Taking Stock of Earnings

Now that we are nearly through the 4Q earnings season, we thought it would be a good time to take a look at how corporate America fared for the final quarter of 2013. According to data obtained from Bloomberg, 93% of the companies in the S&P 500 have reported 4Q earnings so far. Among those companies, aggregate earnings grew 8.7% compared to 4.2% growth in the 3Q and 3.9% growth in the 2Q. In fact, earnings growth accelerated sequentially for the third straight quarter in 2013. On its face, this sound pretty positive. For the bulls, this acceleration in earnings growth provides justification for the huge increases in stock prices last year. Are they right?

Well, not so fast. Anyone who reads this Market Commentary regularly knows where we are headed in this one. The problem is that companies continue to generate ever higher earnings on scant top-line growth (revenue). Revenue growth in the 4Q was just 0.7% compared to 2.6% in the 3Q and 1.5% in the 2Q. So while it is an unambiguous positive that earnings are up, there is this continued nagging issue of the sustainability of the earnings growth. Companies can only cut expenses so long before they run out of opportunities. Corporate margins are already running near all-time highs as managers have tried to identify every possible source of inefficiency. Is it reasonable to expect margins to continue increasing indefinitely while they are already some 50% above long-term averages?


There are also questions about the quality and composition of the earnings growth in the 4Q. The table below shows earnings growth by industry sector for each quarter in 2013. The table reveals that the Financials sector contributed heavily to aggregate index earnings growth in the 4Q. In fact, by my calculations, the Financials sector contributed over 40% of overall earnings growth. Why is this important? As we wrote about following the 2Q earnings season, banks continue to generate earnings through the release of loan loss reserves. This means that the banks are making adjustments because they set aside too much money to cover loan defaults during the financial crisis. These reserve releases have been padding earnings for many quarters now. At the same time, the operating environment for banks remains quite difficult. Margin compression, weak loan growth, and pressure on fee income (lower mortgage originations) are combining to make revenue growth nearly impossible. And these trends, which have been plaguing bank management teams for many quarters, have been slow to improve.



Source: Standard & Poor’s and Bloomberg.

The widespread optimism about a dramatic acceleration in economic growth and earnings growth is likely unwarranted. Margins continue to rise to uncharted territory with the help of bank reserve releases. Unless and until we start to see more respectable top-line growth, we will hold back our optimism. In the meantime, we believe it makes sense to stay defensive by owning high-quality blue chips.