You Said: “Earnings”?

A reader recently complained that no one was mentioning the “market’s” earnings anymore and that he could not find estimates for the S&P 500 anywhere.  Being French educated, I could not miss such an opportunity to give a long answer to a simple question. So, here it is…

First of all, there are estimates for the S&P 500 out there. The reason why your brokers don’t mention them much, I suspect, is that these estimates can hardly be used to justify a bullish stance on the broad market.

Casually perusing recent brokerage reports, I found estimates of the S&P 500’s earnings between $50 and $57 for 2001 and $53 to $64 for 2002, with First Call “consensus” numbers of  $54.54 and $60.36 respectively. These compare to operating earnings of $56.16 in 2000, so that little net progress is expected over this year and next.

“Operating” earnings, in case you wonder, are what Ed Yardeni, of Deutschebank, calls EBBS – earnings before bad stuff. Reported earnings, including so-called “non-recurring” items, would have been around $50, not $56.16, in 2000.

I won’t waste too much time arguing about these estimates, except to mention that Ed Hyman, of ISI, has a model of the S&P 500’s operating profits that forecasts 2001 earnings to be down 19% from last year, with a bottom in the third quarter at minus 25% year-over-year. This would produce earnings of just over $45 for all of 2001, well below the current consensus. To be fair, even Ed Hyman, one of the country’s best forecasters, does not call for a decline of that amplitude. Still, downward earnings revisions keep coming in. Yardeni, for example, just lowered his estimate to $47 for 2001, but he sees a rebound to $57 for 2002.

The more important point, for valuation purposes, is that corporate profitability has been historically high, in recent years. As a result, earnings are unlikely to grow in the future at the pace of the 1990s, when they started from a low base. Yardeni points out that the S&P 500 earnings rose 10.8% a year, on average, during the last decade, led by a doubling in the profit margin that is unlikely to repeated. The 1990s also saw the share of corporate profits in the National Income return to highs not seen since the mid-1960s.

The spectacular recovery of corporate profitability achieved in the 1990s actually originated in the mid-1980s, when American industry was still viewed as hopelessly declining.  It was the result of a cultural revolution in management, with new concepts such as continuous-flow manufacturing, “just-in-time” and total quality control drastically increasing the efficiency of both labor and capital.

Parker Hannifin is a well-managed “old economy” company that I have known for many years, though we do not, at this writing, own the stock. Though it is well focused on its main business, the breadth of its markets is such that the Federal Reserve uses it as a source of information on the pulse of the economy. This makes it a good indicator of how much the management revolution of the 1980s rate boosted margins and returns on assets. In the decade to 1998, Parker Hannifin’s returns on assets and equity rose from 6.6% to 9.8% and from 13.3% to 19.8% respectively. Around that time, Parker Hannifin’s president told me: “Frankly, we had never thought we could ever achieve returns like the ones we now enjoy”.

In addition, by the mid-1990s, revolutions in information and telecommunication technologies, together with the Internet, began to further contribute to corporate efficiency and profitability.

And, after a bubble of excitement, it is now the users who are proving to be the real, lasting beneficiaries of this most recent technological revolution -- as they have with past ones. So, the full benefit to operating profit margins from these combined revolutions probably has not yet been realized.

The problem is that, in recent years, corporate profits also have been artificially inflated by other, non-operating factors, so that broad segments of the economy will now suffer an offsetting “withdrawal effect” that will slow earning for a while.

One of the drawbacks of the earlier management revolution is that it increasingly brought to the top of the corporate ladder a generation of leaders proficient mostly in cost cutting. After the early gains from new management techniques had been achieved, it became obvious that most of these new leaders really did not know how to manage the businesses for growth. Their solution was to merge, in the hope of squeezing some more savings from such combinations.

Unfortunately, whatever logic initially supported that trend was ultimately corrupted, with the help of hungry investment bankers, complacent auditors and gullible financial analysts. Among other shenanigans, corporations began to take increasingly huge write offs upon merging. Since these were treated as non-recurring items and indicated managements’ determination to aggressively restructure the combined entities, analysts cheered them, rather than using them to question previously reported earnings and growth records.

In this win-win situation, merger-related write-offs became increasingly generous, often allowing corporations to recapture some of the excess reserves into the operating earnings of later years. Post-merger reported earnings became all but impossible to analyze but nobody complained, since everyone profited. The problem is that, as a result of such manipulations, both the level and the implied growth rate of reported earnings became artificially and significantly inflated.

These, of course, were not the only shenanigans. Under pressure to meet revenue goals set by demanding but unrealistic leaders, some desperate, and unscrupulous managers began booking sales before they actually took place, thus preserving for a while the illusion of growth. This is what happened at Sunbeam Corporation under the leadership of “chainsaw” Al Dunlap, until all hell broke loose.

In the last few years, many of these arguable techniques for managing earnings have received broad publicity, as well as increasing scrutiny from the SEC. So, one can hope that they have begun to recede.

Furthermore, resistance to mega-mergers is increasing globally. There is a political and economic limit to how big corporations can become, so that the game of earnings growth through acquisitions is not an open-ended one.

Over the coming decade, stock market valuations will have to reflect both the disinflation of reported earnings and the lower growth that many merged companies can hope to achieve without the benefit of creative acquisition accounting – at least under current managements.

Starting in the mid-1990s, so-called new economy companies added a whole new layer of profit inflation to the one created by the merger wave among old economy corporations. To an unprecedented degree, this was made possible by the growing linkage between the stock market and the economy.

The “tech” and Internet stock market bubble gave new economy companies almost unlimited access to stock market financing, leading to an orgy of investment – not only on new equipment, but also on commercial space, advertising, etc. This spending boom contributed a significant portion of the overall economy’s growth – especially between 1997 and 2000. Yet, as has now become evident in the current struggle for survival of many telecommunication equipment suppliers, much of it was not needed.

Of course, many Internet companies with little more than an idea for a business were also able to raise enormous sums from venture capitalists and stock market IPOs. As these sums were spent on people, space, equipment and advertising, an unsustainable layer of demand was added to economic activity. With many of these companies about to disappear, the economy’s growth of the last several years will not be repeated in coming ones. While these fledgling companies obviously did not contribute to the overall profitability of the corporate sector, their purchases and job creation did inflate, for a while, the earnings of their suppliers and the providers of consumer goods to their newly rich employees.

At the moment, the US economy is in the midst of one of the most violent inventory corrections in recent history. The way inventories are liquidated is by cutting production and selling out of stock. So a one-time adjustment is pushing economic activity below sustainable levels. Soon, of course, economic growth will resume, but from a lower level than achieved at the top of the boom, and at a more sustainable, lower pace than in recent years.

I will not even attempt to list the accounting gimmicks used by some Internet companies, from the invention of fuzzy pro forma accounting to the use of questionable barter deals to boost reported sales. Let’s just say that, for many, accounting creativity matched or surpassed technological prowess. But profits of more mature companies received an unsustainable boost from the “tech” euphoria as well.

Easy access to financing allowed many creditworthy suppliers to finance -- on an unprecedented scale -- purchases by their financially weaker customers. Many of these customers are now struggling to survive -- forget paying back supplier loans. So, significant amounts of sales and profits booked by large, reputable companies in the last several years may eventually prove to have been phantom ones.

Then, there is the options game. Employee compensation at many large “tech” corporations increasingly has been in the form of options grants with very low exercise prices. Even without mentioning the future dilution that will result for shareholders, this artificially reduced salaries and related charges. Now, however, many options have gone the Jacques Cousteau way -- under water. It’s a fair guess that employees who have not been laid off will eventually insist on a little less dream and a little more cash, thus boosting costs during increasingly challenging times. In addition, corporations will see the tax savings accruing to them when options were exercised evaporate, and some of the largest ones may actually have to start paying taxes.

Note that old economy companies, while much less aggressive in the use of options, often have included some pension fund market appreciation into operating earnings. This is as legal as the options game but just as dubious in terms reporting true “recurring” profits.

Finally, many of the most successful “tech” companies had built valuable stock portfolios in recent years. This started as a way for industry leaders to keep a close watch on emerging technologies and markets, as well as future customers, suppliers or potential competitors. As many of these “venture” investments got floated onto the stock market, these corporate investors were able to reap enormous gains by selling a fraction of their holdings on the IPO or shortly thereafter. Now, however, the “paper” gains remaining in their portfolios have all but evaporated, eliminating one of the easiest tools for managing reported earnings.

Generally, therefore, we expect future profit growth at many companies to be held back by the partial disappearance of non-recurring items that have been included in operating earnings. But beyond this, there also is a question as to whether the earnings of various stock market indexes are truly representative of what is going on in the economy or the broad market.

UBS Warburg, for example, calculates the change in operating earnings for the S&P 500 companies between QII 2000 and QII 2001 at minus $13.1 billion. While the health care, financial and energy sectors actually showed modest gains, the technology sector accounted for $10.1 billion, or more than 75% of the total profit decline. Yet, the technology sector accounted for only 20% of the capitalization-weighted S&P 500 index. Was the recent profit decline for the S&P 500 (or, for that matter, its preceding profit take off) representative of what happened to “the market”? Obviously not.

Capitalization weighting of indexes tends to replace companies’ true economic performance with a sort of virtual reality heavily influenced by investors’ fantasies and willingness to pay up for stocks with “momentum”. For example, the construction of the Dow Jones Industrial Average has its own shortcomings, but it is not weighted according to stock market capitalization of its component companies. Had it been, according to Business Week, it would have lost 25.6% of its value between January 14, 2000 and April 9, 2001. As it is actually constructed (by adding up the share prices of individual components), it declined only 16% during that same period.

In spite of their irrelevancy, let’s stick with the market indexes for a while. By almost any measure, they are still overvalued. Jeremy Siegel, professor of finance at Wharton, recently provided Business Week with a chart of the stock market’s price/earnings ratio going back to 1870. The “market’s” average PE, over 130 years, has been 14.2, and never had it been as high as it was in 1999, when it reached 32.5.

By the way, this takes care of the argument that low interest rates justify recent high market valuations, since there have been many periods in the past 130 years when interest rates were even lower than they are today.

The S&P 500’s PE ratio has now fallen to about 25. In good part, this is due to the PE of its (capitalization-weighted) technology sector falling from 47 to about 33 in the past year, according to Deutschebank.

Still, no matter how you look at it, even after the recent correction, stock market indexes are not cheap. For example, the S&P 500’s price to cash flow, price to sales and enterprise value to EBITDA ratios have also declined significantly. Yet, this only brings them back to their 1997-1998 levels, when they already stood more than 60% above their levels of the early 1990s. In other words, while much of the 1997-2000 bubble has been erased from the indexes’ valuations, the bulk of the 1990s bull market has not.

Over the 74 years from 1926 to 2000, annual returns on large-company stocks have averaged less than 11%. They have been a bit higher on small company stocks, but with greater volatility. Long periods of above-average returns naturally tend to be followed by periods of below-average gains – often because of more frequent stock market declines.

In addition, there are many academic studies documenting the intuitive conclusion that future returns tend to be lower when starting from a base when PE ratios and other valuation criteria are high.

Finally, other studies show that future returns also tend to be sub-par when starting from a period when companies’ profit margins have been historically high.

Since all these elements are still present, I don’t see how stock market returns in the next several years can fail to disappoint investors still viewing 15% annual gains from the stock market as being a “reasonable” expectation.

Fortunately, in my experience, periods when investor expectations are being lowered are propitious ones for stock pickers. One reason is that bull markets tend to be moved by fashions. Shares of companies that are out of the prevailing fashion will often under-perform during most of the bull market, ending up with more reasonable valuations at the market top. Another reason is that circumstances that have created the bull market fashion will change. This often coincides with a change of the profit drivers in the economy. Companies that struggled but survived in good financial condition under the previous environment often see their performance improve with the change in profit drivers, and this tends to improve their allure for investors, who then allow them richer valuations.

The bull market of the 1990s, especially its last leg, was in fact quite narrow. Excluding the tech sector, drug companies and a few large exceptions like General Electric, gains were very subdued and PE ratios barely increased. This, for value-oriented and contrarian stock pickers, should present many attractive investment opportunities.

July 6, 2001
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