SERIOUS MONEY:THE SECOND-QUARTER reporting season is almost complete and the verdict is clear: corporate America has excelled in the face of a lacklustre economy. Twelve-month trailing earnings have climbed more than 80 per cent from their trough last autumn, a pace of recovery exceeded only by the sharp rebound from the profit-cycle low of 1921, writes CHARLIE FELL
More than half of the S&P 500 constituents reported bottom-line numbers that beat consensus expectations by more than one standard deviation, and not surprisingly, analyst estimates for the current calendar year continue to move higher.
The almost exclusive focus on current earnings is difficult to justify given that stocks are a claim on a stream of long-term future cash flows. Indeed, the correlation between short-term changes in corporate profits and stock-price movements is not statistically significant, while the relationship between earnings growth and the multiple that investors are willing to pay for one unit of earnings is tenuous at best. Investors would be better served to focus on the determinants of corporate profitability and future growth thereof, in their effort to add value.
It is important to recognise that fundamentals determine value; profitability or return on equity (ROE) is the primary driver of share values and wealth creation.
Indeed, the return a firm earns on shareholders’ equity should be the same as the return an investor receives in the long run. In other words, economic profits should be zero. The fact that ROE has exceeded stock returns over long periods would seem to violate this economic principle but this is an artefact of conservative accounting methods. Most assets are valued at historical cost, for example, while the intangible value of research and development is expensed and not recorded on the balance sheet – thus, the denominator is understated and ROE is overstated.
Determining the composition of returns is central to understanding the key drivers of financial performance and value creation. At its simplest, ROE can be expressed as the product of net margin, asset turnover and financial leverage.
Examining the S&P 500’s stellar earnings recovery within this framework reveals that all of the more than two percentage point improvement in ROE for the non-financial constituents has been driven by margin expansion. The net margin has climbed 2½ percentage points from its cycle low, as companies have benefited not only from a realignment of their operating cost structures, but also from lower raw material prices, reduced borrowing costs and a favourable effective tax rate.
However, firms have yet to reap the full benefits of their aggressive cost-cuts and the resulting operating leverage, given that revenue growth has been muted, though accelerating top-line growth is anything but guaranteed in the current climate. Consequently, margins should exhibit only modest expansion from current levels.
Asset turnover captures the efficiency with which a firm utilises assets to drive sales. The trend on this component of profitability has been in decline for much of the past 30 years. Though sales per dollar of assets improved during the last profit expansion, the more than 15 per cent decline in revenues during the downturn has seen this measure flirt with multidecade lows.
The outcome is disappointing given the cautious asset management employed by the corporate sector through the recession. The net result is that corporate America’s revenue-generating capacity has barely grown in the past two years. The outlook is far from encouraging given that reliable indicators of economic activity point to annualised growth of just 1.5 per cent in real terms during the next six to 12 months.
Incorporating a relatively conservative price deflator, this implies a decline in the pace of year-on-year growth in nominal GDP from roughly 4 per cent during this years second quarter to just 3 per cent by next summer. These numbers are simply not consistent with robust sales growth.
Asset turnover will also be constrained by the amount of capital that is tied up in unproductive investments. It appears that neither net margin nor asset turnover will contribute to significant improvement in corporate profitability in the future, which leaves fiscal leverage as the last hope for the perennial optimists. Financial leverage or assets per dollar of equity at roughly three times is low compared to the 1990s average of 3.4 and, with the excess cash removed, the ratio drops close to the 1980s average of 2.6.
Thus, the non-financial constituents of the SP 500 do not need to deleverage, though this is a far cry from arguing that corporate America is ready, willing, and able to gear its balance sheet. Indeed, the record level of cash sitting on corporate balance sheets is a sign of caution and possibly reflects increased liquidity demand given the possibility of a further reduction in the supply of credit from an already fragile banking system.
A studied analysis of the determinants of corporate profitability reveal that returns are close to cycle peak; the resulting decline in earnings growth to single-digit levels is likely to take many investors by surprise. To be forewarned is forearmed.
www.charliefell.com
