Profit reports a mixed bag as volatility bites for underperformers.

While stock watchers are always looking for the next hot tip, experienced investors will tell you there is no more vital time than right after reporting season ends to be across your portfolio.

This is because once a company reports, we witness the fruits of its labour and get an insight into its future.

But at Lincoln Stock Doctor we believe it is the assessment of numbers that is most important. This allows you to make an informed decision about a company's fundamental performance and its current Financial Health.

By the numbers

This year’s 2017 annual reporting season was a mixed bag for investors. One thing that has become more evident over the years, particularly this season, is the level of volatility associated with stocks that miss the grade. This is often irrespective of the quality of the result and/or the price action leading up to the profit release.

Of concern for us is the current Financial Health of the market. With only 27.5 per cent of companies listed on the local market able to boast manageable levels of financial risk, it reminds investors, as highlighted in the chart below, of the minefield that is investing in the Australian market and why many global investors see us as high risk.

There is a slight deterioration in the Financial Health of companies compared to the last reporting season. And with many listed companies either not generating profits or positive cash flow, or lumbered with high levels of debt, we doubt there will be any significant improvement in the coming months.

We caution investors when seeking investment opportunities to avoid companies that do not meet the fundamental grade.

There was a timely reminder in July when the once $5-billion Paladin Energy Limited lost the fight and was placed in the hands of administrators; a company that was last financially healthy in 2004, but years of restructures and business transformation plans finally gave way to financial distress. It all caved in under a wall of debt and trouble.

Tempered outlook statements

Earnings growth this reporting season was solid. Among the ASX 20 the average growth rate was 5 per cent. Looking deeper into the market, of those that have reported at the time of writing, the EPS growth of the All Ordinaries rose about 15 per cent, indicating this was a good year for businesses.

However, it was clear this season that despite the strong results produced by many, several muted outlook statements from boards hit investor confidence – particularly as this comes in an economic environment where business confidence levels are quite upbeat.

The softer guidance may be in response to:

The current sluggish domestic economy. The strengthening Australian dollar negatively impacting foreign earnings. Concerns over a specific industry slowdown, e.g. retail/property. Uncertain legislative direction and shifting policy focus. An attempt to avoid over-heated expectations and thus create unachievable hurdles for the business.

Stocks such as Telstra (TLS), BlueScope Steel (BSL), AMP and Crown Resorts (CWN) all felt the wrath of a disappointed market. Even Domino’s Pizza Enterprises (DMP), which delivered solid profit growth, felt the strain as investors re-rated this once-high Price Earnings (PE) darling to what many, including ourselves, believe are more reasonable and rational levels given the expected future growth profile.

At the time of writing and despite the disappointments mentioned, the market has only tempered growth expectations by about 0.5 per cent. It will be interesting to see how this plays out over the coming months.

Last year the market was decidedly dovish in its outlook statements as concerns started to rise over Brexit and an eventual economic slowdown in China. None of these events, not even a subsequent Trump election win, were factors in the fundamental results of our businesses this year. If this were to happen again, then muted comments around outlook could form the basis for future upgrades.

But a fact of investing life this reporting season has been the enhanced volatility. One reason is the market’s average PE trading above its historical average.

A high PE would have suggested that optimism did abound, with many investors willing to step up to the plate to acquire companies at levels where nothing short of delivering on expectations would suffice.

Following the earnings season, our market is now trading on a forward PE of about 16.07 times, which is still above the long-term average of 13.8 times. This means that the risk of short-term volatility remains elevated.

Last year at this same time we saw a similar picture develop where many high PE stocks were eventually punished when they came out with muted business updates at their AGMs or, in some cases, only a few weeks afterwards.

Investors will be hoping this trend does not happen again in 2017. Rather, the market will be hoping for earnings upgrades across the board to sustain the premium paid on the market.

What it means for the market’s future

At Lincoln Stock Doctor, notwithstanding the above, we are optimistic after this reporting season about the market for the coming financial year.

Our perennial and unwavering faith in the market comes from the fact that there will always be great businesses to invest in. And, when volatility again rears its ugly head, we will use the opportunity to snap up some bargains. Or, as was the case with the GFC, pick up stocks at once-in-a-generation levels.

Setting aside our burgeoning optimism for a moment, economic and funding conditions remain accommodative and should not put stress on businesses. The global economy continues to power ahead, with a rising interest rate cycle overseas – a sign of a global economy on the move.

Therefore, we believe that businesses with global exposure are ready to reap the rewards of a rapidly improving global economic outlook.

Further regarding interest rates, although long-term bond rates have started to trend upwards, in our mind there is still a compelling case for income investing over the next 12 months as the gap between dividend and the bond rate is still large, despite a brief closing in the past six months. This bodes well for our banks and Australian Real Estate Investment Trusts (A-REITs), which have enjoyed a nice run in the past six months.

10 top stocks from this reporting season

As always there were some stocks that excited us fundamentally. The following were a list of Stock Doctor “Star Stock” recommendations that we held in our portfolio leading into the reporting season. While some spiked on the day of their result, others were sold off, unfairly in our opinion, and have since recovered.

As with any stock decision, you need to consider your own personal objectives and tolerance to risk. Be sure to do research and have a well-defined investment strategy that will allow you to act with discipline.

Star Growth Stocks Code Status Health Forecast return on assets % Forecast reveue growth % Earnings per share (EPS) growth % Aristocrat Leisure ALL Star Growth Strong 24.5 15.2 32.1 Cochlear COH Star Growth Strong 28.4 11.4 10.7 Credit Corp CCP Star Growth Strong 19.6 17.1 20.3 Fisher & Paykel Healthcare FPH Star Growth Strong 25.9 16.9 12.0 MNF Group MNF Star Growth Strong 14.7 10.3 32.6

Star Income Stocks Code Status Health Forecast EPS (cents) Forecast annual dividend per share (cents) Forecast gross div yield % Adelaide Brighton ABC Star Income Strong 29.6 20 4.9 ANZ Bank ANZ Star Income Strong 240.1 160 7.7 Arena REIT ARF Star Income Strong 13 12.9 5.8 Charter Hall CHC Star Income Strong 36.3 31 5.6 Rural Funds Group RFF Star Income Strong 13.4 10 4.9

Source: Lincoln