What We’re Watching
Whether earnings declines potentially trough this quarter, should these two drags continue to fade, is the key question for us this earnings season. Given how far 2016 estimates have fallen (down 5.6% year to date), they may at least hold steady as companies report results (a rise is seen as unlikely). Remember, many of these management teams delivered their 2016 expectations to investors in late January and early February 2016 when recession fears peaked, stocks and oil bottomed, and the U.S. dollar was near recent highs. Conditions are better now, suggesting the tone of guidance may be more positive.
Some other things we will be watching this earnings season:
· Profit margins. Wage pressures have increased gradually and have started to impact profit margins. We will be watching for signs of further pressures that could lead to margin compression. To date, corporate America has done a terrific job maintaining high profit margins.
· Capital allocation decisions. We would like to see companies deploy more capital to invest in future growth, which investors may view as a positive signal for the future. We are fine with companies returning capital to shareholders, but we would like to hear that companies are making capital spending a bigger priority.
· Emerging markets demand. China, which has been seeing some improvement in economic conditions, is always worth watching. But U.S. companies may continue to be impacted by weakness in the commodity-producing regions and geopolitical hotspots overseas such as Brazil, Russia, and South Africa.
We believe energy, financials, and healthcare are the key sectors to watch. For energy, we would like to see evidence of further U.S. production cuts beyond the 8% drop already experienced. The quarter may prove difficult again for financials given lower interest rates and financial market volatility. Healthcare results should be strong again, but scrutiny over high drug prices may persist.
Quick Thoughts On Divergent Profit Measures
The large gap between operating earnings and GAAP earnings has been receiving a lot of attention from the financial media, and becoming a concern among some investors that it may signal even more earnings troubles ahead. The biggest reason for that gap has been the energy downturn, which has led to significant downward adjustments of oil and gas reserves valuations. The impacts of the energy downturn are well known and the associated risks were seemingly more than priced in when oil prices bottomed earlier this year. The gap between earnings measures was the effect, not the cause, and does not suggest increased earnings quality concerns are warranted, in our opinion.
Other similar periods that saw significant divergences in these earnings measures included the bursting of the internet bubble and the financial crisis, when acquisitions, intellectual property, and financial assets were significantly devalued. During these periods, the gap between the operating measure and GAAP earnings has ranged as high as 30% depending on the data source used for the operating earnings calculation.