A column by John Authers, Investment Editor for the Financial Times, examines the relationship between the stock market decline and earnings. When this blog began, it was merely an attempt to document trends in corporate earnings and economic conditions for my own personal use. Although the trend showed some ominous clouds on the horizon, little did this author know that his blog would document one of the biggest stock market crashes of all time. And so, as we all try to feel around in the dark for investing opportunities, and analysts attempt to predict corporate earnings growth, and interesting dynamic has appeared in non-financial companies.
Cutting to the chase, it is well understood that the global economic crisis has been caused by a credit crunch/financial crisis (put simply, banks have been/are in big trouble and needs lots of government money/insolvent). So, as Authers points out in his column:
growth of the market value of world financial stocks, as measured by MSCI indices, has fallen almost exactly in line with earnings – which are now seen to have been grossly inflated by artificially cheap credit for years. Both have fallen about 70 per cent during the crisis, and both are somewhat lower than in 1994.
In other words, financial companies stock prices are more or less reflecting perfecting their current condition, completely discounting future growth. Only a severe shock to the banking system (swine flu, perhaps?) would cause further severe declines in the market. Note, this may seem like a buying opportunity, and perhaps it is, but only, in this author’s humble opinion, for those with high risk-tolerance and an extremely long time horizon – if we use the S&L crisis of the 1980s as an example, banks could be unwinding toxic assets for 5 to 10 years, at least – and that assumes a bottoming in housing prices. Instead, this story is merely the backdrop for a look at the rest of the market.
Authers notes that, “For non-financial companies, however, where earnings also outpaced share prices somewhat during the years of the credit bubble, the picture is different. Morris shows that prices have fallen about 50 per cent from their peak, while earnings have dropped only 14 per cent.”
So, does that mean that the market has oversold non-financial companies? Authers: “The bad news is that shares are predicting a 50 per cent fall in non-financial companies’ earnings. The good news is that this is already priced in. “
While the financial crisis has no doubt spread to the real economy (oil and natural gas prices have tumbled, layoffs are going to extreme levels, consumer spending has severely contracted), the market may have overreacted to how severe the recession would cut into earnings of non-financial companies and underestimated how quickly some companies could prepare. Is there an investing opportunity in the stock market? To answer that, we turn to Bespoke Investment Group, and its analysis of earning beat rates (i.e. percentage of companies that report better than expected earnings):
A total of 430 US companies and 156 S&P 500 names have reported their quarterly numbers since earnings season began with Alcoa’s report on April 7th. We’re always monitoring how companies are reporting versus expectations, and below we highlight the percentage of companies beating and missing estimates as earnings season has progressed. At the start of earnings season, more companies were missing estimates than beating, however, this trend has changed significantly as the bulk of reports have come in this week. At the end of last week, 50% of US companies had beaten estimates, and this number has increased every day this week to its current level of 57%. Last quarter only 55% of companies beat estimates, so if we begin to see the “beat rate” increase quarter over quarter instead of decrease, it will be a positive sign for the market.
And stocks within the S&P 500 are reporting even better numbers. Again, after a slow start, the current “beat rate” for the 156 S&P 500 companies stands at 67%. Earnings season still has a long way to go, but the current trend has investors optimistic.
Subscribe to Bespoke Premium to receive more earnings season analysis.
Remember that, when we boil it down to its essence, a company’s share price is essentially a function of two items: (1) earnings per share; and (2) earnings growth expectations. As an example, let’s say XYZ company reports full year earnings in 2008 of $1 per share. Thus, outside of its book value, the stock of the company is worth at least $1. However, it will generally trade at a higher price because the market assigns a multiple to that baseline price. That multiple, the price/earnings ratio, demonstrates the market’s expectations for the company’s growth. Historically, PE ratios for the market average between 15 and 25. At a PE ratio of 15, XYZ company’s shares would trade at $15.
As noted above, the market’s growth expectations for non-financial companies are extremely low. Such expectations set up an environment where companies that report better-than-expected earnings will generally be rewarded by a sharp increase in their share prices, especially those that disclose future guidance on earnings that is positive. Although many considerations go into investing in any company, given the stock market environment for non-financial companies discussed in this article, one may wish to focus on well-managed companies whose PE ratios have fallen below 10. Is this easy? Absolutely not; any investing decision requires homework and a determination of whether the opportunity fits within an individual investor’s portfolio strategy. However, it seems opportunities have arisen.
Have Non-Financial Stocks Been Punished Too Severely?
Posted by Gregg Killoren on April 28, 2009
A column by John Authers, Investment Editor for the Financial Times, examines the relationship between the stock market decline and earnings. When this blog began, it was merely an attempt to document trends in corporate earnings and economic conditions for my own personal use. Although the trend showed some ominous clouds on the horizon, little did this author know that his blog would document one of the biggest stock market crashes of all time. And so, as we all try to feel around in the dark for investing opportunities, and analysts attempt to predict corporate earnings growth, and interesting dynamic has appeared in non-financial companies.
Cutting to the chase, it is well understood that the global economic crisis has been caused by a credit crunch/financial crisis (put simply, banks have been/are in big trouble and needs lots of government money/insolvent). So, as Authers points out in his column:
In other words, financial companies stock prices are more or less reflecting perfecting their current condition, completely discounting future growth. Only a severe shock to the banking system (swine flu, perhaps?) would cause further severe declines in the market. Note, this may seem like a buying opportunity, and perhaps it is, but only, in this author’s humble opinion, for those with high risk-tolerance and an extremely long time horizon – if we use the S&L crisis of the 1980s as an example, banks could be unwinding toxic assets for 5 to 10 years, at least – and that assumes a bottoming in housing prices. Instead, this story is merely the backdrop for a look at the rest of the market.
Authers notes that, “For non-financial companies, however, where earnings also outpaced share prices somewhat during the years of the credit bubble, the picture is different. Morris shows that prices have fallen about 50 per cent from their peak, while earnings have dropped only 14 per cent.”
So, does that mean that the market has oversold non-financial companies? Authers: “The bad news is that shares are predicting a 50 per cent fall in non-financial companies’ earnings. The good news is that this is already priced in. “
While the financial crisis has no doubt spread to the real economy (oil and natural gas prices have tumbled, layoffs are going to extreme levels, consumer spending has severely contracted), the market may have overreacted to how severe the recession would cut into earnings of non-financial companies and underestimated how quickly some companies could prepare. Is there an investing opportunity in the stock market? To answer that, we turn to Bespoke Investment Group, and its analysis of earning beat rates (i.e. percentage of companies that report better than expected earnings):
Earnings Season Beat and Miss Rates
A total of 430 US companies and 156 S&P 500 names have reported their quarterly numbers since earnings season began with Alcoa’s report on April 7th. We’re always monitoring how companies are reporting versus expectations, and below we highlight the percentage of companies beating and missing estimates as earnings season has progressed. At the start of earnings season, more companies were missing estimates than beating, however, this trend has changed significantly as the bulk of reports have come in this week. At the end of last week, 50% of US companies had beaten estimates, and this number has increased every day this week to its current level of 57%. Last quarter only 55% of companies beat estimates, so if we begin to see the “beat rate” increase quarter over quarter instead of decrease, it will be a positive sign for the market.
And stocks within the S&P 500 are reporting even better numbers. Again, after a slow start, the current “beat rate” for the 156 S&P 500 companies stands at 67%. Earnings season still has a long way to go, but the current trend has investors optimistic.
Subscribe to Bespoke Premium to receive more earnings season analysis.
Remember that, when we boil it down to its essence, a company’s share price is essentially a function of two items: (1) earnings per share; and (2) earnings growth expectations. As an example, let’s say XYZ company reports full year earnings in 2008 of $1 per share. Thus, outside of its book value, the stock of the company is worth at least $1. However, it will generally trade at a higher price because the market assigns a multiple to that baseline price. That multiple, the price/earnings ratio, demonstrates the market’s expectations for the company’s growth. Historically, PE ratios for the market average between 15 and 25. At a PE ratio of 15, XYZ company’s shares would trade at $15.
As noted above, the market’s growth expectations for non-financial companies are extremely low. Such expectations set up an environment where companies that report better-than-expected earnings will generally be rewarded by a sharp increase in their share prices, especially those that disclose future guidance on earnings that is positive. Although many considerations go into investing in any company, given the stock market environment for non-financial companies discussed in this article, one may wish to focus on well-managed companies whose PE ratios have fallen below 10. Is this easy? Absolutely not; any investing decision requires homework and a determination of whether the opportunity fits within an individual investor’s portfolio strategy. However, it seems opportunities have arisen.
This entry was posted on April 28, 2009 at 11:43 am and is filed under Economy, Finance, Investing, Market Commentary, Personal Finance, Stocks. Tagged: Economy, Investing, Market Commentary, Personal Finance, Stock Market. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.