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Temperature check for ASX companies

Last week I wrote about some of the earnings season cat and mouse games played by companies looking to present their results in the best possible light.

Sometimes, however, a business is genuinely doing well. Other times, the company’s results are so poor; no amount of obfuscation is going to mask the train-wreck.

At The Motley Fool, we’re business-focussed investors, with a long-term perspective. That doesn’t mean we hold on blindly and against all logic, but it does mean we’re prepared to ride out short term bumps for the longer term gains that are on offer.

In that vein, one 6-monthly result is usually not going to move the investing dial. Don’t get me wrong – it’s always nice to see a half-year report that supports your investment hypothesis – but one swallow doesn’t make a summer, either way. Instead, we keep an eye on the broad themes that come out of each earnings release, to see if our hypothesis is strengthening or weakening.

This earnings season has been notable for a few trends – some industry-specific, and others more general.

Prices are falling

Both JB Hi-Fi (ASX: JBH) and Woolworths (ASX: WOW) (through its Dick Smith Electronics chain) have reported continued price deflation in consumer electronics, echoing comments made previously by Harvey Norman’s (ASX: HVN) Chairman, Gerry Harvey. These products are getting cheaper due to a combination of increasing economies of scale in production (more volume and better production techniques means a lower cost per unit), increasing competition and a stronger Australian dollar.

Woolworths is also fighting deflation on a second front, this time in a price war with Coles Supermarkets, owned by Wesfarmers (ASX: WES). This deflation is largely a phenomenon of their own making, as both companies drop prices aggressively (lead by Coles) to entice customers into their stores. It won’t be fatal for either group, but its effect is to restrain sales and profit growth. Consumers are winning, the retailers are suffering and by all reports, supermarket suppliers are also feeling the pain.

Quality counts

Despite talk of gloom and doom in the Australian economy, many companies are recording strong profit growth, record sales and are reporting bright futures. It helps immensely to be in the right business, but well-run businesses can be successful, no matter what their trade.

Consumer spending is somewhat anaemic and Europe’s economy is seemingly stuck in the mire, but that hasn’t stopped BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) planning to expand their Escondida mine in Chile. Noni-B (ASX: NBL), despite a tough discretionary spending climate, lifted profits simply by being good at the basics of retailing – inventory, staff and margin management. Domino’s Pizza (ASX: DMP) continued its great run – both here and in Europe – posting solid profit gains. Even the aforementioned supermarket retailers managed to eke out growth in a tough market.

Capitalism Works

It’s easy to be a successful business when the money is flowing and confidence is high. A rising tide lifts all boats, as they say. When times get tougher, investors have a wonderful opportunity to analyse businesses at the low-water mark – barnacles and all – and to discern real management ability, brand strength and the underlying economics of a company’s business model (or lack thereof).

The best companies survive the tough times, while the lesser-quality businesses go to the wall. It’s sad for those involved, but economic downturns are the refining fires of industry.

At the same time, new businesses sprout up to meet our wants and needs. Other businesses grow by meeting them more completely, conveniently or cheaply. 1300 Smiles (ASX: ONT), a Queensland-based dental aggregator, is growing by providing services to dentists who wish to just focus on their patients. Westfield Group (ASX: WDC), after some GFC-induced pain, is demonstrating the strength of its management and brand, even as some retailers close down or are taken over. Even News Corp (ASX: NWS, NWSLV), despite its UK newspaper troubles, managed to grow profit on the back of cable television and its film and DVD business.

Foolish take-away

Some of the themes of this earnings season are universal. Quality companies – with able management, strong brands and fortified finances – will always win when things get tight. Equally, the refining, evolutionary processes of capitalism are working as they always have. Some of the themes are specific to this time, such as the price deflation – imposed or self-imposed – that we are seeing in some industries.

Investors are confronted with two questions during earnings season, namely whether the trends are likely to continue, and if so, are the companies in your portfolio likely to be the winners from these trends. I would argue that now is the time to be picking up quality businesses that are going through temporary pain, and offloading businesses found wanting in the face of these trends.

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Scott Phillips Is The Motley Fool’s feature columnist. Scott owns shares in Woolworths, Harvey Norman, Domino’s and Westfield. You can follow him on Twitter @TMFGilla. The Motley Fool’s purpose is to educate, amuse and enrich investors.This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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