It’s axiomatic that over the long run, corporate earnings growth should be driven by nominal growth in gross domestic product (GDP). Over the short run, however, the course of earnings and economic growth can diverge. Indeed, since the onset of the financial crisis, earnings have expanded among S&P 500 companies even as the economy has remained sluggish (see Figure 1). This can be explained by a number of factors, including a growing share of profits and national income going to capital vs. labor, growth in exports and share buybacks (see Neel Kashkari’s “The Cure for Baldness”).
Now, in our view, these tailwinds seem set to ease, and corporate profit growth is unlikely to be as strong in the future as in the recent past. If so, the relationship between real GDP growth and earnings provides a useful lens to distinguish earnings growth generated by real economic activity from that linked to inflation.
If real economic activity is lower, we would expect that top-line growth will be increasingly driven by inflation, and cost management will be critical to generating earnings growth. As we survey global equity markets, we are looking for individual companies with inflation-linked revenues and supply side advantages to drive revenue growth, and ample cost levers to improve margins. We believe these attributes hold the key to sustained earnings growth in the current economic environment.
The turning tide
Our view contrasts with sell-side consensus earnings estimates, which imply continued strong expansion, both among companies in the U.S. and overseas, despite slow economic growth (see Figure 2).
PIMCO has an even more cautious view for 2013 as we expect real GDP to expand by 1.50% to 2.00% in the U.S. and 1.5% to 2.0% globally. In the U.S., at least, history suggests corporate earnings generally fall with real economic growth of 2% or less (see Figure 3). Between 1930 and 2011, for instance, the U.S. economy experienced real GDP growth of less than or equal to 2% in 25 of 82 years. During these years, EPS declined by 1.3% per year on average with a median decline of 6.8%. In contrast, in the 57 years in which real GDP growth exceeded 2%, the EPS growth rate averaged 14.4%.
In our view, this inconsistency between the top-down and bottom-up outlook is a result of unrealistic assumptions. Given a sustained low-growth environment, we anticipate that the majority of companies will face lower real revenue growth than consensus estimates currently predict.
However, while revenue growth may slow, it is important to remember that it is only one part of the earnings growth equation. Nominal earnings growth is a function of a firm’s real revenue growth, real cost growth, and the respective inflation rate of those two inputs. By focusing on all three components – revenues, costs and inflation – and moving away from a narrow focus on top-line growth, we think there are attractive investment opportunities to be found today. In particular, we are focused on identifying firms with one or a combination of the following characteristics:
- Ample cost levers: Companies that have identifiable cost saving alternatives through either lower cost inputs or overhead reduction.
- Supply side advantages: Quality firms that are able to take market share, generate abnormally high margins, or both.
- Inflation-linked revenues: Companies that have pricing power, either via contractual price increases, prices tied to rising input prices, or having superior products and services.
Ample cost levers
While we continue to seek companies with opportunities to generate real top-line growth, these firms are in limited supply. Without any structural advantages, many companies are likely to face headwinds in attempting to take share from competitors, leading to increased price competition and the erosion of margins across the industry. Firms that do have a structural advantage tend to already trade at elevated valuations. Consequently, while the opportunity set may be narrower, we are focusing on the set of companies that have identifiable costs to cut. Such companies still exist, albeit on a more one-off basis, across a variety of sectors. Some banks, for example, still have opportunities to reduce funding costs as higher-cost funding rolls off, and to rationalize branch footprints as consumers migrate to online banking, which should reduce real estate and headcount costs. Some pharmaceutical companies are better at managing their research and development efforts and streamlining their sales forces, while some telecom companies are managing labor costs and capital expenditure programs to be more closely aligned with business needs.
Supply side advantages
We also are searching for companies with distinct supply side advantages. These structural advantages generally include unique characteristics such as location or access to raw materials that cannot easily be duplicated by competitors. This advantage can allow companies to take market share without sacrificing price, generate abnormally high margins, or both, regardless of the prevailing economic environment. An example of such an advantage would be participants in the North American oil and gas industry that have access to cost-advantaged oil and gas from non-traditional reserves. Given that U.S. demand for petroleum products still exceeds local supply, some participants in the supply chain are generating higher profits as they benefit from less expensive oil and gas inputs, and cheaper transportation and storage costs relative to international competitors.
A final means through which a company may generate earnings growth is by having inflation-linked revenues that can increase more than costs. While headline inflation expectations currently remain subdued, over the long term we expect the loose monetary policy of central banks to translate into higher inflation. One potential drag on equities in an inflationary environment is the inability to pass inflationary cost increases through to customers, negatively impacting earnings. Some companies, however, sell products that can command robust price increases over time. Other firms that have pricing power with explicit revenue inflators will have the contractual right to pass inflation through to customers while also growing earnings. These types of companies often include the owners or operators of critical infrastructure assets, such as toll roads or water systems, where regulations include mechanisms for increasing tariffs with inflation.
With real GDP growth across the developed world expected to remain at low to moderate levels, companies will likely face sustained headwinds in generating consistent top-line growth. Historically, in the face of such economic challenges, companies have found it difficult to generate the levels of bullish earnings growth currently predicted in consensus estimates.
In addition to concentrating on top-line growth, we believe investors should also look to the three characteristics identified above. By focusing on cost levers, supply side advantages and inflation-linked revenues it may be possible to find attractive earnings growth in a low-growth world.
Victoria Lonsdale contributed to this article.