Mark Lister, 25 July 2017

The August reporting season will see many listed companies share their latest financial results. This is shaping as a crucial time for the local market, which posted its strongest first-half performance since the NZX 50 Index came into being in 2003.

There’s nothing more important for share prices than the underlying trends in corporate earnings. Many other factors have an influence, including investor sentiment, economic conditions and government policy. However, the single biggest driver of a company’s share price is what that company is earning, both today and in the future.

When trying to figure out if shares are expensive or cheap, we can’t just look at what the price is doing. Investors must pay close attention to where profitability and cash flows have been heading.

Take the US sharemarket. It’s up more than 10 per cent this year and the major indices are at record highs. Must be overdone and due for a fall, right? Maybe, but not necessarily.

March-quarter reporting saw US corporate profits rise some 13 per cent, the best performance since 2011. The June quarter is shaping up pretty strongly too, certainly better than many had expected.

This strength in corporate profits has surprised people, and we’ve seen the earnings revision ratio turn positive for the first time in six years.

While US share prices are higher than they were some months ago, they’re actually slightly cheaper because profits have risen faster than share prices. Investors are paying less for each dollar of earnings than they were in February, so “higher” doesn’t always mean “more expensive”.

For an example a little closer to home, consider Auckland Airport, a cornerstone of many portfolios. It’s been a stunning performer in recent years, and at around $7 the share price is up some 182 per cent compared with five years ago. If you add in five years’ worth of cash dividends the returns are higher still, at about 234 per cent.

That sounds spectacular, and it is, but the company’s earnings have been going up strongly too. In 2016 Auckland Airport earned 18c of profit for every share on issue, some 134 per cent higher than the 8c of profit per share from five years earlier.

Most analysts will say Auckland Airport shares are fairly pricey, and I don’t disagree. However, you could also argue that about three-quarters of the share price strength during this period is due to genuinely improving fundamentals.

Markets are expensive, with New Zealand share prices sitting very close to all-time highs. Meanwhile, there is a long list of things that could derail our ageing bull market, including political uncertainty, central bank policy changes and high debt levels.

Despite all those worries, what matters most to investors are the cold, hard cash-flows businesses are generating. The coming reporting season will either vindicate the strong share prices, or tell us they’ve got ahead of themselves.

This article was published in The New Zealand Herald on Tuesday 25 July 2017