James Saft, Reuters Columnist
The US 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%. That compares well with a disappointing third quarter, when earnings for the group barely grew, nudging up just 0.1%.
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% of output, near historic highs and about 10% 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 utilisation, and with it profits, to otherwise unsustainable levels.
At the same time, the share of output that goes to labour costs has shrunk to lower than it reached even during the depths of the Great Depression. Clearly that is in part because globalisation 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 labour 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 US 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 US 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 behaviour, 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 theorises, 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 US, 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)