Key points

  • Investors have generally reacted positively to third quarter earnings
  • However, cost cutting rather than underlying sales growth has been the main driver of the improvement
  • Higher wages are starting to undermine profit growth
  • Businesses where margins are unsustainably high may suffer deteriorating earnings in the long run
  • Overall, we would rather earnings are missed for the right reasons than beaten for the wrong ones

The outlook for US equities may not be as encouraging as the latest earnings figures suggest, says Richard Saldanha.

Better-than-expected US corporate earnings have been one of the main factors propelling a recovery in the S&P 500 following the sharp falls seen in August. Having analysed the numbers, however, we have concerns that the earnings are not as positive as the headlines may suggest.

With almost all US corporates having reported their quarterly results we have seen a positive reaction from investors. Around two-thirds of those companies have reported better-than-expected earnings. However, only one-third have exceeded expectations in terms of revenue, suggesting that the strength in the bottom line has been driven more from cost cutting than underlying sales growth.

This concerns us for a number of reasons:

  • Companies can reduce costs only so far and if revenues fail to improve profit will eventually stop rising.
  • If vital investment is not taking place the long-term health of businesses will suffer.
  • If the limited growth in revenue continues, it will raise concern over the strength of the wider US economy.

US companies have done a good job of defending margins

The trend of bearing down on costs to drive earnings growth has become particularly evident during this earnings season, but it is certainly not a new phenomenon. Indeed, it has been evident since the global financial crisis. While we have seen sluggish economic growth in the period since, profit margins recovered very quickly and are now at close to all-time highs. Many investors are now questioning the sustainability of these margins given increased wage pressures and limited room for further cost reductions.

Rising wages pressure profits

There are signs that higher wages are starting to undermine profit growth. The strength in the labour market has been the main driver of this trend, with the unemployment rate falling to around five per cent, the lowest since 2008. In addition, Walmart and other major US businesses (such as Gap and McDonald’s) have raised their minimum wage this year.

Why does any of this matter? Shouldn’t we just be glad that earnings are rising however this is achieved? The recent better-than-expected figures have certainly pleased Wall Street. However, the outlook may not be quite as rosy as the numbers suggest. Businesses where margins are unsustainably high may suffer deteriorating earnings in the long run. We also fear the focus on posting positive short-term figures could be undermining the long-term health and growth potential of companies and the wider economy. Cutting research and development, for example, can boost short-term profit at the expense of future growth. There is also the increasing pressure from activist investors on company management to cut costs to drive higher earnings and subsequent cash returns to shareholders.

Missing earnings for the right reasons

If earnings have undershot guidance because management has, for example, increased investment or spent more on advertising this could prove positive if it helps drive the long-term health of the business. Moreover, given the market’s focus on short-term headlines, these events can even create investment opportunities that we can exploit. The market can, for example, punish a company that misses its earnings target even though we know it has done so through increased investment in an area that will drive longer-term earnings growth. Our overall strategy is to focus on the long-term prospects of businesses and to conduct in-depth analysis that reveals the underlying factors driving earnings.

Important information

Unless stated otherwise, any sources of all information is Aviva Investors Global Services “Aviva Investors”) Limited as at 11th December 2015. Unless stated otherwise any views and opinions expressed are those of the author and should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St. Helen’s, 1 Undershaft, London EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority and a member of the Investment Association.