Withering from a great height

There are four occasions every year where stock market investors get particularly myopic and focus their attention are on the slew of financial reports coming from mostly US companies, writes Aidan Donnelly.

Quarterly earnings season is important as it allows investors gauge the current and future prospects for the companies they are investing in. The fourth quarter season is now drawing to a close and perhaps has taken on more significance than any other for the last few years.

The reason for this heightened importance lies in the fact that with equity market valuations at, or above, historical fair value levels, much of the returns that investors will garner from equities in 2015 and beyond will be predicated on the growth rates of corporate profits over those years.

The scores on the doors

There were many dark clouds creating heightened levels of pessimism among analysts in the run in to this earnings season, that saw the majority taking the machete rather than the scalpel to the profit forecasts for the companies they covered. The result of this was that we saw year-on-year aggregate profit growth rates for the S&P500 fall from low double digit percent to a mere 1.7% over a three month period.

As is often the case, the pendulum of pessimism had swung too far and as companies began reporting actual results, the percentage of companies beating estimates was very high. As a result of these upside surprises, the earnings growth rate for Q4 2014 inched higher and now stands north of 3%.

At the sector level, the healthcare and telecom services sectors reported the highest year-over-year growth in earnings, while, not surprisingly given the near 60% fall in the price of oil, the energy sector reported the largest year-over-year decline in earnings.

The energy sector reported the largest year-over-year decline in earnings.”

What of the future?

While we know what has happened over the preceding quarter is of use to investors, what is always watched more closely are the comments from company managements regarding prospects for the current quarter and beyond.

Looking at the first half of 2015 in light of what many companies have said, analysts are now projecting year-over-year declines in both earnings and revenues for both Q1 2015 and Q2 2015 for the US equity market (S&P500), compared to expectations for earnings and revenue growth for both quarters back on December 31st.

With the price of oil remaining near recent lows, most of these downward estimate revisions have occurred in the energy sector.

In fact, full year 2015 earnings estimates are down 9% from the peak in October. Expected revenue growth has fallen to 0% from 4% and expected earnings growth has declined to 3% from 12%. Estimates often start out too optimistic and moderate over time, but the speed and magnitude of the decline during the last four months has been dramatic.

As I have said, the major reason for the reduction in profit expectations for the market overall is the significant declines in profitability seen for energy companies. While it would be convenient to park the blame solely at this door that would be a mistake. There are two other factors at play that should not be overlooked.

At their very essence, company profit expectations should reflect the changes in economic activity in both their home countries and the wider world.

Some of the indicators, such as GDP forecasts and business sentiment surveys, have been, of late, pointing to regional slowdowns. Whether it is the mixed data coming from some of the largest emerging market countries such as China – or the fact that Russia has slipped into recession – or that Latin America is faced with decelerating growth and high inflation, the economic growth forecasts for these global engines are reducing.

As for the developed world, Europe and Japan have been weak for an extended period, although some improvement is evident recently, but more worrying would be any deterioration in the outlook for the US – a fact that cannot be ruled out.

Green-back boogie

Currency fluctuation emerged as one of the biggest causes of earnings surprises over this reporting season, despite the obvious move in the US dollar. Companies routinely cited currency moves as the reason for earnings misses and lowering future expectations. This is understandable given the magnitude of the change in the dollar and the large volume of business that is conducted overseas by US companies.

It is estimated that c.34% of S&P 500 sales originate abroad, with some sectors and industries materially higher. This has exacerbated the headwind to revenue caused by converting foreign sales back to U.S. dollars for the purposes of financial reporting.

Companies that obtain a large portion of sales from outside the US have been the primary source of post-earnings announcement negative revisions, further suggesting that the strength of the US dollar has played an important role in the decline in forward earnings estimates.

So whether it is the likes of the management of consumer products giant, Proctor & Gamble, who said: “Across all currencies, foreign exchange headwinds are forecast to be a $1.4bn after tax profit negative impact over the course of the fiscal year. This is the most significant fiscal year currency impact we have ever incurred“, or the CEO of healthcare company, Johnson & Johnson, who remarked: “If currency exchange rates were to remain where they are now for the balance of the year, then our sales growth rate would decrease by nearly 5.5%, reflecting the recent weakening of the euro and other major currencies against the US dollar”, the problem is real and in some cases, very significant.

Calculating the cost

While it is straightforward to calculate the impact on revenue from changes in the US dollar, it is more difficult to assess the implications for earnings per share. This is because companies hedge currency risk, either with derivatives or through supply chains, which provide natural hedges when labour and materials are sourced near the point of sale.

Therefore, in aggregate, the full extent of the impact of foreign exchange may take some time to materialise.

Of course where currencies are involved, there is always the other side of the coin (pardon the pun). And here we have seen earnings upgrades for many of the large export oriented companies based in Europe across sectors like industrials, consumer goods, and pharmaceuticals.

Given the weak demand outlook in their domestic markets, the competitive uplift from a weak euro in foreign markets is a welcome relief.

So with all this bad news circulating about the outlook for corporate profits, you could be forgiven for thinking that share prices must be in a tail spin since the beginning of the year.

The truth is quite the contrary with most major indices in positive territory so far. Maybe investors view the issues of oil and the dollar as transitory in nature and are willing to look through them or maybe things aren’t a problem until they are a problem. Time will tell one way or the other.