Taking Stock of Corporate Earnings
by Neuberger Berman, Investment Strategy Group
The corporate earnings season for the second quarter of 2012 has just about ended. Investors entered this period with much apprehension as the global economic slowdown set expectations for disappointing earnings. However, U.S. numbers surprised on the upside, contributing to a rally in equity markets worldwide. Given the importance of the corporate sector to the current economic recovery, we take a deeper look at recent earnings data to highlight important trends.
An Engine of Growth
In the first half of 2012, global growth fell below expectations, which in turn led Wall Street analysts to revise earnings expectations lower. This shift is notable as the corporate sector has been viewed as a source of strength in the global economy. In the U.S., for example, employment has been driven by private payrolls as the government sector has continued to shed jobs. In our view, a sustained improvement in the U.S. economy is therefore contingent on the health and optimism of the corporate sector, as activities such as increased capital spending could improve employment and growth prospects.
United States â Still Holding Up
S&P 500 earnings for the second quarter were stronger than expected, with 70% of companies in the S&P 500 beating estimates. Earning growth was approximately 7% higher than the same period last year with financial names leading the way. However, this strong performance is not necessarily a cause for celebration as it largely reflects one large bank's return to profitability after incurring sizeable write-downs during the second quarter last year. Excluding that influence, earnings growth was only 3%, with the cyclically sensitive sectors such as Materials and Energy reporting the lowest growth rates. For the full year, Wall Street analysts expect S&P 500 companies to generate earnings of $101 per share, an increase from $95 in 2011.
GDP AND EARNINGS GROWTH ACROSS REGIONS
Source: GDP growth data are IMF estimates as of April 2012. Earnings growth data are from FactSet as of
August 20, 2012 and are derived from bottom-up estimates.
Underlying the modest earnings numbers was a more ominous trendâless than half of companies exceeded sales estimates, the lowest level since the first quarter of 2009. In fact, there was virtually no growth in overall sales, indicating that the global slowdown had affected revenue growth for U.S. companies. Views from management during earnings calls confirmed as much. The S&P 500, which is estimated to derive around 40% of sales and earnings from outside of the U.S., has seen the impact of a contraction in Europe and a slowdown in emerging markets. Firms with high levels of foreign exposure reported more negative earnings surprises than domestically focused companies. The stronger U.S. dollar also came into play, impacting earnings through reduced sales and currency accounting effects.
While demand from U.S. investors held up reasonably well during the second quarter, companies noted that they continue to find it difficult to raise prices and are growing concerned that the uncertainty surrounding the U.S. âfiscal cliffâ will affect capital spending decisions and consumer confidence. Consequently, companies have been lowering guidance for the third quarter and analysts' revenue estimates are indicating a slight contraction from the second quarter.
Europe, Asia Showing Weaknesss
Across the Atlantic, downward estimate revisions have plagued European stocks for months. Still, analysts expect companies in the MSCI Europe Index to achieve slightly positive earnings growth for in 2012 (see display). In the second quarter, more companies missed earnings expectations, with smaller-cap names suffering the most significant negative surprises.1 Earnings growth expectations are generally negative for cyclically sensitive sectors such as Technology, Materials and Energy, while the consumer sectors are expected to hold up best. Stocks in the UK, which represent the largest component of the MSCI Europe Index, are expected to see a 5% decline in earnings for 2012, compared with an 11% gain in 2011.
The negative outlook extends to Asia, where, as of mid-August, more than half of earnings reports came in below expectations. Contractions in export-related sectors (caused by weakening demand from Europe) and a slowdown in China have reverberated across the region. Sectors such as Materials, Telecommunications and Technology experienced the weakest earnings. Downgrades in earnings expectations were highest in global trade-focused countries such as Korea and China, but South East Asian countries with strong domestically driven economies were an area of strength.
A Mixed Picture for Stocks
While the recent earnings season paints a somewhat gloomy picture of growth prospects going forward, it is worth noting that U.S. corporate profits and margins are at near-record levels. U.S. corporations have continued to grow earnings through improved productivity despite flattening sales. Outside the U.S., uncertainties in the growth trajectory of Europe and Asia make investing a bit more challenging. For the year ahead, the consensus is for global earnings growth to be weaker this year before rising again in 2013 as the eurozone gradually heals.
In our view, currently depressed stock valuations are likely discounting a lower earnings growth rate than analysts anticipate, making us relatively positive on large-cap U.S. equities. However, we are more cautious about Europe, particularly on domestically focused companies, seeing the need for further clarity on economic developments. We continue to believe that Asia is in a secular growth trend with the caveat that investors should maintain a longer-term view as the shift to developed status may at times prove turbulent for some markets.
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