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Surprise: Earnings Turn Out Better Than Expected

Jeremy Glaser
Robert Johnson, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Nearly 90% of U.S. companies have reported third-quarter earnings. I'm here today with Bob Johnson--he is our director of economic analysis--for his take on the quarter and also for what investors can expect for earnings going forward.

Bob, thanks for joining me.

Bob Johnson: Thank you for having me, Jeremy.

Glaser: You described this quarter to me as kind of an odd earnings season earlier. What does that mean? What do you mean by it being odd?

Johnson: Statistically, it was a great earnings quarter. You hear some of the data on the popular companies and you might say, "That's crazy--what I'm hearing is not so good." So, that's the dichotomy. Let me start, first, by talking about the company comments a little bit and what's going on. Obviously, Amazon (AMZN), Netflix (NFLX), IBM (IBM), Kohl's (KSS), Macy's (M), all disappointed and all big-profile, popular names. So, certainly, it hasn't been necessarily a great quarter. And when I went back and looked at the FactSet numbers, I was actually kind of surprised that we've done as well as we have statistically.

Glaser: So, how many companies did beat estimates?

Johnson: It was about 77% this time, and that's the highest number we've had since 2010. So, that's really very impressive. The number typically is pretty high. It's between 68% and 72% or so, but this one is really a pretty large upside surprise percentage. Each percentage is a little bit smaller, which means probably that the economy is evening out a little bit. It's not just one thing doing great, which is probably good news.

Glaser: Is this just the fact that expectations were just too low or are companies actually doing a little bit better?

Johnson: I think they actually are doing better. I think the earnings number this quarter--that is, the third quarter, I should say--looks like it will be about 7.7%. As recently as Sept. 30, they thought the earnings growth in the third quarter would be as low as 4.5%, so we've pretty dramatically outperformed. But as you mentioned, it's a little bit of game. Companies try to talk down their earnings right at the end of the quarter, so they can have a nice little upside surprise. So, usually, the nadir of the earnings-growth rate is on the last day of the quarter--in this case Sept. 30. And I think there was certainly a little bit of that going on, but the number overall is pretty good.

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Glaser: We heard a lot of management teams be a little bit cautious on the fourth quarter, everything from low oil prices to currency headwinds. What's your view for next quarter? What are the expectations there?

Johnson: If you look at the analyst expectations on FactSet, their general thought is that earnings growth will be around 4.5% in the fourth quarter. Now, keep in mind I just told you it was like 7.6% or 7.7% in the third quarter, so that's quite a bit slower. You might ask why is that? The majority of it is probably due to the oil industry, which is swinging from having expected 7% growth in the fourth quarter just a month or two ago to now a decline of 7% in earnings because of the drastic fall in oil prices. So, that's certainly weighing on the headline number. But I would say the growth rates, even outside of oil, are probably a quarter to half of what they were. So, if it used to be 7% or 8%, maybe now they are 5% or 6%. So, the numbers certainly have come in a little bit.

Glaser: We've been talking earnings here. What about top line? Is most of this just being driven by financial engineering or share buybacks or, again, are we seeing strength?

Johnson: As usual, there is a gap between the two, in the third quarter specifically. Again, we saw about 7.5% earnings growth, but on the revenue side the growth was only 4%. So, clearly, things like the share buybacks that you talked about were a factor, and also improved margins were also a factor. So, there are several things that weigh in that, but it's a lot better than when we started the recovery, when we saw 8% to 10%--and maybe even more--earnings growth and no growth in revenue. So, we've kind of closed that gap a little bit.

Glaser: So, help us put 2014 in context from maybe the beginning of the recession: What does earnings growth look like and what does that mean we can expect for earnings growth in the future?

Johnson: I think that's really important to talk about. At the beginning of the recession, we just had massive growth in S&P earnings. In 2010, the first year of the recovery, we had 40% growth in S&P 500 earnings, which is a pretty dramatic number. And in fact, we got back up pretty quickly above the pre-recession levels on that metric. Things continued to look pretty good in 2011, but not nearly as good at 14% growth. And ever since then--that's 2012--we've kind of been in this 7% to 9% range in terms of EPS growth. Nice steady growth, but certainly not accelerating and not falling apart either.

Glaser: Now, this is against the backdrop of somewhat uneven economic recovery. But right now, the economy is doing a little bit better; it seems like earnings are backing off. Has that surprised you that those aren't moving in the same direction?

Johnson: That's something we've talked about for a long time. And I think, for people who have listened to us regularly, it shouldn't come as a huge surprise. For S&P 500 companies that actually report the data, 25% to 40% of their revenues come from overseas markets. So, they are much more dependent on what happens in China, what happens in Europe, than what happens here in the U.S. And frankly, a lot of overseas markets--and even the U.S. markets--are serviced by production overseas. So, even though we might see great growth in China or whatever, it might be produced by somebody in Vietnam to ship to China. So, it's not always good news for the U.S. worker, per se. But now we've have a situation where Europe has clearly slowed dramatically, maybe even moving into a recession, and China's growth is not nearly what it was at one time. And all of that is slowing down the S&P 500. At the same time, the U.S.--because of oil and several other factors--is actually getting a little bit better.

Glaser: So, what does this mean for stock market returns? Are corporate earnings going to be a big driver of those returns? What could we expect from today's valuation levels?

Johnson: Looking at our price/fair value levels that we calculate at Morningstar--where we do a discounted cash flow on each company we cover and then compare it to where the stock price is--those, right now, are pretty close to one to one. In other words, what we think is the correct fair value and where we are is just slightly over one, and it's been there at that level since about February. So, it's been very steady.

A lot of people think that means there's no growth or no hope for the stock market, but actually each year, as we mentioned, earnings tend to go up. And so, if we stayed at the same multiples we are at right now, we'd expect whatever the EPS growth is for 2015 to be your stock market return. So, therefore, I'm very comfortable in saying that, based on earnings alone, we probably have a 5% to 10% upside potential in the U.S. stock market, even with these relatively high valuations.

Glaser: Bob, thanks for your take on earnings today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.