Earning Their Keep

As we’ve written, we anticipate robust equity returns in 2012, driven by myriad underappreciated positives. One of these is growing corporate profitability—firms are lean, healthy and growing, and we expect that trend to continue in the year ahead.

Q4 2011 didn’t disappoint—through Friday, February 24, 461 of S&P 500 companies have reported Q4 2011 results. Of these, 63% beat expectations and 10% met estimates.* Aggregate earnings-per-share growth is estimated at 9.4% year over year—the ninth straight quarter of overall earnings growth—logging a new all-time high for US corporate profits.

It was a solid quarter overall, in our view, even though growth didn’t match Q3’s gangbusters pace. The number of firms beating estimates is still above the long-term average, and growth slowing a bit three years into an expansion isn’t surprising.

In fact, as we move further into expansion, it’s unreasonable to expect continued torrid earnings growth or for growth to continue in all sectors. Early in the recovery, earnings were boosted by many firms’ sweeping cost-cutting. But while firms remain pretty lean and mean overall, they’ve largely stopped cutting and started investing more. In 2011, non-residential fixed investment—businesses’ spending on facilities, software, equipment and the like—rose 9.2%. This healthy spending promotes growth over time, but it shaves margins as the money’s spent. Hence, it’s also helpful to look at revenues. Here, too, American businesses logged their ninth straight quarter of aggregate growth. For the 454 firms reporting revenues through February 24, aggregate revenue-per-share growth is estimated at 7% year over year. Firms are bringing in money just fine.

Importantly for equity investors, slower earnings growth in Q4 or after shouldn’t stifle the market’s rise. Valuations aren’t as compressed as they were at this point in Q3 2011’s earnings cycle, but they’re still quite low historically—stocks haven’t risen as fast as earnings, which suggests there’s still a disconnect between share prices and company fundamentals. And don’t discount the surprise factor. Forecasters ratcheted down earnings estimates in recent months, reflecting continued dour expectations for the US economy and private sector. Q4’s 9.4% may be a little more than half Q3’s 18% aggregate earnings-per-share growth, but it was plenty strong enough to surpass expectations. Markets typically like positive surprises.

Looking ahead, analysts still expect 10% earnings growth overall in 2012, but quarterly rates vary. Again, not gangbusters, which means even modest earnings growth would beat these low benchmarks—and we think that’s likely this year.

Could something happen to derail ongoing earnings growth? Sudden developments are possible, but for now, we don’t see much reason US or global macroeconomic conditions should dampen corporate profitability—including a eurozone recession. More likely, firms keep chugging, and stocks enjoy a nice tailwind from underappreciated corporate profitability.

*Source: Thomson Reuters “This Week in Earnings,” February 24, 2012.