It’s earnings season again and we’ll soon have fresh data points on the health of the economy and corporate profits. Based on operating results and outlooks provided last quarter, I believe the earnings recession we’ve been in for the past year will drag on for another quarter. While I typically don’t use Wall Street research to confirm my analysis, in this case sell side analysts and I are on the same page. According to a recent Financial Times article, “Analysts [are] forecasting the longest profit recession since the financial crisis. Earnings of the major groups that comprise the S&P 500 index are seen falling 5% in the second quarter from the same three-month period in 2015.”
While earnings growth may be negative again this quarter, I’m not expecting significant deterioration in Q2 vs. Q1. Based on what I’m observing with the 300 small cap companies I follow, I believe revenue growth overall will remain weak, but earnings declines may moderate slightly year over year. While operating results should continue to be sluggish, earnings comparisons are becoming slightly easier. Furthermore, companies that were hurt by sharply lower energy prices and currency have had time to adjust and reduce costs. I also expect the use and abuse of non-GAAP adjusted earnings to continue, which optically could soften the blow from weak revenue growth. Lastly, adjusted EPS will be aided again by corporate buybacks.
Due to the increasing abuse of non-GAAP adjusted earnings and low-ball sell-side earnings estimates, I believe it is becoming more important to focus on revenues, volumes, and uncontaminated (GAAP) operating results. For example, CSX reported earnings today and several headlines regarding their earnings release state something similar to, “CSX Profits Top Estimates”. While the headlines suggest the quarter was good, actual results were quite poor. Adjusted EPS declined to $0.47 vs. $0.56, but more important volumes declined -9% and revenues declined -11.7% (management can’t non-GAAP volume and revenues). While coal volumes were a major drag (-34%), many of its other divisions saw volume declines as well, including: Agricultural (-8%), Phosphates and Fertilizers (-8%), Food and Consumer (-4%), Chemicals (-13%), Metals (-8%), Forest Products (-8%), Waste and Equipment (-2%), and Intermodal (-4%). The only gains in volumes were auto (+1%) and Materials (+13%). I will learn more tomorrow after I listen to the conference call, but this is interesting data and confirms what several other transportation companies have reported, including trucking (WERN recently announced weak results as well).
In conclusion, when you read headlines that company XYZ “beat” earnings estimates, it’s usually a good idea to dig a little deeper and go beyond the earnings estimate game. The earnings estimate game is played between Wall Street analysts and company managements (managements spoon-feed earnings estimates to analysts and the company beats the estimates – it’s almost as easy and fun as money printing!). Fortunately absolute return investors aren’t required to play this game and can spend their time analyzing actual results.
Although I’m expecting another weak quarter of GAAP earnings and sales (yes, most companies will beat analyst earnings estimates), I don’t have a strong opinion on the market’s reaction. I know how markets should respond, but “what should happen” has been a poor predictor of stock prices this market cycle. Earnings have declined for four consecutive quarters and for the most part, stocks could not care less. However, there was a moment earlier this year when it appeared investors were paying closer attention to fundamentals. In January and February, stocks declined sharply while another round of poor corporate earnings were being announced – fundamentals were once again influencing stock prices. For disciplined value investors, it was refreshing and encouraging. Unfortunately, the rise in correlations between stocks and fundamentals was short-lived. Before asset price declines became disorderly, central banks came to the rescue again by stepping up their policy response, driving asset prices sharply higher. I thought the ECB’s announcement that it would buy corporate debt was particularly dip buying inspiring!
With stocks again at record highs, it appears central bank policy continues to override fundamentals. Until this changes I believe it’s important to continue to follow business results and fundamentals, but keep in mind the profit cycle and market cycle have gone their separate ways and what should be happening (lower profits = lower stock prices) isn’t happening. As a fundamental analyst and absolute return investor, this is a frustrating environment, but there isn’t a lot we can do about it except wait for correlations and market psychology to change. I think it’s also important to consider that regardless of whether earnings decrease by a little or increase by a little this quarter or next quarter, the stock market is priced for VERY STRONG earnings growth. This growth is absent from actual earnings results and company outlooks. At this time, I see little evidence that second half earnings will grow significantly, which many analyst forecasts and stock prices are depending on.
In any event, enjoy earnings season! I’ll be particularly interested if results matter this quarter. As stated previously, over the past year, financial markets have shrugged off negative earnings trends. I am on alert as to when fundamentals matter more than monetary policy/market intervention. I’ll also be on alert as to when stocks respond more to actual results versus responding to whether or not a company beat easy-to-beat-spoon-fed earnings estimates. I’m not holding my breath, but one of these quarters I’m confident fundamentals and valuations will trump all. Until then, I’ll patiently wait in cash and let others play along with the central bankers and the earnings estimate games.