Tag Archive: earnings

Tech fundamentals still favor Hardware over Software

While the Technology sector has been less dominant in terms of returns this year than it was last year, it remains the largest sector in the US market by value and the focus of much investor attention.

Our view within the Technology sector for some time now has been to favor hardware-related industries over software-related or services areas, and the latest update of both bottom-up and top-down indicators continues to support this view.

The table below shows some of the key bottom-up fundamental metrics we track for all sectors and industries, and focuses on the six US Technology sector industries (using the GICS industry classifications) within our broad 2300-stock US universe.

The revisions breadth measures shown in the table are based on the proportion of analysts covering each stock who have raised their earnings estimates over the last three months net of those who have lowered earnings estimates. That is, the number of upward revisions to estimates minus the number of downward revisions relative to the total number of analysts covering a stock. We use a weighted average of estimates for each company’s current fiscal year (2021 for most companies right now) and next year (2022) to calculate a consistent 12-month forward earnings figure.

Source: Mill Street Research, Factset

The first column shows the average breadth reading for all stocks in each industry on an equal-weighted (“EW”) basis, while the second column shows the same data on a cap-weighted (“CW”) basis. Naturally, the cap-weighted figures give much more weight to the largest stocks in each industry, while the equal-weighted figures will be relatively more tilted toward smaller names. All stocks in our US universe require a minimum market capitalization of $200 million and at least three analysts reporting estimates, among other criteria, so there are no micro-caps or stocks with very few analysts included.

A few key points jump out from the table:

  • Revisions remain net positive in most areas of Technology, in line with the broadly positive revisions activity in US stocks overall.
  • The average revisions breadth readings on a cap-weighted basis are higher in every industry than the equal-weighted readings, and often much higher. The sector-wide average of about 51% far exceeds the equal-weighted average of about 19%. This means the largest Tech stocks have much more positive analyst activity than the average stock in the sector, i.e., a big-cap bias.
  • The strongest industries are those which focus on hardware right now, while software and services industries are substantially weaker.

We see that on an equal-weighted basis, the Technology Hardware, Storage & Peripherals industry has the highest proportion of positive revisions, followed closely by Electronic Equipment, Instruments & Components and then Semiconductors & Semiconductor Equipment. All three of these hardware-related industries also have the highest revisions breadth on a cap-weighted basis.

At the bottom of the list we see the large Software industry, which has marginally negative net revisions breadth on an equal-weighted basis. This means the average Software stock has a roughly equal number of analysts raising versus lowering estimates. However, on a cap-weighted basis, the revisions figure is strongly positive. This means that a few mega-cap names in the industry have strong revisions, while the majority of mid- and smaller-cap names have relatively weak revisions.

A similar but less dramatic picture is seen in IT Services, where revisions are much lower than in the hardware related industries on both equal-weighted and cap-weighted metrics. The cap-weighted figure is still higher than the equal-weighted, as it is for all Tech industries, but by a much smaller margin than in Software.

The overall picture from the bottom-up, stock level analyst revisions data is that hardware makers continue to surprise analysts positively across large and smaller companies alike, while providers of software and tech-related services are much more mixed and dominated by the largest names in those areas.

The second chart below provides some macro, top-down context for the bottom-up fundamentals we see. The top section of the chart plots the year-on-year percent changes in aggregate spending on investment in computer hardware (blue line) and in software (red line) over the last 30 years. The data come from the quarterly GDP data produced by the US Bureau of Economic Analysis. As of the end of 2020, the growth rate of investment in computer hardware had jumped to 16%, the highest reading since the previous recessionary rebound in 2009-10. Growth in software investment spending, by contrast, had only grown 5%, which is near the lower end of its recent historical range.

Source: Mill Street Research, Bureau of Economic Analysis

The bottom section of the chart plots the ratio of software to hardware spending over time. We see that the line has tended to rise, indicating higher growth in software spending than hardware spending on average over the long run. But the latest readings show a drop, reflecting the jump back toward hardware spending that occurred last year and likely is still ongoing. In the longer-term, it seems likely that software spending will again resume its higher growth rate versus hardware, but the preference for hardware is still very visible in current analyst earnings forecast behavior and could last a while longer as the world continues to adapt to the post-COVID landscape.

S&P 500 earnings have fully recovered, but with wide differences among sectors

The S&P 500 has reported another strong earnings season for Q4, with 79% of companies beating consensus earnings estimates for the quarter. This would be the third highest such reading in Factset’s data since 2008. The beat rate for top-line sales was similarly high at 77%. Aggregate income for the index is about 4% above year-ago levels, indicating that net income on a quarterly basis has fully recovered pre-COVID levels based on Factset’s data.

However, when we drill down into the earnings trends in the S&P 500 and its component sectors, we see the wide differentials in earnings patterns among sectors.

The charts below use quarterly index operating earnings per share as reported by S&P (S&P’s data differ slightly from Factset and other sources). The grey shaded areas are the current bottom-up consensus forecasts for the four quarters of this year.

S&P 500 Quarterly Sector EPS p1Source: Mill Street Research, S&P Dow Jones Indices

The top section of the first chart above shows us that the overall S&P 500 index is expected to see its quarterly EPS rise steadily over the next few quarters and see quarterly EPS exceed the previous peak of Q2 2019 by Q2 of this year, before reaching a new high of $47.06 by Q4 (which would be up 37% from Q4 2020).  The aggregate index figures, however, hide the variation among the 11 sectors that comprise it.

We see that Consumer Discretionary is expected to see earnings recover but not decisively exceed recent highs. Consumer Staples shows a choppy upward pattern, with Q4 expected to be slightly below Q3 of this year.

The Energy sector is expected to rebound from heavily negative earnings during 2020 to moderately positive EPS this year, but still well below the levels seen in 2018 and early 2019 (though if crude continues to rise, that could change).

Financials are expected to see earnings generally plateau around current levels, with no improvement in EPS from Q4 2020 levels, and still near levels seen in 2018-2019. Low net interest margins on lending have been a heavy headwind, partly offset by profits from stock and bond market activity and mortgage-related fees.

Health Care is expected to see a jump in earnings in Q1 of this year and then hold steady at new highs. As we will see, it is thus one of the few sectors where the consensus sees new highs in earnings occurring this year.

Turning to the second chart below with the remaining sectors, see that Industrials (as a classic cyclical sector) had a big drop in earnings in 2020 (with the Transportation component weighing heavily) but is expected to fully recover by the end of this year. Naturally, Industrials should be among the biggest beneficiaries of both fiscal stimulus and re-opening from COVID limitations.

S&P 500 Quarterly Sector EPS p2

Source: Mill Street Research, S&P Dow Jones Indices

The Technology sector, as one might guess, has been least affected by COVID and almost certainly got a boost in the second half of 2020 due to a surge in spending on IT as workers and companies scrambled to work remotely wherever possible. Consensus calls for earnings to continue growing and reach new further new highs this year.

The Materials sector is seeing a big rebound in earnings from a decline that began well before COVID hit when commodity prices and global growth were already relatively weak. Analysts expect the sector’s earnings to hit a near-term peak in Q2 of this year (matching the 2018 peak) before easing by year-end.

Communication Services has been under earnings pressure for some time, as a mix of some big Tech-related firms along with Telecom, Entertainment and Media firms. Earnings are expected to rise steadily from the current (Q4 2020) lows through the end of this year.

Earnings for the Utilities sector look to remain in a range, with no discernible growth trend visible. Demand for electricity, natural gas, and other utilities has seen little overall growth for years, and regulations in many areas keep revenues and profits relatively stable.

Finally, the Real Estate sector (principally REITs), has seen earnings hit hard by COVID, and the consensus is for only very modest recovery this year as demand for commercial real estate is likely to remain depressed.

Overall, it appears that only the Growth-oriented sectors of Technology and Health Care will see earnings reach true new all-time highs this year. Other sectors may approach or just exceed 2019 levels, while a few have further to go. While fiscal stimulus and re-opening should provide a tailwind for earnings in many sectors, those winds are not blowing at the same speed for all.

Semis vs Software trade now favors Semis

Within the broad Technology sector, there are often significant divergences among the various industries. A key intra-sector industry relationship that many investors use as a touchstone is the relative performance of Semiconductors versus Software.

These two industries capture different parts of the Technology ecosystem. Due to their widespread use in so many devices and products, the Semiconductors and Semiconductor Equipment industry reflects demand for hardware, both within Technology (servers, PCs, phones) and in other sectors (e.g. autos), and thus tends to be much more cyclical. Software tends to be much more stable, with more recurring revenue, and nowadays is closer to a service-type industry. There is much less chance of major “shortages” or “oversupply” of software of the kind that semiconductor makers must often deal with.

So even though software and semiconductors are complementary products (each requires the other), it is not hard to see that they can often have significantly different fundamentals and relative returns on an intermediate-term basis.

Our indicators currently show a growing shift in favor of Semiconductors over Software, both in fundamental earnings trends and relative returns. This is a reversal of the trend seen in the 2017-2019 period, when Semis lagged Software, and much of 2020 when relative performance was mixed.

The chart below shows the strong relationship between relative earnings estimate revisions activity in the two industries and their relative returns. The data are drawn from our broad US stock universe of about 2300 stocks (roughly, all US stocks with at least $200 million market cap and three analysts reporting estimates), and the constituents of each industry are equal-weighted in both the revisions and return series. The return series uses a five-day moving average to show the trends more clearly. Earnings estimate revisions breadth measures the average net proportion of analysts raising versus lowering estimates for each stock. Readings above zero mean more analysts raising estimates than lowering them on average.

US Semiconductors vs Software Revisions and Returns

We see that Semiconductor revisions breadth began losing its relative strength versus Software back in 2017, and continued through early 2019. At that point, Semiconductor revisions started to recover while Software continued a slow deterioration, allowing the relative revisions spread (middle section) to turn up from very negative (i.e., pro-Software) readings. That spread turned positive (favoring Semiconductors) in early 2020, just before COVID-19 hit, and then weakened again as many industries weakened simultaneously in the spring.  Both industries then had a simultaneous sharp rebound, along with most of the rest of the market, through the fall.

The last few months are where we again see a distinct divergence. Software revisions have clearly been losing momentum since September while those of Semis have held up and actually grown somewhat stronger. The spread is now quite wide and at multi-year highs in favor of Semis.

The bottom section of the chart shows the relative returns of the two industries, and we see the clear tendency for relative returns to follow the relative revisions. The relative return series has recently broken out of the range it inhabited for most of 2020, and looks set to follow the relative revisions higher. This suggests that Semiconductors should continue to outperform Software as long as the relative earnings indicators maintain their recent clear bias toward Semis.

US earnings estimate revisions trends remain strong amid Q4 earnings season

While certain heavily shorted stocks are getting much of the attention lately due to retail-driven price surges, the bigger picture news is Q4 earnings reports and analyst behavior.

We track earnings estimates for a broad universe of about 2300 US stocks (market cap of $200 million and up) and construct estimate revisions indicators using two key metrics: breadth and magnitude. Breadth is the net proportion of analysts raising versus lowering estimates for a stock, which is -100% if all analysts are cutting their earnings estimates and +100% if all are raising estimates (0 indicates a balance between positive and negative revisions, or no activity at all). We look at this proportion based on revisions that occurred over the last 100 calendar days (about one quarterly reporting cycle).

Magnitude is the size of the changes, measured as the percent change in consensus mean earnings (EPS) estimates over the past month. It will thus be more sensitive but also more volatile.

The first chart below shows the average daily readings of those two indicators for all US stocks. The red line is the average revisions breadth and the blue bars are the average revisions magnitude. We can see that revisions breadth is holding at very high levels (the long-run average is actually slightly negative because analysts tend to start off with high estimates and trim them as time goes on). This means that a solid majority of stocks have more analysts raising than cutting their estimates for earnings over the next 12 months, and this has been the case consistently since July.

United States_AbsERS_Daily_20210126

The blue bars are now starting to rise again, and we can clearly see the quarterly reporting cycle in the data. The earnings season for Q2 2020 earnings that started last July provoked a big upswing in revisions magnitudes (due to a high proportion of earnings reports beating consensus estimates), and then the reports for Q3 2020 earnings three months later also provoked a similar jump in estimates.

Right now, we see what looks like a third consecutive acceleration in estimate revisions developing as Q4 2020 earnings are now being reported, and are mostly coming in better than consensus expectations. So even after months of analysts raising estimates, they are still being surprised positively by the actual earnings reports.

Where are revisions strongest? The table below shows the average revisions breadth readings for the 11 GICS sectors in the US (using the same broad universe of stocks). We see that Financials is at the top, with a very high reading of over 50%. While Financials have had strong revisions for a while now, the latest jump is likely because Financials are among the first to report earnings in a given quarter and most have reported positive surprises so far: 30 of the 34 Financials in the S&P 500 which have reported so far have beaten consensus estimates for Q4. Analysts often then respond to “earnings beats” by raising estimates for future quarters.

US Sector Abs Rev Breadth tableBeyond Financials, it is still mostly cyclical areas that have the strongest revisions activity, including Industrials, Consumer Discretionary, Technology, and Materials. And while all sectors have net positive revisions breadth, the weakest by a considerable margin are Real Estate, Utilities, and Health Care.

So the message from analysts continues to be strongly favorable for future earnings expectations, even after two consecutive quarters when earnings beat expectations substantially. The macro influences of fiscal and monetary policy on corporate earnings are now well established and likely being embedded in analyst forecasts. This is clear from the relative strength in the cyclical sector revisions indicators.

While equity markets have jumped sharply over the last three months and potentially priced in a lot of good news, the positive trend in earnings estimates from analysts that has supported equity prices thus far looks to be intact for now.

Politics aside, earnings estimates are still improving

While the headlines and market reactions are dominated by the US election results right now, it is worth keeping in mind the news on corporate earnings trends. More than 75% of companies have now reported Q3 earnings, and the results have been extremely strong relative to expectations. The results have not, however, been immediately greeted with positive price responses. Market action being attributed to the election may also be influenced by a lagged response to earnings reports.

According to Factset, within the broad S&P 1500 index universe (large, mid, and small-caps), 84% of companies have reported positive surprises (earnings ahead of consensus estimates) for Q3 so far, and the average “beat” has been quite large in percentage terms. Whereas the consensus forecasts expected S&P 1500 earnings to be down about -25% from a year prior in Q3 when the quarter started (July 1st), the actual results look like they will be around -8%: still down, but far less than expected.

However, Factset’s calculations indicate that only 48% of stocks had a positive stock price impact immediately after their report. Worries about the election and the prospects for further fiscal stimulus in recent weeks may have dampened investor responses to what would otherwise be favorable corporate earnings news. With some of the political uncertainty in the process of being resolved now, investors may now be willing to reward positive earnings news.

So how are analysts responding to the corporate news flow with regard to their forward earnings estimates for the next 12 months?

Our data show that analysts continue to show significantly more estimate increases than decreases in the US, and increasingly that is true for the lagging developed ex-US (EAFE) universe.

The charts below show our indicators of analyst estimate revisions activity in the US and EAFE markets (Europe, Australasia and Far East, i.e., developed ex-North America markets). The red line is the average net proportion of analysts raising versus lowering earnings estimates (right scale), and the blue bars indicate the average percentage change in next-12-month (NTM) estimates over the last month (left scale).

United States_AbsERS_5Nov2020

EAFE Markets_AbsERS_5Nov2020

We see that the US estimate revisions indicators shifted dramatically from severely negative in the spring amid the initial COVID-19 lockdowns to positive over the summer (starting after Q2 earnings reports) and have recently accelerated further to their highest readings in many years. This reflects the impact of the massive stimulus programs started in April and continued through the summer, but which are now fading. It also reflects the heavily conservative estimates that analysts made amid the extreme uncertainty around the impact of COVID-19 and the lack of corporate earnings guidance: with much less information to go on and plenty of unprecedented events, they took a very cautious view on their earnings estimates. Thanks to stimulus and other measures (forbearance on debt repayments, evictions, etc.), earnings have been better than those pessimistic estimates.

A similar pattern has played out, to a somewhat lesser extent, outside the US, where growth was already somewhat weaker than in the US and stimulus efforts were more mixed. This is partly due to the issues in Europe where coordinated fiscal policy is more difficult to do, and the fact that interest rates were already zero or negative in most of the region and thus couldn’t be lowered much more. The same is true to some degree in Japan. And while the US election will be resolved one way or another in the coming days and weeks, the impact of Brexit on the UK and Europe remains an ongoing risk factor.

The recent trend in analyst estimate activity thus remains favorable, but faces risks from the current upswing in COVID-19 cases in the US and Europe as well as the timing and scope of any further fiscal support for economies. Thus choppy market action with an upward drift continues to look most likely, with significant rotation under the surface of the major indices.

Is the rebound in earnings estimate revisions peaking?

Our measures of aggregated earnings estimate revisions trends have shown some of their most dramatic movements on record this year, and now may be looking extended.

After reaching historically extreme negative readings in April/May amid the initial COVID-19 lockdowns, earnings estimate revisions activity has now lurched back up to extremely positive readings. Better-than-expected Q2 earnings reports and the effects of massive monetary and fiscal stimulus are now finally reflected in analyst earnings forecasts. However, with fiscal stimulus weakening (and little imminent sign of movement toward new stimulus) and no meaningful further scope for interest rate cuts, the “snap-back” in earnings estimate activity could soon drop off.

The first chart below shows our measure of aggregated analyst earnings estimate revision activity in the US, for our broad universe of over 2000 stocks (equally-weighted) on a longer-term time frame. The data are month-end values except for the latest data point.  The red line represents the “breadth” of estimate revisions, meaning the aggregate net proportion of positive versus negative revisions (changes) to forward 12-month earnings estimates over the prior three months (i.e., number of analysts who have raised earnings forecasts minus the number who have reduced forecasts, as a percentage of the total number of analysts for each stock, scale right). The blue bars represent the “magnitude” of the month-on-month changes in forward 12-month forecasts, i.e., the average percentage change in earnings forecasts from a month ago (scale left).

United States_AbsERS

We can see that the low point in April matched (or exceeded) the extremes seen in the 2008 Great Financial Crisis (GFC) period, which is not surprising given that the drop-off in economic activity this year was greater than in the GFC. However, the combined fiscal and monetary stimulus recently produced in response was also greater than any previous post-WWII period, and so revisions metrics have shown a faster and more extreme rebound than at any previous point in our data. Stock prices appear to have moved ahead of aggregate estimate revisions, raising the question of whether this apparent good news for earnings is already priced in.

Perhaps more concerning is the risk that revisions (i.e., analyst sentiment) have reached highly optimistic readings now and may already be starting to revert. The chart below is calculated identically to the one above, but plots the daily figures (rather than monthly) over the last three years. Here we can see that the blue bars are already coming down from their latest peak, suggesting that the upward momentum of earnings estimate revisions may be fading now that Q2 earnings reports are over. The breadth series (red line) is based on revisions over the last three months, so it encompasses a full calendar quarter and is thus more stable. If revisions breadth starts to turn down (as it did after the tax-cut surge in early 2018) alongside current elevated valuations for equities, then the recent signs of higher stock market volatility could persist into Q4.

United States_AbsERS_Daily

The S&P 500 is top-heavy, but so are fundamentals

There has been much discussion about the increasing concentration of the market cap weighted indices in the US, with the S&P 500 now showing some of the highest levels of concentration among the largest constituents in history. The top 20 S&P 500 stocks (4% of the constituents) currently comprise 38.6% of the index weight, while the top five companies alone make up 23.8% of the weight.

But what about the underlying fundamentals? Are they as concentrated as the capitalization weightings? Broadly speaking, the answer is yes.

Following are a chart and two tables based on the top 20 stocks in the S&P 500. The chart below shows the proportion of total estimated operating income and sales made up by the top 20 S&P 500 stocks each month over the last 15 years. The figures are based on consensus analyst forecasts for net income and sales for the current fiscal year (currently FY2020), rather than trailing reported financials.

Top 20 SP500 Earn Sales

The first message from the chart is that the top 20 stocks do in fact make up an increasing proportion of income and sales, but the proportion is not historically outlandish. The largest stocks have tended to produce 30-40% of total index earnings and 31-35% of total sales, and are near the upper end of those ranges now.

And possibly more surprising to some, the proportion of earnings expected to be generated this year by the top 20 stocks is very similar to the proportion of market cap they hold (39.1% of earnings as of the end of July, vs 38.5% of market cap). The proportion of sales from the top 20 is similar but slightly lower at 35%. So the most heavily weighted stocks in the index are in fact producing a comparable proportion of earnings and sales in aggregate (not for every stock of course). The S&P 500 has long been “top-heavy” to varying degrees due to the presence of a few dominant mega-cap stocks, but right now that broadly captures the similarly concentrated nature of the underlying fundamentals.

What are the top 20 stocks by earnings and sales? The tables below show the latest monthly lists. While some names naturally appear on both lists, there are some notable differences in the lists of earnings versus sales, as profitability varies significantly in some cases. Amazon.com, for instance, has the second largest sales but is not among the top 20 for earnings. The same is true for a number of other well-known names whose earnings are either depressed right now or whose profitability is structurally lower.

List of Top 20 SP500 Net Inc List of Top 20 SP500 Sales

And finally, for some interesting historical perspective, the tables below show the top 20 S&P 500 stocks by earnings and sales 10 years ago (as of July 2010). Notably, the range of estimated profits among the top 20 was narrower 10 years ago, and a number of the names have changed over the last decade.

List of Top 20 SP500 Net Inc 10 yrs Ago List of Top 20 SP500 Sales 10 yrs Ago

Earnings uncertainty still extremely high going into Q2 reporting season

July 10, 2020

As Q2 earnings season gets underway, the level of uncertainty about future earnings among analysts remains extremely high. Despite somewhat calmer equity market activity recently, our data shows that the level of disagreement among analysts regarding earnings over the next 12 months (NTM) is still well above the highest levels reached in the Great Financial Crisis (2008-09) period (chart below).

US Estimate Disperson

The chart plots monthly (and latest) readings for the average dispersion of analyst forecasts around the mean for US stocks (standard deviation of estimates as a percentage of the mean estimate for each stock, averaged across all stocks in our 2300-stock US universe*). A higher dispersion number indicates a wider range of estimates (more disagreement about the level of future earnings) for the average stock. The solid horizontal line is the long-run average, and the dashed lines are +/- 1 standard deviation from the average.

One reason for the extreme level of disagreement among analysts is that a record number of companies have withdrawn their usual earnings guidance in light of the uncertainty surrounding the impact of COVID-19 and related government responses.

And equity analysts, like many other workers, have also been forced to work from home and unable to travel to visit companies, attend conferences, and gather information as they normally would. So with less scope to do their own legwork and less input from company management, analysts have far less information to work with now than usual.

These limitations on information access, alongside the obvious difficulty of predicting economic activity and earnings in an unprecedented global health crisis, no doubt help explain why there is little confidence about forecasting future earnings. We might therefore expect to see a greater number of earnings surprises when companies release their results.

And while theory suggests that higher earnings uncertainty would normally prompt investors to reduce the valuations given to equities, that has not been the case recently as aggressive stimulus from central banks and government spending have in fact pushed equity valuations much higher.

*Note: our US universe includes stocks with at least three analysts covering them, a minimum $200 million market cap, and at least $2 million/day average trading volume.