Equity Earnings: Burning the furniture
Many companies with strong balance sheets are using that position to bolster weak income statements, writes Christopher O’Dea. This is persuading equity investors to pay more attention to company fundamentals
The last US earnings season taught a hard lesson – it matters which stocks you hold in your portfolio. Companies that beat earnings estimates reaped big rewards while those that fell short suffered steep sell-offs. After nearly a decade in which stock values were boosted by overwhelming monetary stimulus led by the US Federal Reserve, company fundamentals are again the primary driver of equity performance. And equity investors are doing their own homework instead of looking to company guidance.
While monetary stimulus around the world will continue to bolster overall equity valuations and encourage a ‘risk-on, risk-off’ approach to portfolio management that can be implemented with passive strategies, the renewed primacy of company results means active management will play a larger role in institutional asset allocations in the year ahead. Not all active managers will beat the benchmarks, of course, but in an era of slow but steady economic growth, rewards will flow to managers that can determine which companies are best positioned to turn opportunities into earnings without resorting to financial engineering to make their numbers.
The third-quarter results parade will be remembered as the pageant that turned the spotlight on the cracks in the US equity bull market – mainly sluggish industrial growth and the slowdown in China. While the bull market itself is not threatened, equity returns will increasingly be paced by companies that can produce real growth in the new normal of low growth, low inflation, and low interest rates.
The number of companies beating earnings estimates was in line with last year’s third quarter – about 74% of the 300 that had reported by late October, says Jack Ablin, chief investment officer at BMO Private Bank. “My issue isn’t earnings,” says Ablin. “My issue is the revenue, and few companies are beating on their revenue.”
By late October, he says, just 33% of reporting companies exceeded their revenue projections – far fewer than the median 50% that exceed revenue estimates in a typical reporting season. “You don’t necessarily want to say they’re burning the furniture to heat the house,” Ablin says, “but that’s really kind of worrisome.” Many companies have strong balance sheets, he says, but too many are using that capital position to shore up weak income statements by reducing the number of outstanding shares through buybacks, or by acquiring inorganic revenue through M&A. “You can do that for a little while,” Ablin says. “But sooner or later, companies are going to have to produce some earnings.”
That could be a tall order. Quarterly projections for 2016 earnings growth from S&P Capital IQ show that investors expect the pace of earnings growth to slow in nine of 10 sectors in the first quarter of next year. Only telecommunications services companies are expected to accelerate early in the New Year, before slumping in the second quarter. The sector was also a bright spot in the third quarter, with 67% of reporting companies beating both earnings per share and revenue estimates, ahead of the 59% such companies in IT and 54% reporting a double beat in healthcare.
“Almost every management team believes they will do better than their competition, whether they foresee a good year or a bad year ahead”
Ongoing stress in the energy sector is expected to cause continued declines in energy-sector earnings, although the projected pace of quarterly declines is expected to moderate to between 25% and 39% from the nearly 70% plunge in the third quarter of 2015.
While an outright decline in earnings is expected only in the energy sector, the slowdown in earnings growth will be acute. At the start of October, investors projected S&P 500 earnings would increase by more than 5% in the first quarter of 2016; by the end of the earnings season that estimate had been cut to just 2.9%. That markdown may not have been enough – Ablin says US equities at the end of October were 22% overvalued on the basis of the S&P 500’s price-to-sales ratio over the past 20 years.
Decelerating earnings growth would reflect weaker economic activity, but might not present an accurate picture of business conditions in a given sector. That has got equity investors delving deeply into corporate accounts rather than relying too much on earnings. With revenues declining, “companies have been talking down their [earnings] guidance,” says Harry Talbot Rice, head of global equities and co-manager of the Sarasin Equisar Global Thematic funds at Sarasin & Partners in London. “EPS [earnings per share] as a metric is a terribly easy indicator to manipulate,” he says, noting that share repurchases, which have soared to record levels in 2015, are a common method of showing higher per-share performance as revenue sags.
According to BofA Merrill Lynch, only 26 S&P 500 companies issued guidance in September, the fewest for any month since 2000. The monthly average over that period is 125. “The elimination of guidance is actually a boon to the truly active managers who do their homework,” says Jack Rivkin, chief investment officer at alternatives advisory firm Altegris Investments. “With companies offering less guidance,” Rivkin says, “there becomes a real separation between those who do their homework and those who don’t.” Fundamental research almost did not matter during the years of quantitative easing, but times have changed and “as we enter a different era, dispersion of company performance as well as stock performance will increase”.
It is likely that many companies will report a big gap between expectations and results. “With rare exception, particularly in slower GDP growth environments, expectations almost always start out the year higher than what ultimately occurs” Rivkin continues. “Almost every management team believes they will do better than their competition, whether they foresee a good year or a bad year ahead, but not all companies can gain market share, particularly in a slower growth environment.”
The upshot for investors is that the reduction in guidance “raises the stakes for the passive managers and passive strategies, and improves the stakes for active managers,” Rivkin says. “If we take this year as an example, the market is basically flat year to date, but half the stocks are up on average 16% and half are down 16%.” That environment, he adds, “can produce a big difference in returns over many years if one is able to pick the winners and the losers”.
While acknowledging the weak revenue outlook, Union Bancaire Privée sees potential for global equities. “We have been fairly constructive for equities for 2016,” says Martin Moeller, equity portfolio manager at UBP. Although GDP growth has been moderate, he says “it has been stable, and that has not been so bad for the equity market”.
Moeller says global equities could produce returns in the mid-teens in 2016, comprised 10% appreciation, a 3% dividend yield – well above cash or government bond yields – and another 2% to 5% as an equity risk premium. The current risk premium of about 5%, he says, is higher than the 2-3% typical for a late-stage market where valuations have become expensive because it is providing a cushion against rising rates.
Rivkin expects a five to 10-year period where US equity returns will track nominal GDP, for a 3.5% to 5.5% annual return. He is advising clients to adopt a mix of long-only, long-short, and uncorrelated strategies in the equity bucket, and, where possible, less liquid strategies where it is very clear there is an illiquidity premium.
All told, the ‘new normal’ for equities that emerged from the third-quarter earnings parade bodes well for active managers, says Sarasin’s Rice.