By Elio D’Amato, Chief Executive Officer, Lincoln

"Only when the tide goes out do you discover who's been swimming naked." - Warren Buffett

On the beach, the tide normally happens twice a day. In the sharemarket, companies normally report their earnings twice a year. And like a tide revealing the general detritus and naked people of the hitherto shallow waters  - to extend the analogy of our investing hero Mr Buffett  - reporting season offers a voyeur's delight of corporate successes, failures, outlooks and signals.

At the start of this month, of the 31 companies which were Stock Doctor Star Stocks leading up to the reporting season, 23 remain on the list. That means that 23 companies with a market capitalisation above $100 million once again reported solid earnings per share growth (EPSG) of greater than 8 per cent; delivered a return on assets (ROA) of at least 8 per cent on an annualised basis; and met our stringent criteria for Financial Health across the areas of balance sheet, cash flow and profit statements.

Reporting season December 2009: Strong earnings in stormy seas

Source: Lincoln Stock Doctor. *Prices at close 9 March 2010

The even better news was that 19 new Star Stocks entered the list, dismissing the commonly held belief that companies would not perform well in 2009.

Companies that have recently had well documented problems, on the other hand, unsurprisingly did badly when it came to results. Even with improved credit conditions, companies that had high debt levels and/or weak cashflows experienced poor earnings. This may seem unsurprising, but if you still believe the Lamborghini school of thought - that safety comes at the expense of performance - then take a look at some of these large-cap companies that came up on the Lincoln Stock Doctor filter.

Reporting season December 2009: Bloated balance sheets, sunk earnings

Source: Lincoln Stock Doctor. *Prices at close 9 March 2010. ** EPS growth from prior year's negative earnings will be N/A.

Beyond companies that suffered from fundamental performance drag, other disappointments came from Telstra Corporation Limited (TLS), a company that has otherwise enjoyed consistently healthy cashflow and balance sheet results; Qantas Airways Limited (QAN), which reported a 72 per cent drop in profit; and QBE Insurance Group Limited (QBE), which came in below expectations on falling insurance margins. Telstra suffered a double-whammy too with the introduction of draft legislation that could possibly not only give the Federal Government unprecedented powers over the telco's operations, but see the creation of the National Broadband Network Company (NBN Co) as a competitor in retail broadband.

In smaller caps, regulatory uncertainties slashed the share price of litigation fund manager IMF (Australia) Limited (IMF), which otherwise reported a disappointing result, and remuneration consultancy McMillan Shakespeare Limited (MMS), a company that did report strong earnings, but could nevertheless fall victim to recommendations in the as-yet-unseen, however much speculated, Henry Review of taxation.

Outside the specifics, we can also see industry patterns emerging. Some companies were hurt this earnings season by a strong Australian dollar, lower prices for certain commodities and the continuation of weak demand in some markets. The costs of restructuring also crimped profits for companies that were still recovering from their pre-GFC debt-fuelled splurge. Companies like Asciano Group (AIO) and MAP Group (MAP) were, for instance, still feeling the pain.

On the other hand, currency and demand-side challenges failed to interrupt the continuing strong performance of Star Stocks like CSL Limited (CSL), which makes the majority of its sales in US dollars, or ResMed Inc (RMD), which is another export-focussed business. Even the expensive write-off of Lihir Gold Limited's (LGL) ill-timed investment in Ballarat Goldfields was no match for excellent operations at its core project in Papua New Guinea.

Indeed, any of the industries that Lincoln's Star Stocks belong too could be said to have experienced a tough six-to-twelve months, but ultimately strong management will triumph in any situation. Despite cutthroat competition in the mining services industry, Monadelphous Group Limited (MND) has grown from $20 million cap tiddler in 1996 to a $1.28 billion industry heavyweight 14 years later. Sometimes strong management can grow a business even quicker; JB Hi-Fi Limited (JBH) has seen its share price rise almost three fold in three years.

Obviously there are exceptions to every rule and bad things do happen, but in the majority of cases, strong management equals strong results and that's why we prefer fundamental-based investing every time.  But rather than just seeing who the naked swimmers were, this reporting season gave us a view for what the next waves will be and where to swim and avoid the sharks. Positive outlooks were given by the majority of large and mid-cap companies and the continued recovery in global markets remains a key theme going forward.

A majority view that American interest rates will rise also suggests that the US dollar will regain against currencies like our Aussie and that the so-called ‘carry trade' (good for foreign exchange speculators, bad for exporters) will unwind. Australian businesses that export to the world, or price their goods and services in US dollars, will benefit from such an occurrence happening. A stronger US dollar will also make Australian stocks cheaper for international institutional investors, bringing fresh funds to ASX-listed companies. Most importantly, as fears subside and the economic recovery solidifies, global fund managers will be more willing to invest beyond the typical safe havens (ironically, the US and Europe) and test the waters in markets like ours.

Assuming that the sun keeps coming up each morning and that the global economy doesn't go into another shock, the coming year looks positive for sharemarket investors. The key takeaway from this period's reporting season however is that high risk doesn't always equal high reward but that good management leads to good profits. Look for companies with strong earnings and ROA trends and look for businesses that manage the balance sheet and cash flow equations. If you do this then ultimately you will be rewarded with a portfolio of profitable businesses that pay good dividends and go up in price. Don't do it and you could be swimming with sharks.

Lincoln is Australia's premier fundamental analysis research house and fund manager offering intelligent sharemarket solutions for the conscientious investor.

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