In last week’s Market Commentary, we talked a little bit about how investors should attempt to isolate non-recurring items (both positive and negative) when evaluating the performance of a company or an index. The goal is to get a clearer idea of core, recurring earnings power before all the noise that can distort the true picture. This is important because management teams are notorious for using financial engineering to achieve their financial targets. Why would management teams want to do this? Well that’s pretty obvious. First, incentive compensation is often tied to the achievement of goals such as earnings growth, book value growth, returns on equity, etc. And second, management teams tend to own a lot of stock in the companies they manage. If earnings come in better than the underlying fundamentals would suggest, stocks prices can react more positively than they otherwise would. So today we want to expound last week’s discussion in an attempt to defend our cautious intermediate-term earnings outlook.
According to data obtained from Standard & Poor’s, operating earnings for the S&P 500 will increase close to 11% this year. If achieved, S&P 500 operating earnings will have grown at nearly a 16% annual rate since the financial-crisis trough in 2008. While this outsized EPS growth rate primarily reflects a rebound to the levels prior to the financial crisis, earnings have also benefitted significantly from unusual items that should not be considered an accurate reflection of the true economic value being created. Speaking in wide generalities, of course, companies have squeezed nearly every drop of juice from a very slowly growing fruit which, in this case, represents top-line revenue. In addition, revenue itself has benefitted from a number of tailwinds that cannot last forever. As a result, operating margins are running close to all-time highs while, at the same time, earnings-per-share have also benefited from massive amounts of stock buybacks, debt refinancings, and lower tax rates. In a nutshell, we should not expect these outsized rates of earnings growth in the future.
Many of the tailwinds that contributed to earnings growth over the past few years have now turned into headwinds. In the table below, we discuss the many factors that have influenced the rate of earnings growth over the past few years. As you will see, companies (in the aggregate) have a pretty steep hill to climb.
As a final observation related to this discussion, we do not think that the benefits of strong corporate earnings growth can continue to accrue overwhelmingly to capital over labor. Although there remains a large amount of slack in the labor market, there will come a day when wage pressures increase. Moreover, wealth and income disparity has become a very hot topic in recent years, and we wouldn’t be surprised to see continued efforts by politicians to redistribute the economic benefits of the recovery.
Corporate profit margins have always reverted back to the mean. They are significantly above average today, and they could certainly continue to head higher from here. Predicting the turns for a metric like this is as futile as predicting the direction of interest rates. Our view is that some reversion to the mean is likely over a period of years, and therefore expectations for earnings growth should be tempered going forward. As such, we remain invested, but we remain defensive. Sticking to quality in times like these can offer continued participation in the upside while protecting capital in the event of a market downturn.