The wrong question — and the right one — to ask about earnings headwinds 💬
Why expected earnings can rise despite bad news 📈
Something extraordinary happened during the first three months of the year: Analysts revised up their forecasts for S&P 500 earnings.
According to FactSet, analysts currently expect the S&P 500 to earn $228.43 per share. This is 2% higher than the $223.43 expected as of December 31, 2021.
Some of this can be explained by analysts fine-tuning their financial models, which initially may have relied more heavily on guesswork.
Nevertheless, the revisions are pretty surprising considering risks that emerged during the period.1
The question we usually ask
When a new headwind emerges, investors probably think to themselves: How will this hurt the earnings2 of the companies I’m invested in?
Geopolitical turmoil is negative for sentiment for most people, so sales should suffer. Persistent supply chain disruptions are a double whammy since they put a cap on sales while causing more inflation. Higher-than-expected inflation means higher costs of goods, so gross profit margins should shrink. Rising labor costs should pressure operating profit margins. The Fed raising interest rates means financing costs should rise.
These were among the unfavorable developments from the past three months. And yet expected earnings have been revised up.
The problem is we’re asking the wrong question.
The question we should ask
The right question is: Can the companies I’m invested in deliver on earnings?3
It’s similar to the question above, but it broadens the scope of the inquiry to consider more than just the negative impacts of just the unfavorable developments.
Specifically, this question forces you to consider the possibility that earnings may even go unaffected, something that’s proven to be the case during the pandemic. If there’s one thing we all should’ve learned over the past two years, it’s that consumers and businesses are incredibly resilient and remarkably adaptable.
Despite hits to sentiment, consumers have continued to demonstrate a willingness to spend. Among other things, this can be explained by relatively healthy finances, bolstered by $2.5 trillion in excess savings. Also, U.S. employers added 1.7 million jobs in 2022 so far; that’s a lot of new income that previously wasn’t being earned.
Despite rising costs, businesses have demonstrated an ability to maintain and even increase profitability. They’ve been raising prices, cutting costs, leveraging their operating structures, and investing in productivity-enhancing technology.
It’s never ceteris paribus
As a thought exercise, it can be useful to consider how a new challenge could affect the earnings of a business, ceteris paribus — Latin for “all other things being equal.”
But all other things are never equal.
The onset of the pandemic was the end of business as usual. Everyone has had a unique experience with this. Many have found themselves working differently or just flat out doing different work.
In 2020, I worked at Yahoo Finance, which produced eight hours of live programming five days a week from a studio. When everyone was sent home for public health reasons, we were no longer able to use the studio. Did that business get shut down? No. Over the period of 48 hours, managers and producers scrambled to set up a virtual studio while getting on-air talent the critical tools they needed to broadcast from home. It wasn’t a perfect tradeoff, but the live programming never had to go dark.
Businesses will make adjustments in the face of new challenges. This is especially the case for publicly-traded corporations with executives who have to answer to shareholders who demand earnings growth no matter what. Leaders will seek out ways to keep business humming because it’s written into their personal goals, which are in line with the team’s key performance indicators, which in turn are in line with the company’s objectives and key results.
And at the end of the day, the most critical result is always earnings growth. Everyone’s employment status and compensation will be tied to it in one way or another. That’s because earnings pay for dividends and drive up stock prices — two things shareholders care about most.
Another important factor in all of this is emergency monetary and fiscal measures. Say what you want about what the government should and shouldn’t do during crises. But the Federal Reserve and Congress play a massive role in propping up the economy. That’s just American capitalism for you, and it plays a significant role in whether a company can deliver on earnings.
The bottom line: Bad news will emerge, but you shouldn’t expect businesses to just take the L. They’ll make changes to keep profitability up while being mindful of the resilience of their customers and support of their government.
More from TKer: