Three Profit Metrics to Avoid Earnings Season Myopia
Bill Hester, CFA
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Alcoa, the aluminum producer, announces its earnings on Monday. So begins the reporting season of first-quarter company results. During this period in particular, it may be easy to become enamored with past corporate performance and miss potential forward-looking risks. To counterbalance the deluge of earnings reports to be delivered over the next few weeks, here are a few intermediate-term indicators and trends that investors may want to watch to gauge earnings conditions.
Watch Sales Growth for Clues to the Direction in Profit Margins
The current profit margin of the S&P 500 Index is sky high. During the past 40 years it was only higher during 2006-2007, fueled substantially at the time by record margins and earnings of financial companies that would eventually disappear into the ether. The current profit margin is 50 percent above its long-term average.
One of the primary drivers of profit margins is sales growth. But the important role that sales growth plays is often left out of the discussion. Year-over-year changes in revenue have a strong correlation with changes in profit margins historically. This makes sense, because a large part of company expenses are fixed for a period of time, especially contractual ones like those for labor and supplies. So over the short-term, revenue growth often falls straight to the bottom line. So when sales growth comes in faster than recent trends, those new sales help deliver higher profit margins.
Recent data show a divergence in sales growth, which is moderating, and margins, which continue to expand. This is likely the result of corporate executives who continue to be uncertain of the durability of the economic recovery. Even though sales growth has been strong during the last few quarters, corporate cost structures haven't changed materially, which has boosted margins. The graph below compares the year-over-year change in sales in the S&P 500 with the Index's profit margin.
It's important to highlight the recent rate of growth in sales, which is moderating. Even if corporate executives continue to move slowly in hiring and raising wages, if sales growth continues to moderate, margins are likely to be dragged lower over the next few quarters. Even now, profit margins look extended based on their relationship with sales growth. Typically, high profit margins follow strong sales growth. As sale growth moderates, margins decline. This helps explain why there is also a strong inverse correlation between profit margins and subsequent profit growth, as John Hussman has frequently noted.
Another risk factor may be unmet expectations for corporate revenue growth. Ned Davis Research’s Ed Clissold and Dan Sanborn recently pointed out that expectations for sales growth are high relative to the actual historical range of growth rates in sales. Consensus estimates call for S&P 500 sales growth of 14.2 percent in 2011. Since 1975, year-over-year sales growth has topped 14.2 percent only 14 percent of the time, and since 1983, only 1 percent of the time, according to Clissold and Sanborn. “There isn’t much historical precedent for 14 percent year-over-year sales growth”, they concluded.
There has also historically been a negative correlation between profit margins and subsequent stock market returns. The current trailing 5-year return – which began with profit margins close to current levels - is a bit less than 3 percent annually (with intense volatility and drawdown). Based on historical correlations, current profit margins suggest similarly low returns over the next few years.
Valuation Differences Across Sectors
The first graph above shows that S&P 500 profit margins are near peak levels. And we know that by looking at valuation models that normalize fundamentals, the level of valuation of the Index is also extended. Are the sectors within the Index equally overextended on both a profit margin and valuation basis?
The graphs below attempt to provide some insight. The data for these graphs is provided by Ned Davis Research . NDR's analysts have calculated sales and income totals for the main sectors of the S&P 500 going back to the early 1970's, which I've used to calculate profit margins. They have also calculated a set of historical median valuation ratios for each sector. To separate the level of valuations from the impact of peak profit margins, I've used the median sales yield (sales/price) in the calculations below.
As an example, the first graph presents the data for the Consumer Discretionary Sector. The top half of the graph shows profit margins for the sector – which are at record levels. The bottom half of the graph shows sales yields - which are at record low levels (implying high levels of valuation).
The graph below extends this concept by comparing each sector's current profit margin and sales yield to its historical range (as a percentage). For example, sectors in the lower right quadrant have profit margins and levels of valuation that are higher than average for those sectors. The lower and further right you go on the graph, the more extended the current profit margins and valuations are. Keep in mind that by using sales yield we are focusing on how expensive sectors are, relative to a fundamental that isn't influenced by year-to-year fluctuations in the sector's profit margins.
The S&P 500 itself is in the lower right-hand corner. You can see how extended the Index is based on both the level of profit margin and valuation, compared with historical norms. The Consumer Discretionary sector (COND) is even more extended on both measures. Also interesting are the cyclical components of the S&P Index. The Materials, Energy, and Industrial sectors are all at peak levels of valuation (independent of margins) and have near-record profit margins as well. Consumer Staples and Financial sectors are less overvalued relative to their history (keep in mind how highly valued financials were in 2007 prior to their declines, which likely distorts their current level of relative valuation). The Healthcare sector appears least extended on these measures.
It's clear from the graph that any argument that the market and the majority of its sectors are fairly valued relies strongly on the assumption that profit margins will remain near their all-time peak levels. Valuation metrics that aren't influenced by year-to-year fluctuations in profit margins are showing record levels of overvaluation. Near-record profit margins with near-record levels of valuation for most industries suggest potential for risk to the stock market in the event earnings disappoint investors over the next couple of quarters.
Investors May Be Running Out of Surprises
One of the worst-kept secrets in the financial markets is that earnings surprises are not true surprises. Company executives have learned over time that if they provide modest earnings guidance, then beat that guidance, even marginally, their management and company performance look better. Stock prices often react favorably to those ‘surprises'. You can see the development of this sort of "pact" between executives and analysts by looking at the upward drift of earnings surprise rates – which measure the percentage of companies that beat estimates. Surprise rate have generally moved higher from the mid-1990's when a little less than half of companies typically beat estimates, to the recent high where more than 80 percent of companies beat estimates.
This doesn't mean that tracking the earnings surprise rate is without merit, as long as you're mindful of its upward drift. Because of the upward trend in the data, the most useful signals are based not on the level of surprises, but on noticeable reversals of that trend. Bloomberg keeps an index of these earnings surprises, which I've mentioned before as a tool for monitoring potential risks. The graph below shows the index on a monthly basis, with a 12 and 24-month moving average that track its smoothed performance.
It's a relatively short data series that begins in the early 1990's. But over that time, when the 12-month moving average of the index has fallen below its 24-month moving average, especially from a noticeable peak, poor returns have generally followed. For example, the shorter-term moving average dipped below the longer-term average in early 2001, following a noticeable peak in 2000. The two crossed again in 2007, prior to the profit surprise rate collapsing from 70 percent to almost 50 percent in 2009. During both periods the 12-month moving average stayed below the 24-month moving average until a substantial amount of the decline in stock markets that followed had already occurred. There were less effective signals given in 1996 and 2005. The indicator is plotted against the performance of the S&P 500 Index below.
The 12-month moving average of the surprise line fell below the 24-month moving average last week, which is noted on the graph. Again, it's a data series with limited history so the signal alone shouldn't be used for investment decisions. But the deterioration in the positive surprise index will clearly be worth watching as the coming earnings season unfolds.
Earnings reporting season always brings an intense scrutiny of profit metrics, but not always the most helpful ones. During these periods it's easy to lose focus on intermediate term indicators that can provide useful information. The metrics that track some of these trends - the level of profit margins in relation to sales growth, sector valuation, and a downward drifting earnings surprise rate – are currently highlighting potential intermediate-term risks on the earnings front.
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