By Shaun Cochran
In our commentary provided to this paper last month we suggested that we had reversed our August through to October bullishness because markets had rallied significantly and investors seemed to have abandoned their previous cautiousness.
The question we asked then was: what had really changed with the arrival of the then latest, albeit substantially more aggressive, round of European bail out proposals? Today it seems that the market is now beginning to return to this question with gusto.
We do not believe the current weakness is transitory. Europe is descending into recession, there is every likelihood that the U.S. will follow and we, investors in Asia, should know from our Asian financial crisis experience; until solvency issues are addressed a debt crisis cannot be over. Batten down the hatches; we are entering the second and painful phase of the bear market.
In October, we were providing investors with analysis of how Korean earnings have behaved during previous recessionary periods. The value of this process for us was that it offered a reminder that corporate profit margins are a critical metric to watch. This is because they typically lead the absolute profit cycle. To that end the recent results are particularly valuable in trying to assess the most likely direction of the business cycle.
Our recent detailed review of third quarter results was not encouraging in this regard. Numbers declined quarter-on-quarter at all levels, in terms of revenue, operating profits and net profits. This is a rare event, particularly for the seasonally ‘best’ third quarter. In fact, these results were consistent with recessionary bias. Importantly this does not necessarily mean Korea will descend into recession. We see this slowdown as led by the developed world. However, Korea’s large companies are so tightly integrated with global growth, it is inevitable we will see it swiftly in their earnings.
The all-important margin trend is confirming the expectation of continued weakness. For the companies we are following and that have reported to date, margins declined 80 basis points at the operating profit margin (OPM) level and 230 points at the net profit margin (NPM) level (they should be climbing). As we have pointed out, third quarter is typically the best quarter of the year and rarely down compared to a quarter-ago period, yet it was down 38 percent this quarter on results reported to date. This does not bode well for full year profit given that the fourth quarter is reliably the worst quarter having been down quarter-over-quarter in eight of the last nine years or 88 percent of the time.
Not surprisingly these results were for the most part below consensus. The ratio of misses to beats was over two to one for all levels of the profit and loss (P&L). The largest misses were at the net profit line though we should acknowledge that currency played a meaningful but temporary role for many companies.
The natural result is that consensus is coming down. Thus the frequent misses for reported results were paralleled by a clear and proportional bias from analysts to downgrade their forecasts. Interestingly, there was little sign of analysts seeing these misses as temporary as we defined forward consensus as 2012.
Historical trends suggest the four quarter is almost guaranteed to come down versus third quarter, suggesting a disappointing final 2011 result which will establish a low base for 2012. Thus our starting assumption of a developed world led recessionary bias remains very much intact.
We had been assuming that the third quarter earnings would be 5 percent below the second quarter level. With the majority of the results now released it is tracking towards almost a 10 percent fall. We continue to believe investors should be reigning in risk. An opportunity to buy with limited downside will present itself, however we doubt we are there yet.