As Wall Street enters the busiest part of the second-quarter earnings, equity benchmarks have been mostly treading water, and the lackluster moves may be due to an uncertain profit outlook of American corporations in the quarters to come.
Although S&P 500
companies have so far beaten lowered expectations for earnings-per-share, or EPS, growth, only 28% of companies are surpassing revenue growth targets, a figure that underscores a slowing American economy and the struggles U.S. firms will have expanding earnings in the quarters ahead amid valuations for stocks widely viewed as lofty, according to a Monday research note published by Goldman Sachs.
Challenges in growing revenue or sales for companies can sometimes mean problems converting that shrinking top-line revenue into bottom line profit growth.
“The S&P 500 index trades near fair value relative to interest rates, although we believe policy uncertainty and negative revisions to 2020 earnings-per-share forecasts will limit equity upside,” wrote David Kostin, chief U.S. equity analyst at Goldman Sachs. “The stock market’s downbeat response to negative earnings surprises and guidance validates the argument [that] lower interest rates may not lead to higher equity prices.”
Kostin recommends that investors use return-on-equity (ROE) — a measure of determining performance by dividing net profit (before any nonrecurring items) by common shareholder equity (total assets minus total liabilities) — as a framework for studying profits, noting that for the S&P 500, ROE has hit 18.9% during the first quarter of 2019, it is highest level since 1998.
“The S&P 500 appears fairly valued relative to the index’s elevated ROE,” he wrote. He said pressures to profit margins from higher wages, rising input costs and slower demand growth will make it difficult for companies to push their ROEs much higher in the coming quarters.
Given this environment, Kostin recommends investors focus on companies with higher expected ROE growth. “Firms with the fastest expected ROE have outperformed year-to-date as the pace of economic growth has slowed.”
He pointed to Under Armour Inc.
Cisco Systems Inc., Sempra Energy
Global Payments Inc.
Nielsen Holdings PLC.
DXC Technology Co.
and Fidelity National Information Services Inc.
as companies to focus on, given that they have the highest expected ROE growth, according to a Goldman’s analysis.
Companies with high expected ROE “typically outperform in weakening growth environments as investors assign a scarcity premium to firms that are able to expand ROE despite index-level headwinds,” Kostin wrote.