in the horizon, a pullback on the market is not totally unexpected, more so since the FBM KLCI has been one of the outperformers this year, falling 6.3%, outpacing the Asia ex-Japan average by 3.2 pps year-to-date.