Weekly Investment Commentary: Earnings seasoned with a grain of salt
Bottom line up top
- 1Q earnings: so far, pretty good. About 20% of S&P 500 companies have reported first-quarter results. Of those, 76% have met or exceeded expectations on revenue, and 82% on earnings (Figure 1). The blended earnings growth rate for the first quarter is currently 6.6%. Should that number stick, it would be the lowest since the fourth quarter of 2020. This week will be among the most closely watched of this earnings season, with companies representing about 50% of the S&P 500’s market cap reporting.
- What we’re watching. The overall earnings tone has been positive, initially supporting markets, but last Thursday’s comments from the Fed signaling more aggressive rate hikes overshadowed strong corporate results. Looking toward the coming quarters, our investment teams are focused on several key earnings-related issues, including:
- Peaking margins and the importance of pricing power. Expectations for double-digit revenue growth, but only 5% EPS growth, suggest margins may have peaked (Figure 2). Companies that have benefited from pricing power advantages to protect or grow margins in an inflationary, supply-constrained environment could see that change if they experience pushback on price hikes. Forward guidance should shed some light on this.
- EPS growth: back-end loaded? Analyst expectations for the full year appear to be relying on a strong finish to make up for earlier relative weakness. That means downward revisions could become a problem if the U.S. consumer starts to waver, supply chains remain under pressure due to China’s zero-Covid policy or Fed rate hikes curtail demand too much.
- Conviction among the caveats. Not all earnings are created equal. That leads us to favor areas like energy, materials, technology and growth-oriented consumer discretionary companies.
“U.S. corporate earnings have started off well, but there are possible risks we need to watch.”
Portfolio implications
Inflation trends should benefit some areas more than others. So far, higher inflation has had a mixed impact on corporate earnings. Inflation could create more challenges down the road, as well as more opportunities. Higher energy and labor costs could hurt companies that lack pricing power, but we also think inflation-sensitive sectors such as energy and materials should benefit as revenues climb in part due to rising prices.
Shifting valuations are creating opportunities. There’s been wide dispersion in valuation changes, earnings results and returns across sectors this year (Figure 3). Areas of the market with the most severe downward valuation adjustments, such as select growth-oriented companies in the consumer discretionary sector, appear the most intriguing. These companies should benefit from continued strong household balance sheets and climbing wages.
Positive earnings revisions should do the same. We think the technology selloff has set the table for stock pickers, and expect certain segments to experience positive earnings surprises over the rest of 2022. Of those, we prefer higher-quality growth companies with attractive free cash flow yields (such as select enterprise software names) over companies with high valuations in competitive industries that lack pricing power.
“Earnings results so far suggest some sectors and areas of the market offer better value than others, making selectivity critical.”
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Regular meetings of the GIC lead to published outlooks that offer:
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Endnotes
Sources
All market and economic data from Bloomberg, FactSet and Morningstar.
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