The Oscars aren’t for another few weeks, but Wall Street’s version of a red-carpet event played out this past week. Live bloggers and trading-floor telecasters thrilled to the latest earnings reports from aging star Apple (AAPL), naughty but bankable Facebook (FB), and supernova Amazon.com (AMZN).
Against that glitz, it’s not easy for an adhesive maker to stand out. Yet 3M (MMM), which last week reported fourth-quarter results that exceeded analysts’ estimates, bears watching. It offers a more down-to-earth illustration of how earnings growth is sharply slowing among large U.S. companies amid a broader economic malaise.
3M’s earnings per share grew 12% last year, or 14% adjusted for one-time items, on modest revenue gains spread across all of its product categories and regions. For 2019, the company is now calling for growth to slow to a low-single-digit rate. Investors appeared relieved that the new guidance wasn’t worse; the consensus earnings estimate for 2019 has been tumbling since fall, after all. Shares trade at 19 times this year’s earnings, suggesting that 3M investors expect the slowdown to pass quickly.
They may be proved right. And the broader outlook for company earnings this year is a little better than 3M’s—but not nearly as favorable as it was even a few months ago.
As recently as the end of September, Wall Street analysts had been predicting 10% growth in S&P 500 (.SPX) earnings in 2019. Today, the latest 2019 consensus estimate is just under 6%, compared with a hefty 21% in 2018. Analysts expect S&P 500 component earnings to total $170.37, compared with an estimated $161.14 for 2018.
For the first quarter of 2019, the outlook is dismal. This past week, the consensus estimate for first-quarter earnings growth turned negative, at nearly minus 1%, due in part to the impact of the government’s shutdown and a slip in energy profits.
There is scattered talk of an earnings recession looming. It’s too early to predict one of those, but not too early to prepare for one. We’ll look at five well-positioned companies in a bit.
“Be wary of the bounceback stocks have seen since December,” says Richard Bernstein, a former chief investment strategist at Merrill Lynch who today manages $9 billion out of his own advisory firm. “We’re later in the cycle, and things are naturally starting to slow down.”
The S&P 500 had its best January in 30 years, gaining 7.9%
Most companies now reporting fourth-quarter results have been beating earnings estimates, but that happens pretty much every quarter nowadays, and the size of upside surprises has been smaller than usual. It’s not difficult to imagine that when all the results are in, upside surprises will push fourth-quarter growth to 13% or 14%. Tax cuts will account for almost seven percentage points of that.
Bernstein is concerned that a number of companies have used debt to buy back stock and goose growth. But he doesn’t expect an earnings recession this year, and he predicts that the next economic downturn will be milder than what investors expect, because companies have been cautious about expansion. “You should be moderately overweight stocks, but not pedal-to-the-metal,” Bernstein says. “The No. 1 theme is earnings quality and stability.”
Valuations aren’t especially stretched. The S&P 500 trades at 16 times projected 2019 earnings, and the backdrop for stocks is flattering. The 10-year Treasury yields 2.7%, less than half its average of the past half-century. The Federal Reserve has suggested that it might be done raising interest rates for now, given some wobbly economic signals.
When rates were near zero, investors used the acronym TINA to describe the sentiment that “there is no alternative” to stocks. Today, it’s more like TASS—the alternatives still stink.
That bodes well for positive stock returns this year, although there’s a flip side: If investors cried uncle on rate increases while rates were still historically low, it doesn’t say much for their confidence in economic growth. The Fed expects U.S. gross domestic product to grow by just 2.3% this year, versus an estimated 3% in 2018. Longer term, the Fed is predicting 1.9% growth. Population growth has slowed, and productivity gains from technology have shrunk.
One risk for stock investors is that analysts tend to guess too high about earnings for distant quarters, and then over time bring their numbers down to levels that can be beat. That raises the possibility that the ugly first-quarter projection is more reliable than the calls for growth to rebound later in the year. If so, even factoring in upside surprises, growth could be barely positive this year.
But there are a few credible reasons to think earnings growth might indeed pick up as the year goes on. One is that the recent government shutdown, which has ended for the moment, sapped an estimated $11 billion from the economy, but only $3 billion of that is lost for good, according to the Congressional Budget Office. When economists at Wall Street banks recently brought down their first-quarter GDP estimates, some also nudged their second-quarter forecasts higher.
Oil prices are another significant factor. The largest percentage declines in first-quarter earnings estimates are found in the energy sector and are owed to a slide in Texas crude oil to $45 a barrel at the end of 2018 from more than $75 in early October. The price has been rebounding so far this year, to a recent $55, and some energy companies can adjust operations to cut costs, so the hit to future quarters might not be quite as bad. That’s especially true of the fourth quarter of 2019, because it will face relatively easy comparisons with the fourth quarter of 2018, when growth had already begun to sag.
There’s another hopeful sign, and it comes from focusing on companies that are pulling the market’s first-quarter growth estimate down the most.
Some of these companies aren’t exactly wrecks. Apple is expected to be the greatest drag, because customers have been slow to upgrade to its latest phones, but services and accessories are growing nicely, and as long as Apple and Samsung Electronics (SSNLF) dominate the pricey end of the handset market, growth will come around. Wall Street predicts a return to earnings gains in the quarter ending in December 2019, when Apple will have new phones on sale.
Alphabet (GOOGL) is the second-biggest projected drag. It is growing revenues like a youngster, but spending has been rising even faster. Overall earnings growth should resume sometime in 2019; investors will learn more when the company reports fourth-quarter results on Feb. 4. On the other hand, No. 3 and No. 4 are Micron Technology (MU) and Western Digital (WDC), which are stuck in a nastier downturn in semiconductors that might not abate right away.
For stockpickers, there is statistical comfort to be found in the difference between the weighted earnings growth estimate for S&P 500 companies for the first quarter, which is slightly negative, and the median estimate, which is about 4%. It suggests that beyond a handful of titanic profit declines, the near-term outlook for typical companies isn’t so gloomy.
Investors worried about a slowdown might want to favor companies whose growth isn’t overly tied to the economy. Traditionally, that has meant defensive groups like food, drugs, and electric utilities, but grocery spending has shifted toward fresh and away from packaged food, drugmakers are facing pricing pressures, and electricity demand isn’t growing as it used to.
Better to look for what are sometimes called secular, or idiosyncratic, growers: companies benefiting from powerful long-term trends, and not just a sweet spot in the business cycle. Some have expensive shares, but others look affordable.
Here are five to consider:
Stryker (SYK) passed a rigorous stress test when its revenues and profits kept growing right through the global economic downturn of a decade ago. The company is known for its replacement hips and knees, but it has other orthopaedic products for spines, broken bones, and more, and a large portfolio of medical and surgical equipment, including stretchers, scopes, and drills. “Doctors and surgeons don’t like changing the orthopaedic suppliers they deal with because they don’t want to have to relearn procedures,” says Eric Schoenstein, co-manager of the Jensen Quality Growth fund (JENSX), with $6.5 billion in assets spread among just 27 stocks. That keeps customer retention high.
A new robotic-surgery system called Mako gives Stryker an edge over the competition, Schoenstein says. Earnings per share are seen rising 11% this year. Shares trade at 22 times forward earnings estimates. That’s about what investors are paying for defensive Colgate-Palmolive (CL), whose earnings are expected to decline slightly this year.
Schoenstein also likes Microsoft (MSFT), which beat on earnings Thursday but missed on revenue, both by tiny amounts. Given comments by Intel (INTC) and others about a slow patch for sales to cloud customers, investors were concerned about growth for Microsoft’s Azure cloud platform. It matched last quarter’s 76% gain from a year ago.
Microsoft isn’t immune to an economic downturn, but two factors help dampen its exposure to one, Schoenstein says. One is that its customers these days are largely deep-pocketed enterprises rather than consumers. Another is that cloud investments can help companies save money. In response to the earnings report, Wedbush Securities analyst Daniel Ives wrote in a note to investors that despite the lack of a “clean beat,” the outlook for the March quarter was positive, and trends in major products suggest that Microsoft is only midway through a growth renaissance. Shares sell for 22 times forward earnings, and Wall Street expects low- to midteens earnings growth rates in coming years.
Patrick Kelly, co-manager of the Alger Spectra fund (SPECX), favors Microsoft, too, and has high weightings in tech and health care. He also likes an auto supplier that sells for 14 times forward earnings: Aptiv (APTV). It makes electrical systems and advanced safety systems that give it excellent exposure to the so-called Auto 2.0 shift toward more automation in cars, even though it has Auto 1.0 roots. The company was part of the ill-fated Delphi spinoff from General Motors (GM) in 1999, but a little over a year ago, Delphi spun off its traditional engine components and gave itself a jazzy new name. The good thing about Aptiv is that some of the same technologies that will one day automate cars are already in fierce demand in the form of lane-detection and collision-avoidance systems, cruise control that speeds up or down to keep up with traffic, and more.
One hitch is that the company isn’t entirely detached from the business cycle. A near-term downturn in car demand is expected to slow earnings growth to low-single digits this year before a return to double-digit growth rates in the years ahead. That has led to a cyclical-versus-secular debate among investors. Shares have come down by more than 20% since last summer. Despite near-term automotive weakness, Aptiv looks capable of growing much faster than the industry over the long term, Kelly says.
Strategists at Goldman Sachs recently recommended idiosyncratic growth stocks for protection against Brexit, a U.S.-China trade showdown, and other policy hobgoblins. Its list includes well-known world beaters like Amazon.com and expensive up-and-comers like retailer Five Below (FIVE), at 39 times earnings.
One recommendation for the thrifty is Spirit Airlines (SAVE), at nine times earnings. It was a leader in selling stripped-down flights while charging for minor pleasantries like advanced seat assignment, an approach it says allows it to beat competitor fares by 35%.
Legacy carriers have responded with “unbundled” flights. Spirit, under new management, is working to improve its perception with passengers, promoting its relatively new planes and high on-time rates. Discounted bundles of perks, like its “thrills combo”—a checked bag, seat selection, priority boarding, one free flight modification, and double rewards miles—are boosting nonticket revenue.
As an airline, Spirit is subject to fuel-price swings, but as a relatively small player, it can cherry-pick routes. Revenues are growing at a double-digit pace. The company reports fourth-quarter earnings on Wednesday. Wall Street predicts a 32% increase for all of 2018, followed by a 48% earnings gain this year.
For investors who prefer traditional staples, look to the beer aisle—the cans, not the stuff inside them. Mega-brewers like Anheuser-Busch InBev (BUD), whose name is a mash-up of beer makers on three continents, are caught between the carb-consciousness of younger drinkers and the proliferation of craft brews.
Cans, on the other hand, are in fierce demand, not only from craft beer but also from flavored and spiked seltzers and energy drinks. U.S. volumes for Diet Coke rose last year for the first time in years, and marketers aren’t quite sure whether it was the new flavors, like “zesty blood orange,” or a shift to skinnier cans. Even wine makers have been experimenting with cans, which are more portable than glass and more environmentally friendly than plastic.
All of this is good news for Ball (BLL), which is still associated with glass jars for homemade sauce, even though it got out of glass in the 1990s and today is mostly focused on cans. Shares trade at a staple-like 20 times forward earnings, but earnings are expected to grow an uncanny 19% this year and 15% next year.
So don’t sweat the earnings recession just yet, and beware forecasts for either a dire downturn or a shift to a glorious era of runaway growth. The reality is that growth is abruptly slowing from an inflated level, but it hasn’t stalled, and the bull isn’t dead yet.
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