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Slower Earnings Growth Likely in 2015

Matthew Coffina, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Matt Coffina. He is the editor of Morningstar StockInvestor newsletter. We are going to get his take on earnings so far and also his outlook for earnings for 2015.

Matt, thanks for joining me today.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Ahead of this earnings season, we thought currency would be a big issue. We've heard a lot about it as results have come in. What's your take on the impact that currency is having on corporations right now?

Coffina: So, the U.S. dollar has been really strong against pretty much all global currencies, hitting multiyear highs against the euro, the yen, the Russian ruble, and the Brazilian real. This is certainly going to have an effect on a company's reported earnings, particularly for U.S.-based companies that derive a lot of earnings from foreign markets. In our portfolios, our consumer defensive names are Coca-Cola (KO), Philip Morris International (PM). Names like that tend to be the most exposed, but also broadly diversified multinational health-care companies, technology companies, and so on down the line are affected by this. So, the stronger the U.S. dollar is, the less foreign earnings are worth to U.S.-based investors, regardless of a company's reporting currency--and that's what we're seeing right now.

For companies that are fully exposed--companies that don't derive any revenue in the U.S. and derive all of their revenue in foreign markets--it could be a headwind of upwards of 10% to revenue and perhaps even larger on the bottom line, depending on where the costs are located. So, if a company has a lot of costs in the U.S. relative to its revenue, then it will probably also see some margin contraction as a result of the currency headwinds. So, this is definitely a significant issue and something worth watching.

Again, for us, our consumer staples names have been the worst affected, and currency headwinds have really wiped out all of the earnings growth we expected over the past couple of years and into 2015. In dollar terms, even if these companies are growing constant currency earnings by mid- or high-single-digit rates, their earnings in dollar terms have been flat at best or even declining.

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Glaser: If you do see those flat earnings or declining earnings because of currency, is that something that worries you, something that makes you rethink your thesis on the companies, or is this just something that is more transitory and you need to look past it?

Coffina: Well, it's really hard to predict where currencies are going to go. We knew going in that this was a risk--that the dollar would strengthen. It has gone probably a lot worse than I would have expected. If we'd had any sense that the dollar was going to appreciate so much, I would have been much more cautious about [investing in] companies with a lot of foreign revenue. But going forward, we really don't have any more insight into what the dollar is going to do. I can't predict what it's going to do going forward versus what it did over the last couple of years.

So, in general, we try not to base a lot of our decisions on currency fluctuations. I'd say the best that we can do is to maintain broad diversification and make sure that we are not overly exposed at any particular currency move so that our companies that are highly exposed to the stronger dollar are offset by other holdings that are primarily domestic--particularly if they are leveraged to the U.S. consumer, as U.S. consumer sector has been one of the strongest areas in the market.

And remember that the currency moves don't happen in a vacuum. There is a reason that the dollar is so much stronger than international currencies, and it's partly due to monetary policy--the fact that the European Central Bank is easing and other central banks are easing at the same time that the U.S. Federal Reserve is indicating that it's going to start tightening monetary conditions. But that all comes back to relative economic strength. And again, the U.S. economy is much stronger than most international economies. We see Europe, Japan, Latin America, and even China either slowing or close to recessions or even in outright recession.

So, we own plenty of stocks like Lowe's (LOW) or Berkshire Hathaway (BRK.A) that are predominantly in the U.S. and leveraged to U.S. economic growth, and I don't think it hurts to have some other companies that are more leveraged to foreign currencies and foreign economies. It just so happens that in the current environment--and that's really, of course, the purpose of diversification--in the current environment, some of those companies are significantly underperforming others. There could come a future environment where the reverse is going to be true, and that's why we maintain broad diversification.

Glaser: Let's take a look at falling energy prices. What impact have you seen both directly on energy companies and also on some of the other names that you have been following?

Coffina: Energy is definitely the weakest spot in the market right now. Both oil and natural gas prices are down dramatically over the last six months. Natural gas is down upwards of 40%; oil prices are down somewhere around 50%. This is going to have a very significant impact on the earnings of energy companies. If energy prices stay around current levels, you could reasonably expect that the whole energy sector is going to see an earnings decline on the order of 50%. Oil and gas producers see a direct impact from lower oil and gas prices. It shows up directly in their revenue. But most of these companies also have operating leverage and financial leverage that's going to exacerbate the impact on the bottom line.

So, if commodity prices fall 40% or 50%, it's reasonable to expect that earnings for those companies could fall meaningfully more than that--50% to 70%. You have other parts of the energy sector, of course, that are going to be more insulated--[for example,] midstream energy companies tend to have more fee-based long-term contracts. Services companies will also be hit hard by lower energy prices, but I think somewhat less than exploration and production companies or the oil majors. So, there is a spectrum out there of exposure. But for the sector as a whole, I would say a 50% earnings decline is certainly within reason, given the dramatic decline in oil and gas prices that we have seen.

Glaser: With some of these headwinds like the stronger dollar and lower energy prices, what are we seeing in terms of earnings growth for the fourth quarter of 2014? And also, what are your expectations for 2015?

Coffina: So, 2013 and 2014 actually saw pretty robust, double-digit earnings per share growth in the S&P 500. It looks like fourth-quarter earnings are on track to decline slightly versus the prior year. And going into 2015, currently, consensus estimates call for mid-single-digit earnings growth, and I wouldn't be surprised if that's on the optimistic side. Usually, especially this early in the year, consensus estimates tend to be too optimistic. So, it's very possible that we will see little, if any, earnings growth in 2015.

I would just point out, though, that revenue for the [S&P 500 Index] hasn't been growing nearly as quickly as earnings over the last couple of years. Forget about double-digit growth; we are looking at more like low- to mid-single-digit revenue growth. So, much of the recent growth has really been driven by margin expansion. We can debate whether current margin levels, which are near all-time highs, are sustainable; but I don't think too many people out there believe that margins are going to continue expanding indefinitely into the future, which means that, inevitably, earnings per share growth is going to have to slow. And I'd say a mid-single-digit rate, 4% to 6%, is much more realistic over the long run than sustained double-digit growth.

So, investors may have become a little spoiled by the robust growth that we've seen over the past couple of years. But even besides the energy and currency headwinds that we are seeing right now, I think it was inevitable that earnings growth is going to slow going forward.

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

Coffina: Thanks for having me, Jeremy.

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

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