Reporting flow and election fever

Right now we are a little over halfway through the third-quarter reports, and thought we would share our impressions so far.

If we take a step back, we can see that overall expectations for corporate profits have fallen during the year, and estimates for the third quarter were no exception. The updated projections we received from analysts at brokerage firms in early October showed further downward adjustments. On top of this, a series of profit warnings set the scene for the season. The biggest and most spectacular came from IT company Ericsson, which surprised the market with a grave profit warning for the quarter.

The company showed a record-low gross margin, and sales growth going from bad to worse, and the outlook for the fourth quarter was even more dismal. The explanation for the weak results was an increased proportion of services sales and lower capacity sales, which was not welcomed by the market. Nor was the appointment of Colorado-resident Börje Ekholm as CEO. Investors want to see a new roadmap towards increased profitability, while the risk now is that the company and the board have cemented the current strategy of focusing on growth at the expense of profitability. The share fell sharply on the news, and continued its movement when the report showed that cash flow was also weak.

Shares in competitor Nokia were also hit hard after the company warned of weaker sales for the rest of this year and 2017. However, Nokia's continued stable profitability places Ericsson's earnings collapse in sharper focus, and underlines the unsatisfactory nature of the management's explanation of the factors behind the decline. There was also a severe profit warning from Novo Nordisk, when management halved its long-term profit outlook from 10 percent to 5 percent. Pricing and growth are both weighing heavily on the company's profitability, and although market expectations had already been trimmed this was not enough. A halving of growth obviously has a significant impact on a company's net present value, and its share fell 15 percent on the day.

Once the reports started rolling in, the aggregate has been in line with, or slightly better than, the lowered expectations. Overall, profits have been slightly better while sales have been a disappointment. It is clear that improvements in efficiency and cost control are more important drivers than organic growth.

At the sector level, financials demonstrated strength when all four major Swedish banks beat expectations. Swedbank and SEB were the strongest. Profits were generally of good quality since net interest income was strong, driven by the bottoming out of interest rates. Losses on bad debt were also a positive surprise. Another common theme was for somewhat higher costs than expected. Furthermore, the banks have strong balance sheets with little or no need to increase their capital buffers. This means that dividends are assured for this year, which was welcomed by the stock market. Earnings estimates for the banking sector were upped slightly, and share price reactions were slightly positive after strong performance by banking stocks during the autumn.

In the industrial sector, Swedish engineering companies on average reported lower sales than expected in the quarter, while average operating profit was reported better than expected. North America has generally remained tough, with both investment goods such as oil and gas, and short-cyclical industry (cars, trucks etc.) performing worse during the quarter. Europe moved mostly sideways, which was in line with expectations. China grew, largely driven by the automotive industry. Order intake for mining equipment is the segment that has surprised most positively.

In shipping, the quarter's big news was the bankruptcy of Korea's Hanjin Shipping, which impacted almost 3 percent of the global container fleet. Freight owners were driven to other more secure shippers, and freight rates recovered to the same level as a year ago, or higher. It will take time before Hanjins's vessels find new owners or are chartered out to new freight lines, so capacity will be removed from the market, which will have an impact into next quarter.

The consumer sector followed the general trend of better profits than expected but slightly weaker sales. In consumer and retail, September's warm weather had a negative effect on many companies. HM's sales grew by only 1% in September, which implies a sales drop of 9% for same-stores. Even companies in the sporting goods industry like XXL and Amer Sport showed a slowdown in growth. Lurking in the background is the strong structural shift towards e-commerce, which can sometimes make it difficult to distinguish the different factors from each other. In media, the companies that have reported to date have been better than feared. The Nordic TV market was one of the first and hardest hit by viewers moving to platforms like Netflix, but perhaps this will also be the market that first comes out at the other end and stabilises.

Right in the middle of the reporting flow, building supplies wholesaler Ahlsell was floated on the market in Sweden's largest IPO since Telia. The company is attractively exposed to the strong Swedish construction market, has both structural and acquisition-led growth, a profitability strategy and good margins. The share did well on the first day of trading, which could be seen as a positive indication of underlying risk appetite in the market and an attractive IPO price.

It is clear that we are late in the stock market cycle. For a long time, earnings per share in many companies have been driven by stock buy-backs, cost control and acquisitions, while the underlying organic sales trend is relatively uninspiring. However, stock market valuations remain at high levels, especially for what are regarded as quality companies, making prices particularly vulnerable to disappointments, and there is palpable nervousness in price reactions. Reports that have beaten estimates have been rewarded with relatively modest upticks before falling back a day later, while reports below expectations have resulted in share price slumps of up to two digits. This has been a clear trend in the Nordic region, Europe and the USA. Overall, company reports and outlooks have led analysts as a whole to trim back their estimates for the year, while projections for next year still indicate expected earnings growth of over 10 percent.

We have a couple of months left of 2016, and a lot could still happen. In the near term there will obviously be considerable focus on the US election of November 8, with the outcome still wide open. Brexit will be an ongoing soap opera, but with more emphasis on next year since the UK has not yet triggered its exit. Interest rates are another question mark, and we are very likely in the process of leaving over a decade of falling rates behind us. How smooth will this be? As portfolio managers, we are used to dealing with many unanswered questions and background risks. Choosing our holdings with great care and based on fundamental analysis, and keeping an ear close to the ground, will be even more critical to our future performance

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