‘Tis the (Earnings) Season

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Thanksgiving is a week away—cornucopias, turkey, pumpkin pie and delightful food coma are nearly here! Investors have plenty to gobble in the meantime, too, as Q3 earnings season is winding down. To some, the tepid headline growth rate suggests Q3 was a bit of a turkey, but in our view, a closer look suggests corporate America is kicking right along—and likely keeps doing so, lifting stocks higher.

So far, 460 of the 500 companies in the S&P 500 have reported, with 73% beating estimates—largely in line with recent norms. Estimated earnings-per-share growth is 3.5%, with revenue-per-share growth at 2.9%. Earnings grew in 8 of 10 sectors, including Consumer Discretionary, Technology and Healthcare.[i]

While earnings and revenues ticked up a bit from Q2’s 2.1% and 1.7%, respectively, they were still a bit tepid compared to the gangbusters growth earlier in the bull. However, slower earnings growth is fairly normal in a maturing bull market as year-over-year comparisons become tougher to beat. It doesn’t imply stocks are slowing. Rather, it signals a shift in how firms generate earnings and which firms do best. Early in a bull, earnings tend to grow quickly as companies reap the rewards of recessionary cost-cutting. With low expenses, even modest revenue equates to big profits. As the expansion progresses, firms reach the limit of cost-cutting. Some costs stay fixed, particularly in capital-intensive industries. Many firms must raise costs to increase production and keep up with demand. Hence, revenue growth becomes a more significant driver of earnings growth. The firms that do best are those maintaining stable sales growth as the cycle matures.

For example, Consumer Discretionary earnings grew 10.4% y/y, beating all other sectors. Earnings grew in 10 of 12 industries, with Internet and Catalogue Retail, Household Durables (think refrigerators or dishwashers) and Auto Components leading the charge—all of which squares nicely with broader economic activity. Disposable incomes have risen all year, allowing folks to buy more big-ticket items. The ongoing housing recovery is also driving demand for appliances. Looking ahead, with loan growth speeding up, home sales should stay firm, keeping this trend intact. Ditto for income growth as firms continue reinvesting profits and growing their businesses.

Tech earnings also grew nicely, rebounding from Q2’s -8.2% fall with 8.5% growth. Q2’s weakness was tied more to cost pressures—revenues were about flat—but the landscape improved in Q3 with costs easing and revenues growing 2.8%. Looking ahead, there appears to be ample fuel for further revenue growth. Many companies held back on IT spending after the recession and are running on increasingly antiquated computer and software systems. With clunky, freezing computers threatening efficiency, firms are starting to deploy some of their infamous $1.8 trillion cash reserves on new systems. Meanwhile, continued innovations in cloud and mobile computing are boosting consumer and enterprise demand alike.

Financials also appear poised to do well despite being one of the two sectors with negative earnings—an about-face from Q2’s 28.1% earnings growth. One-time factors skewed both numbers, and reality lies somewhere in the middle. Q2’s results looked extra nice because a handful of banks’ one-off loses in 2012 distorted the y/y comparison. In Q3, one large bank had significant legal expenses, which resulted in a rare loss. Strip away this outlier, and Financials earnings per share would have grown 16.1%—the quarter’s highest by a significant margin. Plus, Financials revenues still grew, and looking ahead, widening net interest margins associated with a potential Fed taper likely accelerates loan growth, boosting revenues further still.

Materials grew 9%—a nice bounce from Q2’s -1.2%. This time, the sector benefited from robust demand for construction materials, another byproduct of the housing recovery. But looking ahead, the outlook for the broader sector doesn’t seem great. Metals and Mining firms comprise a significant portion of the sector, so their revenues are heavily dependent on commodity prices and their costs largely fixed. With commodity prices on a downswing, firms likely have a difficult time profiting.

Looking ahead, we wouldn’t be at all surprised if headline earnings growth stayed muted, with sector-specific results varying quite a bit. Even modest growth, however, seems underappreciated—earnings have clocked new highs since 2011, but stocks only just started doing so. Investors still don’t quite realize how well the bulk of America is doing. The more they realize, the more they’ll pay for stocks—especially those with the most stable earnings growth, those standing out from perhaps lackluster headline figures.