Don’t Forget to Stretch

I recently pulled my hamstring and calf muscles. After informing a disciplined value investor of my misfortune, he said, “Stretching is key! Stretching is like the due diligence, listening to earnings calls, etc of working out. Doesn’t feel like you’re making any progress when you do it, but you will pay through the nose if you don’t.” How true!

Stretching is exactly how this earnings season felt. It didn’t feel like I was making a lot of progress — results weren’t very exciting or different from recent trends. Nevertheless, reviewing quarterly results and conference calls is almost always worthwhile as I usually learn something new about a business, industry, or current trends. Quarterly maintenance research is also an essential part of my investment process. Without reviewing quarterly results and calls, I’d have trouble determining where we are in the all-important profit cycle. In effect, I’d be lost from a micro and macro perspective.

Based on my bottom-up analysis, the current profit cycle remains intact. While the media touts this earnings season as the strongest in several quarters, it didn’t seem too dissimilar to me than Q4 2016. In my opinion, it was a relatively stable quarter with certain sectors rebounding from their 2015-2016 lows (energy and industrials benefiting from easy comps), while sluggishness continues in other areas of the economy (many consumer businesses).

As stated in past posts, I believe the hiccup in the current earnings cycle (2015-2016) was a result of the bursting of the energy credit bubble, and to some extent, the strengthening dollar. With the dollar’s strength subsiding and the energy industry rebounding, these trends, along with aggregate earnings growth, have reversed. The rig count bottomed last summer and has rebounded along with the energy industry’s spending on production and exploration. As such, barring a collapse in energy prices, I expect another quarter or two of easy comparisons.

Will we have another energy credit bubble? I’m not sure, but I definitely noticed a spillover effect from the rebound in energy investment this quarter. In fact, I believe it’s one of the main reasons aggregate earnings results continued to rebound. The return of capital and spending not only benefited energy companies, but many industrial, financial, transportation, consumer, and service companies. Furthermore, because drilling has increased without a strong jump in energy prices, margins in other industries have not suffered meaningfully from higher input costs. I put together the following charts of the rig count and corporate earnings (source: St. Louis Fed). Interesting, don’t you think?

The energy boom and bust was directly tied to easy credit. In my opinion, the energy credit bust was far-reaching and contributed to the broader slowdown in the economy, profits, and financial markets in 2015 and 2016. Of course, in hindsight, the decline in profits was temporary. With asset inflation and credit flowing again, the corporate profit cycle has resumed its upward trend. Whether the rebound is transitory — as the Fed likes to say — or something more sustainable is inconclusive, in my opinion. We’ll have to continue to watch for signs of changing trends. However, unless the consumer slowdown that I began to notice last September reverses, I believe corporate earnings comparisons and growth rates will become more challenging later this year.

Below is a summary of the Q1 2017 earnings season. Every quarter I put together company data and commentary that I find interesting and was helpful in forming my macro and profit cycle opinion. I included last quarter, but this quarter it was too long to post. If interested, shoot me an email.

  • The economy in Q1 was stronger than the government’s 0.7% GDP report indicated. Based on my bottom-up analysis, I believe Q1 economic growth was similar to Q4 2016, which came in at 2.1%. Operating results and tones were not recessionary, but were commensurate with slow to moderate economic growth. In aggregate, corporate earnings are positive and the current profit cycle is maintaining its upward path.
  • Industrial businesses, on average, had a good quarter. This is partially due to the rebound in spending within the energy industry, along with the stabilization of the dollar. Construction and aerospace were also solid.
  • Investment in domestic energy infrastructure (onshore) has rebounded sharply. Rig counts are up approximately 30% from a year ago. Considering many energy production companies have hedged a large portion of production in 2017, I expect the rebound in energy expenditures to continue. Easy comparisons for companies tied to energy spending should continue for at least 1-2 more quarters. Cost inflation is increasing throughout the industry. I expect the cost of exploration and production to grow – more capital will need to be raised. Offshore energy remains weak.
  • Auto manufacturing is plateauing to declining. Most businesses tied to the auto industry are aware of this and are not forecasting growth in 2017, but are also not forecasting a sharp decline. Will the auto industry and its credit boom witness a similar situation as the energy industry in 2015-2016 — a credit bust that spills over into demand and the broader economy.
  • Labor in certain industries, such as energy and services, is tightening. I continue to expect wage inflation to gradually become more noticeable in government data.
  • Outlooks and commentary suggest Q2 2017 should be similar to Q1 – slow to moderate growth (low single-digit sales growth), with the dispersion between industries continuing.
  • Outside of businesses directly benefiting from asset inflation, consumer businesses continue to report mixed and sluggish results. The consumer remains in a funk and is not aggressively spending outside of home improvement. The middle class continues to struggle.
  • Although weather was mentioned on several calls, it was not a major factor as has been the case in recent years (Q1s).
  • Several companies noted the first half of Q1 was challenging, while results improved in March. Delayed tax refunds, possibly.
  • Now that energy is no longer a drag, earnings ex-energy adjustments seem to have disappeared from quarterly results and earnings commentary (my post on ex-energy results: link). In my opinion, current equity valuations require growth well above and beyond easy comparisons.