US earnings growth expectations too low

16 May 2019

As the first-quarter earnings season comes to an end, we believe it makes sense to step back from all the geopolitical noise and focus on what really matters over the medium term: companies’ performance.

From the start we felt that US consensus’ earnings growth expectations (-2%) for the first quarter were low in the context of healthy revenue momentum (+5%). With 90% of companies having reported, it appears that the market’s cautiousness was indeed unjustified. Three-quarters of companies have delivered better than expected earnings, surprising by an average of +6%, and leaving the year-over-year growth rate at +1.3%. While this may seem low at face value, one should remember it comes on the back of a strong comparable figure (+26% growth in the first quarter of 2018), courtesy of tax cuts.

In Europe, with half of the companies reporting profits only on a semi-annual basis, it is difficult to draw any conclusion at this stage. But from a revenue perspective at least, growth appears positive.

So all in all, it appears that companies have been able to grow revenue, preserve margins and increase earnings in the first quarter of 2019. Unfortunately, this backward-looking statement has little influence on a forward-looking market like equities. Focusing on the consensus’ expectations and companies’ guidance may be more helpful when trying to anticipate future performance.

The projected outlook

At first glance, the outlook is more mixed. First, negative pre-announcements for the second quarter remain elevated with 77 companies cutting projections versus 15 maintaining them. This suggests that second-quarter growth expectations (+1.1%) could see further downward pressure in the short term. Second, full-year projections (+3%) remain broadly unchanged, suggesting that investors — and most companies — anticipate a re-acceleration in the second half of the year. Although not completely unrealistic, this scenario remains uncertain, especially in the context of growing trade tensions.

Yet, we maintain our view that consensus’ earnings numbers are too low and see three main drivers for positive surprises (and upgrades) ahead:

  • First, US companies have demonstrated an ability to protect margins. Looking at the first quarter versus the same period last year, the majority of companies (ie 52%) in the S&P 500 Index have increased their net-profit margins. Despite headwinds coming from raw materials, labour costs and tariffs, companies have safeguarded profitability via a combination of increased efficiency, operating leverage and price hikes. We see no reason for this to change materially in the next 6-9 months and so more of the revenues should flow through to earnings.
  • Second, we expect continued buyback activity. After purchasing more than $800 billion worth of their own shares in 2018 (up 55% versus 2017), we believe US companies can continue reducing their share count at a healthy pace thanks to a war chest of more than $1.4 trillion. This should support earnings growth to the tune of around 2 to 3% annually.
  • Finally, we expect company executives to manage expectations so that they can deliver good news when reporting. This is particularly important at the end of the cycle when investors are on the lookout for any indication that the worst may be about to happen. This is why companies that have reported negative earnings surprises for the first quarter have seen an average share price decrease of -3.5% between two days before the earnings release and two days after the earnings release. This is much larger than the 5-year average price decrease of -2.5%. The average earnings surprise for the S&P 500 is around 5%. It was above 6% in the first quarter and we would expect it to remain elevated throughout the year.
S and P 500 quarterly buybacks

Geopolitical noise will inevitably surface from time to time. But medium-term investors should look past it. The real focus for any equity investor (as opposed to a trader) should be earnings and whether companies can grow them. We believe they can.

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