As investors pore over third-quarter earnings reports, they are finding signs of corporate malaise that are raising concerns about the outlook for U.S. stocks.
While profit gains have generally been solid, many blue-chip companies are posting weak sales growth or outright year-over-year revenue declines, causing worries about their long-term growth prospects. Others are reporting earnings increases driven by factors that don’t reflect sustainable improvements in their business, such as share buybacks and cost-cutting efforts.
Amplifying those concerns is a softening global economic outlook. U.S. multinational firms are now contending with slowing economic growth in key markets like Europe and China, and a strengthening dollar that threatens to further damp revenue by reducing the value of payments collected in foreign currencies when converted into dollars.
Few investors expect a sustained stock decline. But many traders and analysts say they fear future growth at U.S. companies won’t be robust enough to meet the high expectations currently implied by the above-average valuations on blue-chip shares. Friday’s employment report for October, which showed another month of modest job gains tempered by only slight increases in wages, underscored those concerns.
Investors are responding by punishing shares of some companies that report disappointing sales, even if profits top expectations. Shares of General Motors Co. shed 1.2% on Oct. 23 after third-quarter profit beat Wall Street estimates but revenue rose only slightly. Avon Products Inc. stock tumbled 9% on Oct. 30 after the company reported a slump in sales, even though profit beat expectations.
“Still the theme is anemic revenue growth,” said Laton Spahr, a portfolio manager at OppenheimerFunds Inc.
Earnings for companies in the S&P 500 are on track to climb 7.7% in the third quarter from a year earlier, the sharpest year-over-year rise in any quarter so far this year, according to FactSet. The index is up 9.1% from its Oct. 15 low, finishing Friday at 2031.92, up 9.9% for the year.
Investors note that much of the growth in earnings since the financial crisis has come from deep expense cuts, leaving companies with stronger balance sheets and hoards of cash.
Profit margins for the S&P 500 have grown to record levels, coming in at 10.1% of sales in the third quarter, according to FactSet. But many investors worry because sales, which they view as a clearer indicator of a company’s long-term prospects, haven’t kept up.
Revenue at S&P 500 companies is on track to grow 3.8% from a year earlier in the third quarter, down from 4.4% in the second and below the 4.8% average of the last five years, according to FactSet. Investors are left wondering how much deeper companies can cut and still wring out further expansion in earnings.
- Q3 3.8%
- Q2 4.4%
- 5 YEAR AVERAGE 4.8%
- The last time stocks were pricier than today, revenue growth was 7%, according to Jonathan Glionna, head of U.S. equity strategy at Barclays PLC, suggesting a period of more muted returns are likely on the horizon.
“The easy cost cutting that has been done over the last five plus years is done,” said David Donabedian, chief investment officer of Atlantic Trust Private Wealth Management, which oversees about $25 billion. Mr. Donabedian said he is aiming to buy shares of companies with steady revenue streams, growing dividends and plenty of cash.
Though stocks remain far from bubble territory, they are expensive relative to historical levels. The S&P 500 is trading at 15.8 times analysts’ expected earnings for the next 12 months, versus the average of 14.1 over the last 10 years and the 13.5 of the last five.
The last time stocks were pricier than today, revenue growth was 7%, according to Jonathan Glionna, head of U.S. equity strategy at Barclays PLC, suggesting a period of more muted returns are likely on the horizon.
Meanwhile, companies are contending with a stronger dollar and the slowdown in Europe and in once-booming economies like China and Brazil.
Companies in the S&P 500 derive almost one-third of their revenue from overseas, a figure that has grown steadily for the past 10 years, according to Mr. Glionna.
Troubles for some blue chips are already emerging. Coca-Cola Co. , which derived 58% of its net operating revenue from outside the U.S. in 2013, said third-quarter profit fell 14% and warned it will miss its profit target this year and in 2015. The company said economic weakness in Japan, Europe and emerging markets weighed on its results. Shares fell 6% on Oct. 21, the day Coke reported earnings. Since then, the stock has gained ground, but remains below its Oct. 20 close of $43.29.
Procter & Gamble Co. said Oct. 24 that its fiscal first-quarter profit fell 34% to $2 billion on flat sales of $20.8 billion. The company, which derived about 65% of sales from outside the U.S. in its last fiscal year, also cut its sales forecast and said it expected problems from the strengthening dollar. Still, shares ended the day 2.3% higher after the company reported results. As of Friday’s close, shares were up 7.1% since Oct. 23, the day before the earnings release.
Another cause for worry has been the explosion in share buybacks. These purchases goose earnings per share by reducing the total amount of shares on the market. Critics say buybacks consume cash that could be invested in future growth opportunities.
In the third quarter, buybacks have boosted earnings per share at S&P 500 companies by 2.35%, the highest level in more than two years, according to Barclays.
“Companies to some extent are running out of tricks,” said Jack Rivkin, chief investment officer at Altegris Advisors LLC, which manages $2.39 billion.
To be sure, stocks have a cushion because other assets also appear fully priced. Razor-thin yields in fixed-income securities, slumping commodities prices and signs of weakness in overseas markets mean many portfolio managers are happy to accept modest gains for U.S. stocks into next year.
“Put it all together, it’s still probably the best rate of return compared to other investments,” said Margie Patel, a portfolio manager who oversees $1.4 billion in stock and bond investments at Wells Fargo Asset Management, of the outlook for stocks.
Ms. Patel holds large positions in shares of health-care companies, which have been among the market’s biggest gainers this year. She also owns shares of energy infrastructure companies, which should gain as the domestic energy boom continues, she said.