A few weeks ago I had lunch with the strategist for a major buy-side firm who has been correctly positive on stocks. He said the biggest push-back he got on his bullish call was that profits would be weak. It’s a valid concern. S&P 500 net profit margins are at a record 10%, and revenue growth is anemic because demand is soft around the world. Obamanomics has held U.S. GDP growth to 1.5%, emerging markets have hit a BRIC wall, and Europe will emerge from a severe recession verrrry slowly.
But despite these formidable headwinds Q2 profits were acceptable, with strategists nudging up their 2013 SPX EPS estimates slightly, to around $110. Bears argue earnings quality was low because the biggest upside surprises came from financials. Investors don’t pay much for profits emanating from Wall Street’s inscrutable “black boxes.” On the other hand, the other unforecastable sector in the index, big energy companies, reported poor results. So profits were indeed decent under the circumstances.
Leaner, Meaner, Smarter
Why are profits resilient despite a weak macro backdrop? U.S. firms (and many European firms as well) are expanding earnings through smart proactive management of their businesses and balance sheets. Consider the big defense companies (LMT, GD, RTN and NOC, none of which I own). Going into 2013 it seemed obvious that this was a group for investors to avoid. The stocks looked cheap, but earnings would be hit by the double whammy of American military disengagement from the MidEast and the Sequester, half of which fell on Pentagon spending. Bad call. All four stocks have impressively outperformed, rising 35-45% over the past year versus 22% for the S&P 500. All four reported big upside EPS surprises for Q2 2013, driven in most cases by better than expected revenues and margins. Looking at the forecasts of UBS analyst David Strauss, widely regarded as one of the best aerospace analysts on the Street, EBIT margins and EPS will rise modestly between 2012 and 2014 even as revenue declines about 10% between 2011 and 2014. Credit cost-cutting, restructuring, diversification into non-defense markets, selling more military gear overseas, and share buy-backs.
Profits Used to be More Sensitive to GDP
Why should we care? Because the defense companies are broadly emblematic of the rest of corporate America, which is managing to grow EPS modestly (about 7% this year) even though comparisons are difficult and the world economy is barely growing. This would not have happened in the 1980s or 1990s. Historically, GDP slowdowns often led to profit declines; for example, S&P profits fell 5% in 1985 when real GDP growth decelerated to 4.2% from 7.3% in 1984. Prior to 2003 companies relied on unit growth and price hikes to drive margins, and they were prone to dumb acquisitions and excessive capital spending. Share buy-backs usually didn’t cut share counts; they merely disguised stock option compensation. Non-financial companies egregiously over-invested in the late 1990s, but they “learned their lesson” in the 2001-2003 tech crash and then became even leaner and meaner in the 2008 financial crisis, when many companies pared capacity and moved operations to low-cost locales. Globalization is a big part of the story, of course; an engineer in Boston can work closely with a capable but comparatively inexpensive associate in Hyderbad who works through the night and has work ready when she gets to work the next morning.
This pattern should continue. As I predicted over a year ago, Obama’s anti-capitalist agenda is keeping Keynesian “animal spirits” well-contained, despite low interest rates and a strong stock market. There is not much risk companies will go on an investment and hiring binge over the next couple of years.
Profit resilience is bullish for equity valuations
If profits are less volatile, normalized return on equity is higher and companies deserve a higher PE multiple. Because companies are currently better managed and more shareholder friendly, comparisons of today’s PE’s with history are somewhat misleading. Bears would counter, with some justice, that economic growth is weaker now than in the past, especially if China slows sharply as it “rebalances.” And I would admit that there have been times in the past, particularly the mid-1990s and 2004-2005, when bulls were incorrectly arguing that information technology, just-in-time inventory, and wonderful financial innovations such as derivatives had conquered the business cycle. Boy, were they wrong.
For the record, the current PE on trailing pro forma EPS is 15.8x, versus an average of 16.1x over the past twenty five years, excluding the tech bubble. Of course, interest rates were much higher then than now. A 2% dividend yield looks mighty attractive when the 10-year Treasury yields 2.6%.
Copyright 2013 Thomas Doerflinger. All Rights Reserved.
