Profit Margins Will Be Down in Earnings Season. When Buying Beaten-Up Stocks Makes Sense.

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The good news is that corporate sales are forecast to grow briskly in the first quarter, up from expectations earlier this year.

The bad news is that corporate profits are expected to grow about half as fast as sales. This margin compression doesn’t bode well for stock prices during earnings season, particularly since the market has run up in recent weeks.

The earnings should show an economy that continues to steam along, despite rampant inflation and war in Ukraine. Analysts expect first-quarter sales for S&P 500 companies, in aggregate, to have grown 10.7% year-over-year, up from 9.7% expected growth at the start of the year, according to FactSet. The increased revenue estimates come even as the Russian invasion of Ukraine—and Western sanctions on Russian energy—have boosted commodity prices. On top of that, the Federal Reserve has already begun lifting interest rates to curb economic demand and high inflation. Earnings per share on the S&P 500, are expected to rise 4.8% year-over-year, down from 5.7% expected growth at the beginning of the year. 

When sales growth is faster than profit growth, it means companies’ costs are rising faster than sales and their profit margins are declining. For some companies, higher commodity costs are hurting margins. Others are getting hurt by shortages of steel and other metals. And companies of all stripes are paying higher wages to workers. “We are seeing a real margin headwind for the average company,” says Christopher Harvey, chief U.S. equity strategist at Wells Fargo. 

The falling profit margins are particularly noticeable in the industrials sector.

Caterpillar

(CAT), is expected to see its operating margin fall to 13.4% in the first quarter from 15.3% in the first quarter last year. Even

Deere & Co
.
(DE), which is usually able to lift prices of its farm equipment substantially when its costs rise, is expected to see its operating margin decline to 20.9% from 22% in the same quarter last year. 3M (MMM) is expected to see its operating margin fall to 20% from 22.5% last year. Indeed, the industrial sector has experienced the largest year-to-date decline in first-quarter earnings estimates out of any S&P 500 sector, according to FactSet. 

Meanwhile, the broader stock market, hit hard earlier this year, has been rebounding in recent weeks. The S&P 500 is up about 7% from its closing low of the year, struck on March 8. A more frothy market only makes future gains harder to come by.

So with stocks getting more expensive, it’s less likely that they will post big gains after reporting earnings. The S&P 500’s aggregate forward earrings multiple is now about 19.3 times, up from a low of just under 18 times last month. Stock prices are now reflecting a large expected earnings stream in the future.

When stocks trade at such a lofty multiple, companies typically need to beat earnings estimates by a large percentage to send share prices moving up. “You’re setting up for an earnings season that needs to be good, both in terms of the numbers that come in and the forward guidance,” says Dave Donabedian, chief investment officer of CIBC Private Wealth US. “The bar is set high. It’s going to be tough to clear the bar.” 

That doesn’t mean equity investors should give up hope on finding good buys during earnings season. Companies whose shares have already been pounded before releasing earnings could see their shares rise after releasing less-than-stellar results. They could be enticing buys at the right moment. “How has the company traded into earnings?” Harvey says. If a stock is down, it presents “a little bit of a better risk/reward because it’s priced in some of the bad news.”

Lulu Lemon Athletica (LULU) is a good example. The company posted a mixed quarter, missing sales expectations and beating EPS estimates. The stock gained almost 10% the trading day after it reported earnings in late March. It had fallen 12% for the year through the day before earnings. 

It’s a tricky market. Finding beatdown names into earnings reports is one viable strategy.  

Write to Jacob Sonenshine at [email protected]