The annual moment of truth is at hand. American companies have embarked on publishing their figures for the complete year of 2013. These numbers tend to be more tightly audited than the quarterly updates that come during the year, so this earnings season arguably revolves more around the realities of life in the corporate sector, rather than a game between chief financial officers and their investors.
This year, we should maybe brace for a moment of particularly inconvenient truth, after a year in which the US stock market has rallied by about a third, almost entirely on higher multiples. Forward earnings multiples for the S&P 500, based on consensus 2014 forecasts, are about 16 – well above the historical average, and above the pre-crisis peak in 2007 – suggesting that investors are braced for a significant boost in profits.
The macro arguments for such a stance are respectable. The US economy may well be on the verge of a strong recovery, as it emerges from the fiscal drag caused by last year’s government spending cuts.
But there are different ways to tally earnings across the corporate sector. They can be aggregated on an 'as reported' basis, including all exceptional items; they can be collated on an operating or pro forma basis; or some judgment can be used on which exceptional items are relevant. Any of these versions might be useful. But differences between them can radically skew perceptions.
For example, the S&P 500 takes a strict view, including almost all charges that appear in the official data. This means companies appear to earn less than on other measures, so that their shares look more expensive.
But the version of earnings used in the most widely followed earnings estimates might be too generous. According to Thomson Reuters, corporate earnings in 2013 are on course to increase by 5.7 per cent compared with 2012. This includes earnings for the first three quarters, plus the current expectation that fourth-quarter profits will be up 7.0 per cent.
But Andrew Lapthorne, the indefatigably contrarian quantitative equity strategist at Société Générale, points out that the picture is different if we use the earnings data provided by MSCI indices. MSCI makes a judgment call in its numbers, accepting earnings as reported but giving itself the right to exclude “unusual gains or losses that do not reflect the earnings potential of the company going forward” - such as sales of discontinued operations, restructuring charges, bankruptcy charges or changes in accounting policy.
The difference between these approaches grew clear during the extreme conditions of the profit fall in 2009 that followed the Lehman Brothers bankruptcy. According to Lapthorne, S&P core earnings fell 92 per cent, MSCI earnings dropped 55 per cent – and earnings as used by Thomson Reuters fell 36 per cent. For 2013, MSCI earnings growth is barely above zero. On an earnings before interest and tax basis, excluding the effect of depreciation, Lapthorne finds that US profits have indeed been flat for two years now. So the 'growth' achieved over the past year appears to be the product of accounting manoeuvres and little else.
Meanwhile, companies are talking down their prospects. They always do this before results season, to give themselves a better chance of beating expectations. But the fourth quarter tends to be the time for broader discussions with shareholders. And in any case, the scale of talking down over the past few weeks is unprecedented.
According to Thomson Reuters, 113 companies have so far given the market warning that their results will be lower than expected, against only 14 positive guidances. This ratio of negative pre-announcements is the highest on record.
And while the earnings season is young, companies so far are finding it harder than usual to meet the low expectations they have set for themselves. Only 49 per cent of the 45 companies to report so far have beaten their forecasts, compared with a long-term average of 66 per cent.
Meanwhile, estimated year-on-year revenue growth for the fourth quarter, on Thomson Reuters data, is 0.5 per cent.
Lapthorne crunches balance sheets to draw more bearish conclusions. When measured as a share of sales, capex is nearly 7 per cent, well above average for the last two decades. Meanwhile, US cash piles look less impressive when viewed in the context of companies’ debt. Net debt (debt minus cash) has risen 15 per cent since the crisis. That debt has largely gone towards buying back shares, a move that directly raises earnings per share.
None of this is necessarily that alarming as the companies and the economy try to gain traction in the difficult years following an epic financial crisis. But this take on earnings makes 2013’s remarkable expansion in earnings multiples look ever more hopeful – and ever more unnerving. Is a moment of truth at hand?
Copyright The Financial Times Limited 2014.