What Q3 Earnings Results Say About Stocks and Inflation

Q3 earnings season is drawing to a close. With over 91% of S&P 500 companies reporting through Monday, profits are up 39.2% from Q3 2020, shattering expectations for a 23.5% rise.^[i] Big growth isn’t shocking, considering earnings fell -5.8% y/y a year ago, meaning today’s figures look back to a depressed base.^[ii] But the big divergence from expectations is noteworthy, particularly for what it reveals about how companies are adapting to the supply chain crunch, labor shortage and rising costs allegedly hobbling global commerce.

All sectors enjoyed growing earnings in Q3, with growth rates ranging from 3.7% y/y (Utilities) to irrational (Energy, whose net income rose from a -$1.5 billion loss in Q3 2020 to a $24.8 billion gain).^[iii] The other top sectors, Materials (90.1% y/y) and Industrials (69.2%), received a clear reopening boost and benefited from easy year-over-year comparisons. But the same cannot be said of two sectors that were close on their heels: Tech (36.3%) and Communication Services (35.0%), which is home to several Tech-like giants.^[iv] Both sectors were resilient during lockdowns, with minimal damage in Q2 2020 and modest growth in Q3 2020. Their ability to generate fast growth off relatively difficult year-over-year benchmarks speaks to just how strong their fundamentals are now, in our view.

Exhibit 1 offers one way to see this: gross profit margins. That is, sales minus cost of goods, divided by cost of goods. This is a quick and dirty measure of a company’s core profitability before adjustments for taxes, debt service and other accounting items. Companies with slim margins generally have to get outside financing to fund expansion (think: bank loans or bond issuance) and have a hard time swallowing rising costs. Those with fat margins are much more self-sufficient. They can plow profits back into the business, self-financing future growth. They also have more bandwidth to weather cost pressures. Tech and Communication Services have the fattest gross margins in the S&P 500, which may not shock. But you might be surprised to see both have overall improved margins this year.

Exhibit 1: Tech and Tech-Like Companies’ Magically Expanding Gross Margins

Source: FactSet, as of 11/9/2021. Quarterly gross profit margins for Information Technology and Communication Services, Q4 2019 – Q3 2021.

Those improvements happened despite the well-documented pressure on companies’ costs globally. We have all heard that rising wages, high input costs and big shipping costs and delays are hamstringing businesses the world over. But for these sectors, this is less of an issue. You don’t ship digital services on a container ship. Nor do you need lumber and copper to build software. These companies also tend to have relatively leaner workforces, which also happen to be nimble and global. A restaurant can’t hire remote workers when business picks up and there are no local applicants—an Internet-based company can. It is no accident, therefore, that Tech is among the S&P 500’s top-performing sectors year to date, nor that Communication Services’ Interactive Media & Services industry is up over 50%.^[v]

Cost controls aren’t the only thing driving earnings right now—if they were, then Tech and Communication Services would be alone in the universe of expanding margins. But as Exhibit 2 shows, they aren’t. Their margins top the leaderboard absolutely, but margins are resilient across the board, even in sectors like Industrials and Utilities, which are more prone to rising input costs. Consumer Discretionary and Staples, too, have weathered rising costs and wages a-ok, with margins above pre-pandemic levels.

Exhibit 2: Gross Margins Are Pretty Resilient

Source: FactSet, as of 11/9/2021. Quarterly gross profit margins for all available S&P 500 sectors, Q4 2019 – Q3 2021. Financials is excluded since gross margins don’t apply to that sector’s business model.

How did they do it? Simple: The economy is quite strong right now and demand is robust, giving a lot of companies strong pricing power. That isn’t fun if you are a customer faced with higher grocery bills and other personal costs. But it is the reason earnings can and do rise during periods of high inflation—which, in turn is the reason stocks are often one of the best inflation hedges around.

Combine better-than-expected headlines with resilient gross margins, and it becomes clear analysts overestimated supply shortages’ and rising costs’ impact—and underestimated companies’ ability to adapt. This is the stuff bull markets are made of: Bad thing hits headlines, people fear bad thing, expectations fall, reality goes ok, boom, positive surprise. That is the classic journey up the wall of worry and a timely reminder: Stocks don’t need perfection. They just need companies to continue adapting and finding ways to overcome whatever obstacles arise.