Strategy Monthly
The Importance of Being Earnest
September 15, 2015
Benjamin Graham, the co-author with David Dodd of the landmark text on security analysis, observed that “In the
short run, the market is a voting machine, but in the long run, it is a weighing machine.” The hopes, dreams, envy, fear
and greed of millions of traders drive the prices of securities on a daily basis as they vote with dollars, euros and yen
to buy or sell assets. As emotions wax and wane, so, too, do security prices. Yet in the long run, the value of a company is determined by its ability to generate economic growth, regardless of the volatility of its stock price. That distinction between price and value lies at the heart of a sustainable investment process — and underscores the importance
of being “earn”est.
Profits are important throughout the market cycle, but become even more so when valuations rise to a point that prices provide little margin of safety. Even with the recent correction, the S&P 500 index has nearly tripled from the lows
of early 2009, driving market valuations to elevated levels. At 18.2 times trailing earnings, the
S&P 500 Earnings Growth
% Change Year-Over-Year
price-to-earnings ratio of the equity market is
100%
by no means in bubble territory, but compared
80%
with a long-run average of 14.6 times earnings,
60%
valuations are undeniably stretched.
40%
Earnings growth is easier to come by in the
20%
early years of a market and economic cycle.
na
na
0%
During a period of economic stress, companies
-20%
Consensus
cut costs wherever they can in order to preserve
Expectations
-40%
profitability or viability. That belt-tightening creates powerful operating leverage once the cycle
-60%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
turns, as even modest improvement in revenues
As of September 10, 2015.
Source: Standard and Poor’s, BBH Analysis.
drops straight to the bottom line, to the benefit
No assurance that target forecast will be attained.
of both margins and earnings. And yet at some
point, companies run out of costs to cut — or at
very least the benefits of cost-cutting begin to diminish. Companies then become more reliant on revenue growth to
drive earnings increases, and without the powerful tailwind of margin expansion, profit growth wanes.
BBH STRATEGY MONTHLY / The Importance of Being Earnest
1
The Importance of Being Earnest
September 15, 2015
The current cycle highlights this general trend, as the nearby graph of S&P 500 earnings illustrates. Companies cut costs
throughout the 2008 to 2009 recession, and the resulting operating leverage drove a powerful recovery in profits in 2010
and 2011. The market was both a voting and a weighing machine in the early months and quarters of this market cycle,
as investor sentiment surged along with corporate earnings. Yet as the benefits of cost-cutting ebbed, so, too, did the
pace of earnings growth, which averaged only 6% from 2012 through 2014 and turned negative in the first few quarters
of this year.
Many Wall Street analysts blame the recent contraction in earnings growth on the damage wrought on the energy sector
by an oil price which has collapsed from a high of $108 per barrel in summer 2014 to the present level of $44. To some
extent that explanation holds water. Aggregate earnings of the S&P 500 Energy sector have dropped from $11.94 per
share in the second quarter of 2014 to a loss of $0.51 in the second quarter of this year. Yet as the following table shows,
Earnings per Index Share ($)
Earnings per Index Share ($)
2Q-14
2Q-15
% Change
3Q-14
3Q-15
29.34
26.13
-10.9%
29.60
28.88
-2.4%
Consumer Discretionary
6.95
7.61
9.5%
6.90
7.72
11.9%
Consumer Staples
6.32
6.37
0.8%
6.44
6.17
-4.2%
11.94
(0.51)
na
12.56
4.23
-66.3%
Financials
5.84
5.82
-0.3%
5.70
5.56
-2.5%
Health Care
9.54
9.68
1.5%
8.98
11.56
28.7%
Industrials
7.12
6.96
-2.2%
7.07
7.36
4.1%
Information Technology
8.52
8.86
4.0%
8.66
9.55
10.3%
Materials
4.49
3.79
-15.6%
3.91
3.61
-7.7%
Telecommunication Services
2.92
2.94
0.7%
2.75
3.04
10.5%
Utilities
2.64
2.97
12.5%
4.52
4.28
-5.3%
S&P 500 Index
% Change
S&P 500 Economic Sectors
Energy
Source: Standard and Poor’s, BBH Analysis.
Consensus analyst estimates
energy is but one of four sectors that posted a year-over-year drop in earnings in Q2 2015: Materials, industrials and
financials all posted declines as well. Furthermore, to the degree that analyst forecasts for the current quarter are accurate, five of the 10 economic sectors of the S&P 500 are expected to post shrinking profits in the third quarter of 2015.
This isn’t just about oil prices.
The graph of S&P 500 earnings growth presented earlier shows that analysts presume that index earnings growth will
rebound to a healthy mid-teens rate throughout 2016. Those expectations unfortunately reveal more about the innate
optimism of Wall Street analysts than they do about the likely future path of earnings growth. The following graph illustrates consensus analyst forecasts for quarterly S&P 500 index earnings for each of the past three quarters as well as the
current quarter. In each case, expectations faded throughout the course of the quarter and then proved too optimistic
at quarter-end, as the actual reports came in substantially below even revised expectations. Hope does indeed spring
eternal on Wall Street, offering little confidence that the anticipated rebound in earnings will materialize in 2016.
BBH STRATEGY MONTHLY / The Importance of Being Earnest
2
The Importance of Being Earnest
September 15, 2015
Analyst Expectations for Quarterly S&P 500 Index Earnings
Trend of Estimates During the Quarter
$32
4Q 2014
$31
$30
$29
3Q 2015
2Q 2015
$28
4Q 2015
$27
Final earnings releases
$26
$25
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66
As of September 14, 2015.
Source: Standard and Poor’s, BBH Analysis.
Day of Quarter
Reality argues that, in an environment of modest economic activity and quiescent inflation, companies are struggling to
sell more goods and services, or charge more for the goods and services they provide. Profit growth — the fuel for equity
markets — is running thin.
This combination of weak earnings growth and full valuations emphasizes the importance of a consistent approach
to identifying value — and investing at a discount to that fundamental value. That exercise becomes more difficult as
prices rise and profits wane, but active investing embraces that difficulty and allows the disciplined investor to avoid the
market-wide challenges spelled out above. Furthermore, investors shouldn’t feel compelled to be fully invested in this
market. Although cash offers precious little return at present, its option value is appealing, as it provides the ability to
benefit from price volatility by adding to positions at attractive discounts to intrinsic value.
Once the third quarter comes to an end on September 30, we’ll begin to obtain further evidence of the future path of
profit growth as companies release earnings for the quarter. Those reports have the potential to move both price (as investors vote) as well as valuations (as investors weigh). We will continue to focus on value and allow price to present the
opportunity to acquire that value at appropriate levels. Value is ultimately driven by earnings and is a stabler foundation
on which to invest than the attempt to anticipate future price movements.
G. Scott Clemons, CFA
Chief Investment Strategist
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer
to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding
penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice.
Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by
Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries.
© Brown Brothers Harriman & Co. 2015. All rights reserved. 2015.
PB-2017-06-07-1424
BBH STRATEGY MONTHLY / The Importance of Being Earnest
3