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By Jason Stipp | 02-09-2012 01:00 PM

Corporate Earnings: Now the Hard Part

Companies will have to roll up their sleeves now that low-hanging cost-cuts and post-recession multiple expansion are likely in the rearview mirror.

Jason Stipp: I'm Jason Stipp for Morningstar.

Earnings season is coming to a close, and, for a change, it didn't exactly knock our socks off.

So, given the overall negative tenor potentially to earnings season, I'm checking in today with Morningstar markets editor Jeremy Glaser's alter ego, Bearemy, who tends to look at the glass half-empty side of things, to get his take on this earnings season and what it means for investors.

Thanks for joining me, Bearemy?

Jeremy Glaser: You're welcome, Jason.

Stipp: So, you have been looking at earnings, and the trends that we've been seeing, and you have noticed some differences in this most recent earnings season from what we've seen before. What's your broad takeaway about earnings?

Glaser: I certainly think that one of the big concerns that I've had for a while is that corporate earnings were going to begin to slow down. That doesn't mean that earnings are necessarily going to go negative, but that growth is really going to moderate, and a lot of that was just because growth had been so good over the last couple of years.

I think one of the big surprises coming out of the recovery was just how strong corporate profitability was. Even when the economy wasn't doing that well, even when we were kind of fretting about moving into that double-dip recession, corporate earnings kept coming back stronger than normal. I think that there were a couple things driving this, and most of it was cost-cutting.

We had companies just absolutely cutting to the bone, laying off workers wherever they could, getting more productivity out of the workers that were existing, shedding businesses that weren't really adding anything, maybe even doing some acquisitions that were priced pretty cheaply, but that were able to start producing earnings right away. Corporate America was able to turn its act around very quickly from the bottom of the recession, and start producing a lot of money and a lot of potential cash flow for shareholders.

I think this is something that isn't sustainable; it can't go on forever. You can only cut so many costs, and you can only improve margins so much before you run into an underinvestment problem, where you haven't put enough money into those growth initiatives to keep things going. And at one point you're going to catch up to the growth in the economy, where we did see good emerging-markets growth helped push a lot of earnings forward. Relatively better-than-expected consumer spending in United States certainly helped to push some of that going forward, but none of these are trends that just can go on forever.

I think this quarter we started to see the first inklings of the beginning of that slowdown, beginning to get back to more of a normalized earning growth environment. According to Bespoke Investments, about 60.4% of companies in the S&P 500 beat earnings expectations, beat what analysts thought they were going to make in the quarter. This is down from around 62%, which is the historical average, and down well below the 80%-type numbers we were seeing at the peak of those surprise quarters, where basically every single company was beating expectations, and not just by a little bit, but by a ton.

I think, this is an interesting ... inflection point: Are corporate earnings going to be able to go back on that upward trajectory; I think that's probably not likely due to some of those reasons that we talked about just a minute ago. I think it's showing that we're getting back to some of that normalized earnings growth, that in order to really get bigger, [companies are] going to have to focus on investments, focus on, "how do we improve those returns on invested capital?" Some of that low-hanging corporate fruit, low-hanging cost-cutting is certainly gone.

Stipp: On the flip side, on the stock market side, we've also seen that a lot of those easy gains, that bounce-back from the depths of the recession when people worried about Armageddon that didn't come to pass--those gains are probably gone as well, right?

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