James Bevan: Global economy and the profits cycle
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James Bevan
The global economy is growing slowly and even that pace may be slowing, and commodity prices have been falling since mid-2014, whilst the dollar’s been rising. No wonder there is so much speculation about an earnings recession going on. If that’s happening, then we should be concerned about an economic recession.
From first principles, the profits cycle can be seen to drive the business cycle. Profitable companies expand employment and capacity, while unprofitable ones shrink both.
There are very strong correlations between the year-on-year growth rates of S&P500 forward earnings and those of both aggregate hours worked and real capital spending. The causality runs both ways, but the importance of the profits cycle in driving the business cycle is often ignored when setting policy.
Thus the yearly change in forward earnings did turn slightly negative during June last year and it’s up just 1.1% year-on-year (yoy) through the week of 21st January.
However, the S&P500 isn’t in a profits recession excluding the earnings of the energy sector. The energy sector is weighing down earnings as measured by both Standard & Poor’s (SP) and Thomson Reuters (TR). The former is using much more negative numbers for the sector than the latter.
Divergence
In seeking to understand the Q42015 results once they all are available around mid-February, we can look at several measures of aggregate earnings and according to the National Income & Product Accounts (NIPA), after-tax corporate profits based on tax returns rose to a record high of $1.84tn (saar) during Q2 2015, representing a gain of 8.5%yoy, before dipping 3.3% quarter on quarter (qoq) during Q3 2015, but was still up 1.3%yoy.
NIPA also calculates after-tax profits from current production. This is the measure that is used to calculate cash flow. It has two adjustments that restate the historical-cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current-cost measures used in GDP. It has been essentially flat since Q2 2012 but corporate cash flow has been edging higher into record territory, reaching $2.12tn (saar) during Q3 2015.
SP compiles a series for the total net operating income of the S&P500 and this measure peaked at a record annualized rate of $1.1tn during Q32014. It’s been down each quarter since then by 14.7% through Q32015 to the slowest pace since Q42012. All of that apparent profits recession is attributable to the decline in the net income of the Energy sector.
As noted above, there has been a widening divergence between the SP and TR measures of S&P500 EPS. This tends to happen during recessions because companies sometimes exclude more and bigger “unusual” items from their favoured “adjusted” EPS measures, which TR tracks more closely than SP. During Q32015, TR’s composite showed $29.99 per share, $4.55 more than SP’s total. The former was down only 0.7%yoy, while the latter dropped 14.1%yoy.
On margins, the TR measure of the S&P500’s profits margin dipped to 10.6% during last year’s Q3 from its record high of 10.7% the previous quarter, but SP reported that their margin dropped from a cyclical high of 10.1% during Q3 2014 to 9.0% during last year’s Q3. The NIPA version of the profit margin has been fluctuating around 10% since Q1 2012. The SP and TR earnings measures clearly show significantly different views of the earnings world.
GAAP conservatism
Part of the reason relates to Generally Accepted Accounting Principles (GAAP) rules. US public companies are required to report on EPS in their financial statements based on GAAP, and GAAP earnings are fully loaded with all income statement line items pertinent to the reporting periods.
Even when a judgment call exists, GAAP accountants lean towards the outcome that reveals the least amount of profit, because accountants are trained to follow the principle of conservatism in accordance with GAAP.
Public companies report on several variations of EPS. Those include basic and diluted EPS based on total net income, or loss, with further subdivision by continuing and discontinued operations.
Public companies typically want to demonstrate the best view of their results to investors, and so may wish to exclude (or include) items considered “unusual” in nature from their EPS calculations.
Any such related financial measures would be considered non-GAAP and non-GAAP measures tend to be more favourable because GAAP tends to be more conservative. As SP reported in 2014 “…during difficult times, the term ‘unusual’ appears to be used more liberally [by companies].”
Meanwhile, to avoid misleading investors, the SEC requires that any non-GAAP financial measures are presented and also reconciled against the most directly comparable GAAP measure.
SP reports on two primary EPS series, “as reported per share” and “operating per share.” SP’s “as reported per share” data are derived from income from continuing operations as defined under GAAP. SP’s “operating per share” further adjusts for “unusual” items based on SP’s own views and SP does not always exclude (or include) the same “unusual” items as companies themselves. That’s because SP’s goal is to ensure comparability across industry groups. SP’s “operating per share” is closer to GAAP.
TR also collects data on a variety of different EPS measures including GAAP and adjusted EPS. TR’s goal with its adjustments is to align its EPS data with analyst estimates.
Oil pain
Analysts and companies often work together to ensure that forecasts are consistent with how “adjusted” earnings will be reported. So, analysts tend to exclude (or include) the same line items that companies do!
TR themselves say:
When a company reports their earnings, the data is evaluated by a market specialist to determine if any extraordinary or non-extraordinary items (charges or gains) have been recorded by the company during the period…
If one or more items have been recorded during the period, actuals will be entered based upon the estimates majority basis at the time of reporting.
Any submission of an estimate by a contributing analyst using a non-majority actual or on a non-majority basis results in a call from a Thomson Reuters Market Specialist requiring the contributing analyst to adjust to the majority basis or have their estimates footnoted for an accounting difference and excluded from the mean calculation for the fiscal years in question.
As a technical point, and for the sake of completeness, SP and TR deal with index changes differently, so they are not comparing like with like over time.
In terms of the current picture, while differences exist in the TR and SP data for all sectors, the year-on-year growth rates for energy and materials are particularly different, likely reflecting the scale of “unusual” items and, by extension, the recent recessionary pressures on these sectors.
SP’s data show S&P 500 earnings -14.1%yoy during Q3 but ex-energy, the progress was +3.4%. In contrast, TR see S&P500 earnings as -0.7% with energy, but +6.8% without it.
But the miserable earnings performance of oil companies means that the pain for index earnings from further bad news is now reduced. Thus the earnings share of the S&P energy sector dropped from a cyclical high of 14.9% in August 2011 to a record low of 3.3% now.
Looking forward, the latest weekly data through 14th January compiled by TR for S&P500 show aggregate forward revenues excluding energy as up 2.8%yoy to a record high, but down 0.9%, including energy, and aggregate forward earnings as up 3.4% excluding energy, down 0.5% including energy.
This is all very interesting and important in that we do need to know and understand what’s going on – but one key message that we shouldn’t ignore is that earnings and revenues from quality companies have remained strong and valuations are generally much lower after the sell-off, thereby presenting an excellent long term buying opportunity for investors prepared to put up with noisy markets for a while yet.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
