Company earnings season is upon us once again! This is a much-anticipated quarterly event. Investors and analysts use this period as an opportunity to assess profit trends. Positive profit changes send a strong signal to remain invested and to commit new funds, whereas negative surprises achieve the opposite effect.
The direction of travel, and the rate of change, in earnings matter a great deal. We can see this from our first chart. Here the dark blue solid line shows earnings per share in aggregate and how earnings affect stocks. Stocks are represented by the light blue dotted line, which in this case is the US stock market S&P 500 index (the top 500 companies by market value). The strong message from the comparison is that corporate earnings and share prices move in tandem. In investment terms, they are positively correlated.
The corporate earnings update we are about to receive is also accompanied by additional financial reporting. This is also useful. Corporate statements paint a broader picture, telling a lot about key industry trends and also about activity underway in capital markets globally.
Chart 1: S&P 500 Share price vs Earnings Per Share
Source: FactSet, data as of 06.10.2021
What Can We Expect?
In the coming weeks US companies in the S&P 500 are forecasted to see earnings increase by 28%, the third-highest earnings growth rate reported since 2010.
Interestingly, and contrary to what we normally see, analysts have been increasing earnings estimates throughout the quarter. Analysts usually revise down their expectations ahead of companies announcing their profits because company management typically steer them to a lower number: They do so because it offers a better chance to exceed what has been forecast!
Presently analysts are taking a strong lead from top line growth trends. It seems sales are soaring and this is in turn fuelling earnings growth expectations. Sales are now forecast to grow by 14.9% (year-over-year) compared to 12.6% forecast back in June. The Energy and Materials sector is making a significant contribution to the overall picture with oil companies enjoying a massive rebound in the oil price. In Q3 2020 the oil price was $41 a barrel but at the time of writing it has doubled to $82 a barrel.
What Do We Look For?
During earnings season earnings and sales growth rates grab the media headlines. However, net profit margins offer a deeper insight into corporate franchise strength. Companies that command high margins, and can maintain them, have a strong franchise value. During periods when input costs are rising, they can typically pass these hikes along to customers, by charging higher prices for their goods and services, or innovate to find greater operating efficiencies ways.
In our second chart we can see how companies suffered a hit to margins during lockdowns. In Europe and the UK, companies have restored their profit margins first by cutting their costs, then by refinancing debt at lower debts and more recently through generating more sales as economies reopen and consumer demand surges. In the US profit margins rocketed to record levels. We can also see that UK and European companies have lagged the US.
Chart 2: Profit Margins over Time
Source: FactSet, data as of 06.10.2021
What Is Likely To Happen From Here?
We believe a period of consolidation in profit margins, particularly in the US, lies ahead. Over the long-term margins typically revert to their average over time, through a process known as mean reversion. Mean reversion is not usually a rapid process because there are many variables impacting on outcomes. For example, business model changes through innovation and alternating levels of competition.
At this point many companies believe they retain pricing power, allowing them to pass costs on to consumers. The chart below, taken from the National Federation of Independent Business survey of US small companies, shows companies are passing on higher prices to their customers at a record level.
Chart 3: Percentage of US small companies increasing average selling prices
Source: Haver Analytics, Morgan Stanley Research, data as of 06.10.2021
One of the reasons why companies are confident enough to raise prices is economies are increasingly reopening and household savings are at record levels (chart 4). As long as demand remains high and household savings remain healthy, sales growth can continue to outpace rising cost pressures.
Chart 4: US Household Savings
Source: Longview Economics, Macrobond, September 2021
Conclusions
Quarterly corporate earnings are robust, supported by growing sales and a strong demand backdrop.
Household savings at a record level are being run down as spending resumes on goods and services.
Company profit margins are at record levels in the US making it difficult to push much higher. However, UK and European company margins are lagging, offering upside potential.
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