Earnings rest on shaky legs: James Saft

January 9, 2013

Jan 9 (Reuters) – There are two big-picture reasons to doubt
corporate earnings: they are improbably high and there are
significant reasons to think they are being gamed.

The U.S. corporate earnings season kicked off this week with
a creditable performance by bellwether Alcoa and amid
expectations that fourth-quarter reports for the S&P 500 would
grow by 2.7 percent. That compares well with a disappointing
third quarter, when earnings for the group barely grew, nudging
up just 0.1 percent.

Even that modest growth, though, if it comes, will be
recorded during a period which is, by many measures, extremely
unusual. So unusual that it may make sense to apply a large
discount to discover the underlying truth. This is not an
argument about the fiscal cliff, or the cost of capital, but
simply put we may be in one of those periods when we need to
take a couple of huge steps backward to get the right
perspective.

After all, during the run-up to the real estate bust much of
the commentary was focused on how affordable houses were on a
financed basis, when in fact we should have been worrying about
the assumption that financing would always be there and the way
financing was driving price increases, which in turn was driving
demand.

Similarly, there are good reasons to worry that earnings are
due for a good old reversion to mean, and interesting reasons to
believe that their rise has been driven, at least in part, by
the same force that may bring about their fall: short-termism
among company executives.

THE EARNINGS TREE SCRAPES THE SKY

Just as trees don’t grow to the sky, so it is hard to see
much headroom for corporate earnings, and the profit margins on
which they rely. On a raw basis, corporate profits, before
depreciation, interest payments and tax are above 77 percent of
output, near historic highs and about 10 percent above the
levels where they gravitated during the past 80 years.

In fact, the only times margins even approached this level
in the past was just before the 1929 crash, just before the 2008
financial crisis and during World War II, when war efforts drove
capacity utilization, and with it profits, to otherwise
unsustainable levels.

At the same time, the share of output that goes to labor
costs has shrunk to lower than it reached even during the depths
of the Great Depression. Clearly that is in part because
globalization has allowed companies to arbitrage employment to
low-cost areas, but also clearly is being driven by technology,
which often obviates the need for labor at all. But is cheap
labor and efficient technology a defensible moat? Surely there
is plenty of capital around which might fund competition.

It isn’t too hard, then, to imagine that earnings will, one
of these quarters, begin their long slide back to the mean.

HOLLOWING OUT THE CORE

That is the central puzzle: why is it that, even though
profits are tremendously high, competition doesn’t rush in to
take advantage, thereby shaving everyone’s margins?

Capital investment has instead been woefully low, and not
just in the private sector. Cash reserves at corporations are
huge, while nonfinancial companies in the U.S. have saved more
than they invested every year since 2000, accompanied by a fall
in net domestic fixed investment compared to output. This is not
just a U.S. phenomenon. In Europe the average asset age
increased to 10.3 years in 2011 from 7.4 years in 2001,
according to Goldman Sachs data.

Andrew Smithers, an experienced economist and investor, has
developed a theory that the path of corporate earnings, and
indeed of the economy as a whole, is partly being driven by
executive behavior, which in turn is driven by a set of
misaligned incentives which rewards company chiefs for making
earnings jump up and down and for skimping on investment.

Because executives are increasingly paid in share grants
based on earnings metrics they have two perverse incentives: to
create earnings volatility in order to create good pricing
opportunities for their options, and to squeeze earnings higher
during the three to five years that matter for their pay.

Smithers has demonstrated that earnings volatility has risen
along with the bonus culture, and theorizes, probably correctly,
that investment is being skimped on in order to make margins
fatter and to hit option vesting targets.

The key thing to remember is that you can skimp on
investment for only so long. It might be long enough for
executives to cash out, but eventually a company’s franchise
becomes hollowed out and profits tumble. For this to happen
across an economy, as may be the case in the U.S., is a scary
prospect.

It may not be this quarter, it may not even be next, but
profits look set for a fall.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

2 comments

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As always, great analysis!

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