Over the past three weeks I’ve reviewed approximately two hundred earnings reports and conference calls. While very time consuming and exhausting, my quarterly earnings routine is an essential part of my investment process. With an up-to-date summary of where we are in the profit cycle, I’m better able to normalize earnings and more accurately value the small cap companies I’m considering for purchase.
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Although I’m bearish on small cap prices and valuations, I do not believe the U.S. economy or corporate profits are currently in recession. While second quarter operating results were inconsistent and varied between industries, on average, sales and profits increased modestly. In my opinion, Q2 2017’s results were similar to Q1 2017 and were commensurate with a slowly growing economy – a trend that has been in place since Q3 2014 (interestingly the end of QE3 was announced in October 2014).
Based on the operating results of my opportunity set, I continue to believe the U.S. economy is growing in the low single-digits. Last quarter I stated Q1 GDP growth of 0.7% appeared low (was recently revised to 1.2%). At 2.6%, Q2’s GDP growth looks a little high in real terms. However, on a nominal basis, the mid-3% growth reported in both quarters appears reasonable. To get a more accurate measurement of real GDP, I suggest averaging Q1 and Q2, which puts real GDP growth slightly below 2% and more in-line with my bottom-up observations.
Below is a summary of several business trends I noticed during the quarter.
- Consumer companies, on average, continue to report sluggish operating results. Most volumes and comparisons remain low single-digit positive to negative. Strategies to combat weak volumes and traffic vary, with some consumer companies turning to promotions, while others are reducing inventories and increasing price. Regardless of the strategy, it’s an extremely competitive environment with companies fighting tooth and nail to protect market share or margins (tough to protect both). On the bright side, quarterly comparisons are getting easier (it’s been almost a year since I noticed the consumer slowdown: Consumer Alert). Furthermore, inventories are tightening, which should stabilize margins and reduce the risk of further destocking. However, lower inventories and fewer promotions may also lead to higher consumer prices.
- Despite reports of tame consumer and producer inflation, many businesses reported cost pressures and pricing action in Q2. I’m not certain if or when these increases make it into the government data, but I listed dozens of examples of cost and price increases in my quarterly management commentary write-up (available upon request). Although inflation isn’t spiking higher, it was definitely noticeable in Q2 and certainly isn’t dead (as the bond and equity markets have priced in).
- Industrial businesses, on average, had a good quarter. Companies tied to construction and aerospace/defense reported healthy results. A rebound in energy spending also contributed to improved results. However, the benefit from energy should moderate in Q3 and Q4 2017 as comparisons get more difficult (rig count troughed at this time last year) and the direction of energy investment is less certain.
- Investment in domestic energy infrastructure rebounded again in Q2. Barring further declines in energy prices, most energy companies appear comfortable maintaining 2017 spending. However, rig count growth is moderating sequentially, so expect growth to slow in Q3 and Q4. 2018 remains very uncertain as most capital expenditure decisions are on hold – energy companies are in wait and see mode. And finally, offshore remains very weak with no rebound expected.
- Auto manufacturing is declining slightly. Most companies aren’t predicting a major decline, but there doesn’t appear to be strong conviction on future trends.
- Agriculture remains challenging, but seems to have stabilized at lower levels.
- Transportation volume and pricing appears to be improving modestly. Weakening dollar could help rails/exports.
- Financials are doing well on average. Loan losses at banks are manageable. Insurance may be a bigger trouble spot at the end of this cycle than banking. I believe there is a growing risk insurance companies are underwriting too aggressively to maintain premium growth. And of course their investment portfolios are tied to the bond and equity markets to different degrees.
- Technology results and trends mixed. I need more data.
- Currency was not a major factor in Q2.
- Outlooks and commentary suggest Q3 2017 should be similar to Q2, or what we’ve seen since mid-2014 – slow aggregate growth, with the dispersion between industries continuing.
- Certain companies and sectors such as consumer staples and technology appear to be getting a pass on earnings misses, while others such as consumer discretionary and energy are not. It’s as if investors are normalizing operating results for some businesses, but not all. This is just an observation on sentiment and conformity (possibly exaggerated by ETF and passive investing – what’s working or popular are larger weights in benchmarks which benefit more from investment flows into passive). I do not have supporting data on this – again, just an observation.
As always, if you’d like to read the management commentary that helped form my macro opinion, please shoot me an email. It’s a little longer than normal this quarter (over 50 pages) and was too lengthy to post.
In addition to financial and macro related commentary, there is always plenty of other interesting and entertaining content on quarterly conference calls. In fact, I learn something new every earnings season. For example, as it relates to long-term economic growth, I found Church & Dwight’s (CHD) comments related to their TROJAN division very relevant and interesting. In effect, are smart phones contributing to the decline in population growth and household formation?
Church & Dwight’s management explains, “The condom category declined in consumption by 3% in the quarter. TROJAN condom share in measured channels was down 150 basis points. Although some of that is offset by online consumption — condom consumption, all channels has been soft for the last few quarters. Our research suggests that young people are having less sex. Some of the factors are demographics, young people living at home longer, and surprisingly, the distraction of mobile phone usage.”
If young people are having less sex due to the distraction of their smartphones, is it safe to assume they’re doing less of everything? This would go a long way in explaining weak consumer demand for many products and services. Instead of shopping, eating out, or attending a sporting event, maybe a growing number of young consumers prefer spending their time “non-GAAPing” (your life without bad things) their Facebook page or watching episodes #54-#58 of Breaking Bad on Netflix!
Article by Absolute Return Investing with Eric Cinnamond
