On the Margin
Q2 earnings season is 93% complete as of the time of writing with an earnings per share (EPS) growth rate of -5.2% y/y, while revenue growth is at 0.1% y/y. This will mark the third quarter in a row of y/y earnings declines, but is expected to be the last, according to expectations for Q3 and beyond.
Although company results are always the “story” during earnings season, the puzzle pieces I’ve been more focused on lately are revenues and margins. The reason is twofold: 1) Given the last year of high inflation and pass-through pricing, as inflation falls, revenues are likely to come under pressure (i.e., companies could lose pricing power), and 2) without stronger revenues, companies will have to cut costs in order to protect margins.
To be fair, margins have expanded notably throughout this cycle, meaning there was a decent buffer to absorb a drop in revenues and still maintain decent earnings. But the reality is that margins are contracting now, and have returned to the post-1990 trend line after popping up to their highest level ever in Q1 of last year. That buffer has shrunk.
Let me be clear, margins “at trend” are not bad. In fact, they’re still quite healthy. The thing to watch here is if the line can stop dropping and maintain a healthy clip. I’ve been skeptical of that for a while, and it’s taken longer than I expected to materialize, but the sharp drop in margins alongside the sharp drop in inflation is not a coincidence.
For the rest of the year, the bigger question will be: Which sectors and companies can manage their margins without the tailwind of inflationary pricing power?
11 Recipes for Results
It’s easy to paint with a broad brush, look at things like margins or valuations on a broad index level, and call them relatively attractive or unattractive. But most investors aren’t only invested in a broad index ETF, and many find it much more interesting to make tactical or concentrated moves around the margin (pun intended) of their portfolios.
One way to do so is by sector. Market behavior over the last 18-24 months has been a sector story through and through. The dispersion in sector returns has been nothing short of extraordinary. Likewise, the dispersion in earnings results continues to be almost as remarkable.
Sector returns over the last month (since earnings season began in earnest) have been choppy, and do not follow the patterns in the rather erratic chart above. Specifically, we can see that Energy has reported the deepest earnings decline, while being the best performing sector over the trailing one-month period with +7.6% return. Consumer Discretionary has hit the cover off the ball in this quarter’s earnings results, but is down 3.4% over the last month.
Does this mean earnings don’t matter? No. Earnings matter, earnings always matter. But something else is at play, and my guess is rotation and valuations.
Shopping the Sale Racks
Market action in 2022 and so far in 2023 cannot be explained purely by one or two variables. But there are real patterns in some of the data that have very little to do with earnings results – after all, earnings growth has been negative all year.
The idea of valuations as the biggest driver doesn’t hold true across all sectors, but it does hold true across enough of them to have some explanatory power.
Let’s take Energy and Consumer Discretionary as examples again — one year ago, Discretionary was the second-most expensive sector in the index (as measured by the P/E ratio), and has seen a meaningful shift downward. Meanwhile, Energy was the cheapest sector and has experienced a bounce in valuations.
Some other sectors that have shown this pattern are Real Estate, Utilities, and Materials. The head scratcher remains Technology, which appeared highly valued a year ago, but is even more highly valued today.
This dispersion across sectors has resulted in a relatively flat P/E for the broad index: 18.5x one year ago vs. 18.8x today. There have certainly been fits and starts over that period, but it’s almost shocking to see how little it changed. So much has happened over that period, yet seemingly nothing at all?
New sector leadership has emerged, along with a precipitous decline in headline inflation, and a resulting (in my opinion) rapid decline in margins. We always have to take the bad with the good, and it will always be nearly impossible to call market rotations at the right time. But earnings, revenues, and margins will always show the facts, even if they may not be reflected in the market in the way or at the time we expect. Then again, that is what makes this all so fun.
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