Flat earnings growth in 2023 is a fantasy
In several equity notes we have highlighted that the 12-month forward earnings estimate on S&P 500 is too high currently at $235.34 which is 7% above the expected FY2022 EPS of $219.38. There is nothing unusual in this divergence conflicting with reality as sell-side analysts have a natural long bias, which is well described in research papers, and are slow to react and incorporate new information. The fact that the 12-month forward EPS estimate on S&P 500 is only 4% from its recent peak despite the ongoing margin compression says it all. In any case, many sell-side banks are these days publishing their S&P 500 EPS targets for 2023 and there seems to be a growing consensus that we could flat earnings. In our view this is very naïve. Let us explain why.
If you take EPS of $220 next year and divide with the expected revenue per share of around $1,800 which fits pretty well with a 1-year lag in US nominal GDP growth, then you get a net profit margin of 12.2% which exactly where the 12-month trailing net profit margin stood at in September (see chart). In other words, this view implies that S&P 500 companies can maintain their net profit margin next year. Before go into the arguments why this is a completely detached assumption it is important to understand why our obsession about operating and net profit margins are so important.
If you look at our scatter plot with the 1-year change in operating margin on the x-axis and 1-year change in EPS on the y-axis for the MSCI World we observe a clear association between these two variables. In other words, when looking over a short time period such as one year, the changes in earnings are strongly associated with changes in the operating margin. The variance around the linear fit is a function of revenue growth, interest rates, and the effective tax rate. Okay so talking about earnings in 2023 is essentially a talk about whether operating margins can expand, stay flat, or decline. Our view is that the operating margin will decline next year. Here is why.
- Companies are constantly talking about margin pressures in their Q3 earnings related to especially wage pressures and to some extent still commodities and energy costs. The fact that the Q3 net profit margin in S&P 500 is 11.9% (below the 12-month trailing figure) and trending lower suggests that margins are coming down faster than expected.
- The operating and net profit margin are both coming off historically high levels and margins are a mean reverting process, so this alone indicates that margins will trend down from current levels.
- Wage growth in the US and Europe is the highest in many decades and the main concern of CEOs as wage compensation is typically the biggest cost item for many companies. Whenever you observe outlier data points an investor and analyst should apply the precautionary principle and high wage growth is difficult to offset in an inflationary environment when recent price hikes by companies have now reached a point where they are destructive for volume growth (Home Depot being a recent example of this).
- Another downside risk to EPS next year is that revenue growth could be lower than current estimates as nominal GDP growth is coming down to 6.7% annualised in Q3 down from the average 12.2% annualised in 2021.
On top of this, higher interest rates will increase drive financing costs higher. Not by much because only 20% of the outstanding debt is getting refinanced over the next 12 months, but it will still subtract from operating income before we reach EPS impacting the net profit margin. If we are right about our operating margin call for 2023 then the impact on S&P 500 will vary depending on the equity risk premium (P/E ratio), revenue growth and the actual net profit margin. In our recent equity note Investors should not wish for an average equity market we go through the sensitivity on the S&P 500 related to these variables.