Revenue Becomes King

With second-quarter earnings season nearly in the books, the S&P 500 has produced very modest returns so far this year. The index is up about 2% year-to-date (not including dividends), with very little volatility given the volume of economic and geopolitical news and uncertainty. However, this modest, low-volatility performance masks some very significant volatility within the index’s ten industry sectors. At the extremes, the Health Care sector is up over 11% this year, while the Energy sector is down over 14%.

So what is driving sector returns this year? If we take a look at the chart below, there is clearly a correlation between earnings growth and sector performance. As we would expect, those sectors with the highest earnings growth have performed best while those sectors with low or negative earnings growth have performed the worst. But there are clearly some exceptions. Most notably, earnings growth in the Materials, Utilities and Telecom sectors was positive while the stock performance within these sectors has been negative. Is there some better driver of performance this year?

7c97b256-5366-4a86-a3c7-ff463e35a7b1Source: Data obtained from Bloomberg

We also compared sector-level stock performance to revenue growth in the first and second quarters. What we found was quite interesting. The correlation between 1H stock performance and revenue growth was much stronger than the correlation between 1H stock performance and earnings growth. What are the possible reasons for this? Well, my first thought is that investors are becoming less willing to pay for earnings that are generated through anything other than top-line growth. This makes some sense given the fact that corporate margins are running about 50% above long-term averages. Through the course of the economic recovery, earnings growth has far exceeded revenue growth as companies have used any means necessary to drive EPS growth in an environment of weak end-market demand. These sources of earnings growth have included restructurings/cost-cutting, layoffs, deferral of investments, debt refinancings (lower interest costs), lower taxes, and financial engineering like increased financial leverage and stock buybacks. Perhaps investors are interpreting that the opportunities for additional earnings accretion from these sources are coming to an end. Time will tell.

959a0d74-b224-4bf1-a0c4-789afbc1fe0aSource: Data obtained from Bloomberg

One sector that stands out in the above chart is the Consumer Discretionary sector, in which stock performance has far exceeded revenue growth. We attribute the variance to investor preference for companies with high exposure to the US economy and limited exposure to economies outside the US. (Generally speaking, retailers generate a low percentage of revenue outside the US). This stems from the perception that the US economy is in much better shape than most of the rest of the world. Retail segments such as restaurants, auto parts, and home improvement have risen to very high valuation levels as investors have sought the perceived safety of US-centric businesses. Will those valuations be justified? For the most part, it seems unlikely to us.

The market’s renewed focus on top-line growth is a positive development. In our view, companies have devoted far too much time and energy in driving short-term earnings gains at the expense of long-term earnings growth. With luck, management teams will take notice and respond accordingly.