Let’s start with some facts about profits. US companies have started reporting their Q1 numbers and so far it seems that the numbers are coming in ahead of expectations. But immediately we have problems – which definition of profits is being described here? Don’t companies nearly always beat expectations?
It has been obvious for a long time that the reporting and analysis of company profits is more of an art than a science. However, there are a couple of reasons why this issue has come to the fore of late.
Companies in the US are required to report US GAAP (Generally Accepted Accounting Principles) accounts, but also report other variations – such as operating EPS and cash EPS. Normally the various measures of earnings and the differences between them are the preserve of equity analysts and must be tackled on a company by company basis. At an aggregate level, placing too much faith in any one measure could be considered losing sight of the wood for the trees.
However, today there has been much concern that the more conservative GAAP numbers (a regulatory requirement), have collapsed, while the companies’ own numbers (or ‘pro forma’ accounts) have held up.
Our colleagues at the Equities Forum have written about this here, here, and today, as has Ed Yardeni at his blog. In short, companies can make adjustments to their pro forma accounts that they cannot make in GAAP reporting. The cynical may say that companies are incentivised to flatter their profits and so a widening difference between the two should be a cause for concern.
The more forgiving argue that the fall in the oil price means that energy and materials are the main drivers of this gap (Deutsche Bank suggest $10 out of the $17 total), along with Health Care, a traditional industry where impairments are common. Others emphasise that the strength of the Dollar since 2014 also means that companies with over 50% of their earnings coming from abroad have been hit the most.
The chart below shows that the widening of the gap is broadly concurrent with these trends.
As a cross check, macro-economic profit numbers can be analysed. These are part of the official US national accounts and have been held up (most vocally by commentator Andrew Smithers) as both more reliable in general and as an indicator of profits overstatement in recent years). Here the picture is clear – the slowdown in profits throughout the year in 2015 culminated in profits falling at a 15% year on year pace in Q4 2015, due in part to the problems in the oil industry.
But oil is not the only problem. The macro data show that profits in the financial industry also fell year on year in Q4 and profits from overseas operations fell in 2015 compared to 2014. Nor is looking at GAAP necessarily the way to get around any issue of mis-reporting; a recent survey published in the Financial Analysts Journal suggested that public company CFOs believe that, even within GAAP, 10 cents in every dollar of earnings is misrepresented in one way or another.
What should we expect to happen next?
A good starting point is to look at what analysts expect. The analyst community, in aggregate, remains remarkably optimistic despite recent problems, and seems happy to accept that the adjustments that corporations have made to their pro forma accounts for ‘one-offs’ are genuinely temporary.
The chart below shows the year on year growth rate of S&P500 pro forma profits, expected by bottom-up analysts over time. For years earlier than 2016, the last observations of the lines show actual profits growth achieved.
We can see that despite recent disappointments, analysts still expect growth in profits to be in double digits in 2017 and 2018. It would be fair to conclude that there is a certain amount of anchoring (or gaming) going on here.
What can we conclude from all of this? The key point to note is that there are many measures of company profits and different conclusions can be reached. There’s plenty to support either a bearish or bullish stance. The extremes range from views like “profits recessions lead economic recessions” to “outside of the oil sector everything looks normal” as well as “aside from oil, the level of profits and profit margins are high and must come down further”.
Ultimately what matters for the stock market is longer term profit growth potential and the rating that is applied to those earnings. All the fuss about the current dip in profits and the various conflicting conclusions will probably turn out to be noise in terms of what drives market pricing. A significant dip in profits like the 2007-2009 period would, of course, cause problems, but there is no reason to expect such an outcome at present. The chart shows the long term relationship between price and a constant multiple of trailing earnings for the S&P500 index. A neutral assumption would be for both profits and the stock market to reach new all-time highs in the years ahead.
Markets and analysts have largely looked through what seem to be the specific circumstances of recent earnings weakness. Ultimately the issue of the day continues to be the one Eric discussed at the beginning of the year; namely what is the appropriate valuation for this stream of earnings if we are in a low rate world?
The earnings yield in the US, using rolling twelve month forward consensus numbers, is currently around 6% and the dividend yield of just over 2% is in line with its thirty year average valuation. While US equities are less attractive than they have been for a long time in absolute terms, they are priced to deliver more attractive returns than cash or mainstream government bonds where yields are negative in real terms. There may be very valid challenges, both in terms of structural earnings dynamics and in valuation pressures, but it seems unlikely that accounting shenanigans will be one of them.