August reporting season — often an illuminating time of year for investors as companies present their annual results for the financial year ended June 30.

So far this year, there’s been more thrills than spills as companies unveil their full-year numbers amid what continues to be a robust post-COVID operating environment.

Friday was a case in point, as investors cheered the annual results for a number of big name blue-chips (when even AMP (ASX:AMP) posts a gain, you know things are looking good).

As earnings season kicks into full swing, we spoke with a couple of pro investors to get a sense of howthey approach earnings season.

Reporting season — where to start

So what should investors be looking for?

Metrics such as full-year revenue and core earnings (EBITDA) will always be the starting point.

But for Heath Moss, principal at investment firm HLM Investments, the numbers are usually only part of the story.

“For the larger stocks that I track it’s not so much about the numbers, because they’re fairly well covered and one thing I find in the Australian market is that analysts tend to get it pretty close (with earnings estimates),” Moss says.

In addition, June 30 numbers are historical, and markets are always forward-looking.

“So I’m always more focused on their guidance, and I’m looking for unique commentary on different aspects of business — where they’re seeing growth or slowdowns.”

Moss said another key focus area this year is costs — “we’re starting to see supply-side pressures in the US, so I’m looking for evidence of costs pressures emerging in our market. And when it comes to the numbers I’m generally a lot more conscious of free cash flow than profits.”

Creative accounting

On their face, full-year results can look like fairly simple affairs.

But Peter Johns, who runs leading small-cap fund Westferry Investments, says to be wary of various tricks companies use to ‘dress up’ their headline numbers.

“One thing I focus on at this time of year is H2 results from the second half of the financial year,” he explained.

“Often companies will just report their full-year results without any splits. So you want quick access to those first half numbers.”

“Then you can compare H1/H2 momentum, and also the prior year comparative period (in this case — H2 2020).”

Johns said it’s a “fairly common trick” companies use to report full-year growth numbers that seemingly look strong. But further investigation shows their H2 growth has actually decelerated.

“So what looks like an exciting announcement is one the market will actually hate because it can see momentum has slowed.”

Moss agreed that companies are partial to getting creative with their accounting techniques, with a tendency to “mould numbers”.

“If you look at the June quarter of the June half compared to last year, of course its going look fantastic,” he said.

“But it’s more important to ask ‘how is Q3 to Q4 going, and have they flagged positive momentum into the new year?’

“Another thing I’m doing a lot this year is comparing numbers next to June 2019, because that was when we saw a peak in earnings before the pandemic,” Moss said.

“So how does it compare to two years ago? Because everyone’s going to look good next to 2020.”

Devil in the detail

Drilling into the detail, Johns also offered some useful tips on how to carry out an analytical breakdown of the top-line revenue numbers presented in reporting season.

The current bull market should provide a healthy backdrop for some strong full-year revenue updates. But what percentage is recurring, and what percentage got a boost from one-off factors unique to the post-pandemic economy?

“One thing I’m watching closely this year is the contribution of JobKeeper to full-year earnings,” Johns said.

As a case in point, he cited the example of Adacel (ASX:ADA), the tech firm that makes software for Air Traffic Management & Control systems.

Following the release of its full-year results, the company was one of the best intraday performers on the ASX.

“What happened was their forward guidance for the next year was basically flat. But their FY21 revenues were made up of ~$1.6m in JobKeeper, whereas next year they won’t get any.”

“So the market was expecting a pullback, but they demonstrated that the underlaying growth is actually really strong.”

“On the flip-side, you’re looking for companies that try to sneak it an as normalised earnings, when it could be JobKeeper or an asset sale or other one-off events like that.”

Johns said another metric to watch for is an improvement in debt position.

“If there’s been a big turnaround in net debt (gross debt less cash), that can indicate a material step-change in the business,” he said.

A good example of that in the current reporting season was embattled retailer Myer (ASX:MYR), which rose sharply after reporting an unexpected large net cash position.

Lastly, Johns flagged what he called his “10-minute rule” for assessing results at the smaller end of the market.

“A lot of small caps report during day rather than pre-market. So by time you see them, you’ve got about a 10-minute window to make an assessment before they resume trading,” he said.

“Obviously as a long term shareholder, there’s no need to be doing anything in a 10-minute window. But it’s a framework I use just to see if there’s an opportunity there or a disaster in waiting.”

“In that sense it helps having some background knowledge of that company, where you can understand the context and what things are expected.”