Tracking Quarterly Results

We are about half-way through earnings season, so we thought it would be a good time to provide a preliminary evaluation of the results. According to Bloomberg, 235 of the 500 companies in the S&P 500 have already reported results for the first quarter. Among these companies, roughly 74% beat the consensus expectation for EPS. The average overage has been 4.61%, which is slightly below the average beat for the past eight quarters. In our view, there aren’t many conclusions that can be drawn from the EPS data. Companies continue to sandbag their earnings guidance, and they continue to beat those modest expectations.

Perhaps the more interesting metric to follow is revenues. Among the 235 companies that have reported so far, only 45% have beaten the consensus expectation for revenues. This means that 55% have missed expectations, with the average magnitude of the miss at 1.15%. If we look back over the past several quarters, we find that a pattern is developing. Despite the fact that companies are still beating their EPS expectations rather handily, they are increasingly falling short of top line expectations.

How can we explain the fact that companies continue to beat EPS expectations but are increasingly missing revenue expectations? There are a few possible explanations. The first is that companies facing weak growth prospects have been more aggressive in cutting expenses. As these companies continue to tighten their belts, whether by layoffs or other initiatives, the savings are flowing to the bottom line. A second possible explanation is that many companies are being much more aggressive in buying back their own stock. Given the low level of interest rates, the economics of borrowing to reduce a company’s share count have become much more compelling. And a lower share count leads to higher EPS. And finally, the low level of interest rates has allowed many companies to refinance their higher-cost debt. These savings also flow to the bottom line.

In general, investors should always prefer earnings that are generated through top-line growth as compared to earnings that result from internal corporate actions. The reason is that there is a limit to the amount of expenses that can be cut or the amount of stock that can be repurchased. In other words, earnings growth that results from cost-cutting and/or stock buybacks is not sustainable. There will be a point at which management can get no more blood from the stone.

So far, investors appear willing to pay for the earnings growth we are seeing. The hope is that all the Fed’s monetary easing will ultimately prime the pump to the point where acceptable revenue growth is again possible. But herein lies the catch-22. Strong corporate revenue growth will only happen if and when we see an improvement in demand for products and services. The only way we will see this improvement in demand is through better job and income growth. The only way job and income growth will improve is if companies gain the confidence to invest more aggressively in new projects and employees. Yet companies don’t want to invest unless they see the end demand.

There are several possible reasons for the continued strength in stocks. The most plausible explanation, in our view, is that the Fed continues to hold down interest rates and push investors into riskier assets. Stocks, especially high quality ones, appear relatively attractive to bonds that offer “return-free risk.” Having said that, however, the next leg up for stocks may only come if and when we see better prospects for top-line growth. Earnings simply cannot keep growing at an acceptable pace unless revenue growth improves.