Earnings reports for S&P 500 companies have continued to impress in 2005. Will the good times keep rolling in 2006? There’s reason to wonder, in part because interest rates are expected to rise further, and it’s not clear if the stock market will be able to shrug off the trend indefinitely. The United States economy faces other challenges as well, ranging from trade and budget deficits to next year’s arrival of a new and therefore untested Federal Reserve chairman as replacement for the retiring Alan Greenspan.
Michael Krause, who runs the ETF-focused consultancy AltaVista Independent Research (www.altavista-research.com), reports in the firm’s latest analysis that S&P 500 earnings per share are on track to rise 11.8% next year. Slower than last year, but still a handsome rise. But a closer look at the S&P 500 sectors suggests that there’s more than a little variation in the sources of the predicted earnings growth. In search of some perspective on what’s bubbling beneath the S&P 500’s hood, we posed some questions to Krause via email over the weekend.
Q. In your latest report (“No need to get all defensive: a look ahead at 2006,” Nov. 2005) you write that the S&P 500’s earnings per share look “set to grow” by 11.8% in 2006. That’s a bit slower than the 14.3% estimated for this year, but a decent advance just the same. What sector or sectors are likely to drive next year’s EPS rise, and why?
A. Financials (Amex: XLF), by virtue of the sector’s sheer size, are expected to contribute up to one-fourth of the S&P 500’s earnings growth next year, despite the fact that its own growth rate of 11.4% is basically in line with that of the overall index.
According to current consensus estimates, stocks in the Consumer Discretionary sector (Amex: XLY) are forecast to grow earnings the fastest, at 20% next year. However, I have little faith in this number. Part of the reason is that as estimates for this year have slid 8% since January, estimates for next year have barely budged, giving the stocks that much of a higher hurdle. And, combined estimates for sales and earnings next year imply a huge margin expansion—-greater than for any other sector—-despite already being at historically high levels.
Q. You also warn that “disturbing signals” are emerging in the consumer staples sector of the S&P 500. What are those signals, and what are the implications?
A. Among the warnings signs we see are falling earnings estimates, declining margins, falling asset turnover, and declining return on equity, which is ominous for a sector with such a high price-to-book value (P/BV). Further, the sector trades in line with its historical forward P/E of about 17x, and so it’s not a bargain. Deteriorating fundamentals are particularly disturbing in the case of Consumer Staples (Amex: XLP), since investors often look to it as a defensive sector, a place to hide when fundamentals in more economically sensitive sectors start to head south.
Q. Energy has been a hot sector recently. What’s been the contribution of energy-sector earnings to the S&P 500 recently, and what’s your analysis for energy’s role in S&P 500 earnings next year?
A. For most of the year, it was primarily Energy (Amex: XLE) profits that were driving S&P 500 EPS estimates higher, though not entirely. While we make no predictions as to the price of oil next year, it appears that earnings estimates have now caught up with sustained, high oil prices. Therefore we expect earnings estimates to fluctuate more closely with oil prices going forward, whereas earlier this year estimates rose even on pull-backs in oil prices, since analysts were behind the curve.
4. On a fundamental basis, which of the ten S&P 500 sectors looks the most attractive, and which one looks the worst?
A. Over the next year we particularly like Industrials (Amex: XLI) and Technology (Amex: XLK), which is a bit of a departure for someone who usually has a value tilt. However, the analysis we do shows consistent signs of fundamental strength for these two sectors, including positive estimate revisions, higher margins, and improving return on equity—-the only two sectors for which this is true. But what makes these attractive investment risks to us is the fact that they also trade at a discount to historical forward P/Es. These discounts are also larger than those for most other sectors.
Longer-term we like Financials (Amex: XLF) for valuation. A sector that consistently earns a return on equity (ROE) in the mid-teens (15.2% estimated for 2006) in our opinion deserves a P/BV multiple of 2.1x, rather than the 1.7x pro forma it currently fetches, or a roughly 25% increase. This is based on a trend line of where all other sectors fall on the ROE vs. P/BV spectrum, and given the consistently strong correlation between those two variables.
On the negative side, we dislike Consumer Discretionary (Amex: XLY). Not because we think the American consumer is about to collapse, but because as mentioned above consensus estimates for 2006 are simply unrealistic in our opinion. Analysts made the same assumptions about big increases in margins at this time last year; but 2005 has not panned out that way. If, as we suspect, earnings are flat to slightly down in 2006 instead of gaining 20%, then forward P/E is at least 20x. That is a premium to historical levels, not to mention the rest of the S&P, even Technology.
Q. Switching from sectors to style, the value slice of the S&P 500 has been a strong performer relative to growth in recent years. Some strategists say that growth will soon take the lead again. Based on the fundamentals, what do you expect next year for growth vs. value in regards to S&P stocks?
Here we have a definitional problem, since when most investors talk about growth, they mean fast earnings growth, and they generally expect to pay-up for that growth. However, in a report from last year called “Dirty Little Secret” we found that companies in the iShares S&P 500 Value fund (Amex: IVE) actually had faster earnings growth than did those in the Growth fund (Amex: IVW). The reason for this is because the funds divide S&P 500 stocks into two camps based on price-to-book value, with high P/BV stocks assigned to the Growth fund and low P/BV stocks assigned to the Value fund.
As mentioned above, P/BV is highly correlated to return on equity, but it actually has almost no relationship to earnings growth! This is because many mature firms such as Altria in the Consumer Staples sector are nonetheless able to maintain high ROE (and thus enjoy a high P/BV) by paying out a large dividend. As a result, many of these mature firms end up in the growth fund.
So, to answer your question, the methodology behind those iShares will change soon and the jury is still out as to whether the new rules will result in a growth fund that actually has faster earnings growth. However, your point at the beginning is well-founded: that despite slower earnings growth next year, 11.8% is still a decent advance. In fact, it is nearly double the historical growth rate of 6.2% since World War Two, and rather remarkable in the fifth year of a robust profit expansion. So, with economically sensitive sectors like Industrials and Tech showing enduring fundamental strength, and traditional defensive sectors like Consumer Staples facing their own challenges, I would have to conclude that now is not the time to “get all defensive” and that growth stocks hold plenty of appeal.