The JSE All Share (ALSI) Index earnings per share are growing again. As the chart below shows, nominal earnings are now back at the record levels of 2012, while real earnings and earnings valued in US dollars (at current exchange rates), while increasing,still have some way to go to get back to their peak levels of 2007-08.
The level of JSE ALSI earnings has been assisted by a very strong recovery in the earnings reported by JSE listed Resource companies for the period ending 31 December 2013, off a low base. We show the cycle of JSE Resource Index earnings per share below. The annual growth in these resource earnings is highly variable.
Trailing earnings had declined by as much as 40% on a year before by mid 2013, before their recent recovery. They had previously recorded over 80% growth in their recovery from the global financial crisis. Reported JSE Resource earnings are now increasing and in positive growth territory compared to a year before. These growth rates are gathering momentum of their very low base, helped by the still weaker rand and (hopefully) less disruption of mining output by strike action.
It seems clear that the share market typically anticipates the earnings cycle to some degree. Share prices hold up better than earnings when earnings are falling and when earnings pick up again share prices lag behind. In other words, the earnings are expected to follow a consistent cycle of periods of above and below normal growth rates. They are expected to recover to something like normal when earnings are most depressed and the earnings cycle is at its trough and to fall away back to normal when growth rates have peaked.
A consistent pattern of prices anticipating earnings shows up in the price to earnings multiple attached to resource earnings. The multiple tends to rise in the downswings of the earnings cycle and in to decline in the upswings. We show below the PE ratio for the Resource Index. The PE multiple was at a low point in early 2009 after the post crisis peak in the earnings cycle. Thereafter the PE multiple rose rapidly, even as earnings continued to decline to a negative growth rate of minus 40% p.a. in mid 2010. Then, after the reported earnings had again assumed a strong upward trajectory (reaching a peak of 80% p.a. growth by mid 2011), the PE multiple fell away sharply to a trough in mid 2012. Then the PE multiple recovered strongly as Resource earnings again fell away, having fallen by over 40% by mid 2013. This PE multiple, after rising in 2013 as earnings fell away, has now fallen in early 2014, with the recent uptick in reported earnings.
The crisp question then for investors looking for good returns from Resource stocks is whether or not the growth in resource earnings will be fast enough to overcome a declining PE multiple attached to these reported earnings? As we show below, the severe decline in the PE multiple from its peak in early 2010 was accompanied by positive returns from the Resource sector for a further 12 months – the growth in earnings over this period compensated for the lower value attached by the share market to these reported earnings. Something like this may well happen again: as the PE multiple recedes back to something like normal, the improved earnings may help improve absolute share prices.
The key issue then is the outlook for resource earnings themselves over the next 12 months. Based on history Resource earnings do have a tendency to normalise as the share market appears to expect it to do. We provide below a measure of normalised or cyclically adjusted Resource Index earnings.
This is calculated using time series forecasts based on the previous ten years of monthly data that is rolled forward every month. Our cyclically adjusted earnings are a time series best fit. We suggest that this measure provides as good an approximation of trend or normalised earnings expected by investors as can be derived by statistics. Reported and normalised Resource Index earnings are represented in the figure below over the long run going back to 1980, using 10 years of data going back to 1970 to generate the first estimate for January 1980 and then rolling the forecast forward for each month thereafter by dropping a month and adding one. We also show the results of this exercise close up for the period 2008 and 2014.
Reported Resource Index earnings are currently well below the normalised measure. If earnings do in fact trend back to these normalised levels they still have a great deal of catch up to do. That is, from R2000 of reported earnings per Index share to R2800, a potential increase of 40%.
Such an increase would, as we have shown, not be out of line with past performance and would provide scope for good returns even if the PE multiple falls away. This growth in earnings however is by no means predetermined. It will be dependent on some known unknowns, such as the value of the rand over the next 12 months as well the ability of the mine managers to sustain or even increase output and to control costs.
The rand / US dollar exchange rate, were it to strengthen, would not necessarily be a threat to Resource valuations. If the rand strengthens it may reflect a growing appetite by global investors to take on emerging market and commodity market risk. They would do so if the outlook for global economic growth improves and therefore becomes more promising for emerging market exporters and the prices they are expected to realise for their metals and minerals.
A stronger rand may well be offset on the revenue line of mining companies by stronger commodity markets and higher US dollar prices.
The rand may also benefit from improved SA specifics, in particular a resolution of the strike threats and action on the mines that so damage exports from SA, without the mines having to accede to costly wage increases. It is not the rand hedge qualities of the SA mines that will determine their long term value to shareholders. It will be their ability to generate a flow of earnings, or better still a flow of US dollar earnings, that will be decisive in the long run. In other words, the mine managers through good fortune (strong growth in China) and excellent cost management may prove that they are able to send the underlying long term trend in normalised earnings in a strongly upward direction.