This blog is part of a new series on Institutional Investor entitled Global Market Thought Leaders , a platform that provides analysis, commentary, and insight into the global markets and economy from the researchers and risk takers at premier financial institutions. Our first contributor in this new section of Institutionalinvestor.com is AllianceBernstein, who will be providing analysis and insight into equities.
If you tally up company-by-company consensus forecasts for he Standard & Poor’s 500 index, it would suggest earnings-per-share growth for the index in aggregate in the low teens for this year and next. But Investors aren’t buying it. In their view, the sputtering economy makes recent near-record U.S. profitability unsustainable. In fact, stocks have been priced at levels that would suggest a 15 percent drop in S&P 500 EPS next year — an event typically confined to recessionary periods. Our research indicates that EPS will prove more resilient than many investors believe.
A sensitivity analysis conducted by my colleague Brian Lomax found current consensus estimates reasonable, even assuming abnormally weak GDP growth. Factoring in stagnant GDP and a decline in net margins to 2010 levels, his model indicated that the S&P 500’s EPS would decrease only about 3 percent, to $96, from the consensus forecast of $99 for 2011. That’s far less dire than market valuations suggest.
There are three important factors at work here: First, S&P 500 sales should grow faster than the economy, as they have historically. Second, U.S. companies still have tremendous operating leverage at their command. For nonfinancial companies in the S&P 500, the incremental margin — the potential profit produced for every extra dollar of sales — is currently 12 percent, double the 6 percent historical average. Net margins should continue to be buoyed by higher foreign profits and pricing power (as indicated by the pickup in year-over-year producer prices since 2010) and subdued labor cost growth.
The third factor, which gets little attention from investors, is the enormous untapped financial firepower in cash-rich, low-debt U.S. balance sheets. With companies under intense pressure to put their low-returning cash hoards to more-profitable use, we expect spending on initiatives that could boost EPS, such as acquisitions and share repurchases.
Indeed, M&A activity and buybacks continued in the face of the market’s extreme volatility in recent weeks. Apparently, corporate managers aren’t as shaken by world events as equity investors are. By our analysis, the average EPS of the S&P 500 would increase by $5 if companies simply pared cash balances to a more reasonable 5 percent of assets from their record level of 8 percent today and use the cash to buy back stock.
This exercise has been useful in guiding our search for value opportunities, which became more abundant with the recent market sell-off. But earnings growth is slowing, and the near-term risks have increased. In this environment careful company-by-company research is as essential to ultimate investment success as ever.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.
Joseph Gerard Paul is chief investment officer-North American value equities at AllianceBernstein.
