October 14, 2015
Investment Management
EQUITY MARKET REFLECTIONS
WHAT MIGHT HAPPEN
TO CORPORATE PROFITS?
by Gene Balas, CFA
C
orporate profits are a primary ingredient in stock market valuations. With that
in mind, let’s take a deeper look at the concept of earnings and ask three
questions. First, what are investors currently paying for those earnings? Second,
how might the earnings season unfold as companies report their third quarter results?
And lastly, and perhaps more importantly, what are longer-term the ramifications of
profit growth on corporate actions?
Data provider FactSet offers some clues. Sales for companies in the S&P 500 are
projected to dip 3.4% in the third quarter from a year earlier, with profit margins
at 10.1%, which compares to the record-high of 10.5% in the second quarter. As
companies arguably have less excess to trim from their operations, the effects of
declining sales are expected to take its toll on earnings. (Simply reverting back to
historical levels of profit margins would itself argue for a drop in profits.) Indeed,
FactSet reports that S&P 500 earnings are forecast to fall 5.1% in the third quarter
from a year earlier. Low oil prices, a strong dollar and weak overseas growth (think
Investment Management
Equity Market Reflections
October 14, 2015
China and other emerging markets) are partly to blame. If actual earnings match these
estimates, this would be the first time since 2009 – when we were in recession – when
earnings fell for two quarters in a row.
Ned Davis Research pointed
out in a research note dated
October 7, that, in order
to return to what NDR
determined is “fair value,”
the S&P 500 would need to
fall by 16.8%.
Standard and Poor’s Ratings
Services’ rated universe of
nearly 2,000 US nonfinancial
companies held $1.82 trillion
in cash and short- and
long-term investments as of
year-end 2014, an almost 5%
increase from 2013.
Of course, earnings could come in better than expectations – or they might not. The
backdrop is that, even after the correction, the S&P 500 recently traded with a price
to earnings multiple of 17.9 times trailing twelve months earnings, also according to
FactSet, compared to the 10 year average P/E multiple of 15.7. That means stocks may
be priced for perfection – and could be vulnerable to a correction.
In separate research, and using different valuation criteria, Ned Davis Research
pointed out in a research note dated October 7, that, in order to return to what NDR
determined is “fair value,” the S&P 500 would need to fall by 16.8%. And it’s always
possible that markets could correct even further than simply arriving at fair value.
Let’s now change gears entirely, shifting from how investors might react to any profit
declines to what corporate chieftains might do. After all, one of their primary missions
is to generate profits to return to shareholders. There are several different ways of
boosting profits, but here, we’ll consider two: combining forces with complementary
companies to eliminate redundancies and introducing new efficiencies to their
workplaces to augment productivity.
What we know is that cash on corporate balance sheets is at very high levels, and
borrowing costs are at extremely low levels, especially for companies that carry
investment-grade ratings. Indeed, Standard and Poor’s Ratings Services’ rated universe
of nearly 2,000 US nonfinancial companies held $1.82 trillion in cash and short- and
long-term investments as of year-end 2014, an almost 5% increase from 2013.
Meanwhile, you’d have to go back 40 years to find AAA-rated corporate bond yields
as low as they are now. So, not only do many corporations have enough cash to go
on a shopping spree or invest in new equipment or technologies, they can borrow to
do so. (Of course, the corporate cash balances are not evenly distributed among all
companies; some have significantly more cash than others do.)
© 2015 United Capital Financial Advisers, LLC. All Rights Reserved
www.unitedcp.com
Investment Management
Equity Market Reflections
October 14, 2015
What this means is that, in order to maintain high levels of profits, companies can buy
other companies – the recently announced purchase of EMC by Dell Computers is a
prime example – and/or they can also invest in labor-saving technologies to extract
more output from their current workforces. Now that the unemployment rate is a low
5.1%, according to the Bureau of Labor Statistics, and posted job openings relative to
the size of the labor force is at a record high, as seen in the nearby graph, companies
may find they are having difficulty finding the exact workers they need without
boosting pay significantly. Consequently, investing in new technology may make sense
for some companies.
© 2015 United Capital Financial Advisers, LLC. All Rights Reserved
www.unitedcp.com
Investment Management
Equity Market Reflections
October 14, 2015
The upshot is that increased merger and acquisition activity could be beneficial to
some investors in the acquisition targets. And increased investment in equipment and
software can add to economic activity, both directly in the short term through increased
spending on capital expenditures, and in the long term, through higher productivity
gains, which are an important ingredient in allowing the economy to grow faster
without inflationary pressures and giving workers a pay raise at the same time.
So, as the saying goes, “Necessity is the mother of invention,” a modest squeeze on
corporate profits need not necessarily be a bad thing – at least in the longer run. In the
short term, it is an added risk consideration for investors weighing whether the market
is properly valued relative to its fundamentals.
If you have additional questions about how possible short- and long-term outcomes
for the financial markets could impact your own short- and long-term goals, have a
talk with your United Capital financial adviser. We offer a wide range of strategies to
help clients align their financial goals with their life goals. We call it FinLife. At United
Capital, we want to help you identify the financial choices that are right for you.
Disclosures
United Capital Financial Advisers, LLC (“United Capital”) provides financial life management and makes
recommendations based on the specific needs and circumstances of each client. For clients with managed
accounts, United Capital has discretionary authority over investment decisions. Investing involves risk, including
possible loss of principal, and clients should carefully consider their own investment objectives and never rely
on any single chart, graph or marketing piece to make decisions. The information contained in this piece
is intended for information only, is not a recommendation to buy or sell any securities, and should not be
considered investment advice. Please contact your financial adviser with questions about your specific needs and
circumstances.
The information and opinions expressed herein are obtained from sources believed to be reliable, however
their accuracy and completeness cannot be guaranteed. Opinions expressed are current as of the date of this
publication and are subject to change. Certain statements contained within are forward-looking statements
including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue
reliance should not be placed on such statements because, by their nature, they are subject to known and
unknown risks and uncertainties.
United Capital, Ned Davis Research, S&P Ratings, and FactSet are separate and unrelated entities.
© 2015 United Capital Financial Advisers, LLC. All Rights Reserved
www.unitedcp.com