Stocks fell yesterday despite continued strong earnings. The FOMC meeting concludes today but the market will most likely be dominated by investor reaction to overnight earnings reports from giants like Apple#, Alphabet#, Microsoft#, and Visa#. Overall, these companies beat revenue and earnings estimates substantially. Aftermarket reaction yesterday afternoon was muted, which was an indication that good news was largely priced in.
There is a phrase investors use that you hear a lot this earnings season; beat-and-raise. That expression is used when companies report earnings that “beat” expectations leading managements to “raise” future guidance. On the surface, that would seem to be just what investors want to hear. Since stock prices reflect the present value of future cash flows, stronger than expected earnings should result in higher future expectations and higher stock prices.
However, there may be a fly in the ointment. Make that two flies. The first is rather simple. Analysts, who publish the earnings estimates that aggregate to form the consensus forecasts may either be behind the 8-ball or overly conservative. If that is so, the published consensus may be a bit below the actual estimates. Company managements contribute in that they would rather underestimate future earnings than overestimate.
With that said, there is nothing particular to this day and time to suggest that tendencies of analysts and managements to be conservative is any different now except for the uncertainties related to the pandemic and the subsequent economic recovery.
I said there are two flies. The second, is actually more important. To explain, I have to start with a brief accounting lesson. If a company plans to sell 100 widgets this quarter, it aligns its expenses with expected sales. There are 3 components to pre-tax expenses: materials, labor and overhead. Over the very short run, meaning 3-months, labor and overhead are largely fixed. Thus, when demand surges and your company ends up selling 110 widgets, labor and overhead are largely unchanged. Workers have to work harder to get the job done. If the sales rate continues at 110 per quarter, factories may have to be expanded and more people hired. In the short run, nothing moves that fast. Material input costs rise commensurate with higher demand. If materials are 30% of costs, a 10% rise in sales (from 100 widgets to 110) will cause a 3% rise in costs. The result is exploding margins. Suppose your model was 30% materials, 30% labor, 30% overhead and 10% profits. If sales rise 10%, with only material costs rising, profits rise from 10 to 17, a 70% gain.
That profit improvement is not sustainable. The new margin of 15.5% isn’t sustainable. Perhaps there is some fixed cost leverage that accompanies higher sales, but if the new sales levels can be maintained, the company will have to add more workers, and more overhead.
If the gains aren’t sustainable, their impact on future cash flows will be muted. The reality is that analysts always underestimate earnings when there is a demand surge, and overestimate earnings when there is an economic collapse for whatever reason. That doesn’t mean investors should do the same.
That’s key. After seeing enough earnings reports in recent weeks demonstrating the power of sudden volume surges, investors got the message. Why do you think all the leading averages set new records last Friday? Thus, today, we are likely to see very muted action in the stock prices of Apple, Alphabet, Microsoft and Visa. In fact, they may fall collectively; proof that the good news wasn’t a real surprise. It’s also proof that investors understand that the record margins companies are now achieving may not be sustainable over the long run.
We all know, as consumers, that post-pandemic there is a time to catch up. We are visiting relatives we haven’t seen in over a year. We are buying clothes to go back to work and school. No yoga pants in the office. We have events to celebrate. We also are seeing some supply constraints as demand moved faster than supply. That new grill you want may not be available until after Labor Day. Who wants it then?
Again, higher volume is good. There will be some margin expansion as there will be operating leverage as full capacity is approached. Stocks properly reflect record earnings and a strong outlook. The outsized earnings beats this quarter are an aberration that cannot be sustained.
S&P earnings estimates this year are approaching $200. Forget last year, the pandemic year. That compares to about $163 in 2019. Pretty good. Maybe better than pretty good, but stocks look ahead. In 2022, revenue growth may still be elevated as parts of the economy still have to wake up. Supply chain hiccups have to be solved. But margins? For many companies, beating 2021 margins will be almost impossible. Estimates for next year around $220 seem reasonable. There may be a new normal, but it won’t be all that different from the old normal. We still live in a very competitive world. Consumers won’t allow producers to sustain today’s margins.
The stock market is ahead of the analysts and managements. That’s why (1) stocks are at record highs and (2) “beat-and-raises” this quarter don’t carry the same weight as they normally do.
For the rest of the year, markets will be governed by the declining pace of growth, the future path of monetary policy, and the ability of Congress to pass some, all or none of President Biden’s tax and spending initiatives. Stay tuned.
Today, former NJ Senator Bill Bradley is 78. Cartoonist Jim Davis (“Garfield”) is 76.
James M. Meyer, CFA 610-260-2220