So far, with over half the S&P 500 Index companies having reported third-quarter earnings, the results’ season has been disappointing compared to previous quarters. Although no disaster, there has been clear evidence that earnings growth has been trending lower.
The expectation going into this earnings season was for a 1% year on year decline in earnings per share in the third quarter.
Earnings outpace sales growth
Financials were expected to be the strongest sector. According to Bloomberg, of the 273 companies reporting so far, 63% have enjoyed positive earnings surprises, compared to 69% in the third quarter of 2011; 24% have had negative surprises, up from 21% the same time last year.
When looking at sales growth, the numbers have been especially soft. Of the results so far, only 28% had a positive revenue surprise. The combination of positive earnings and weaker sales reflects improving margins.
For earnings to grow sustainably in 2013, there needs to be more evidence of improving revenue growth, in our view. A turnaround in the global economy will be needed for that support – fortunately, selected green shoots are emerging, such as the improvement in PMIs in China and the US.
One sector of particular interest is technology. We remain structurally positive on technology; however, we highlighted several months ago that the sector was “potentially vulnerable in the short-term”. Since then, the sector has underperformed the S&P 500 Index by 2%, including a fall of 6% in the past month.
Third-quarter earnings have been poor compared to expectations with the weakness evident across all the sub-sectors. According to BofA Merrill Lynch Global Research, the sector is reported as the most overweight by fund managers. With such a high degree of ownership, the sector has been vulnerable to heavy falls on earnings disappointment – the average one-day percentage change on the reporting day is -2.7% so far.
Valuations inspire growth
Valuations are in no sense into bubble territory, in our opinion, and the sector is a clear beneficiary of developing economies’ consumer appetite. Further, the technology sector has very low leverage when compared to a decade ago. On a longer-term basis, the sector offers an attractive risk/reward relationship. However, we believe the short-term performance may be more restrained.
Through this year, investors have maintained a preference towards growth stocks (technology included), the rationale principally driven by the scarcity of global growth. As we analyse third-quarter earnings for sectors and styles vulnerable to disappointment, we are alert to any change in market leadership, especially for signs of outperformance by value stocks.
With short-term valuations for certain regions such as the US no longer abnormally cheap, we believe investors might become more price sensitive, thereby searching for stocks trading on lower valuations.
This is certainly an area to watch, particularly if the pace of global growth accelerates over the next six months.
