- EPS growth has the potential to power the market much higher, particularly if EPS comes in even close to the consensus estimates.
- We are estimating +9-13% increase in S&P 500 EPS over the course of the 2014-2015 time frame.
- When combined with a mild multiple expansion to reflect increased confidence in the economy, we think there is good possibility for +15-20% equity investment returns by this time next year.
EPS Growth To Power Market Higher?
EPS growth has the potential to power the market much higher, particularly if EPS comes in even close to the consensus estimates. We are estimating +9-13% increase in S&P 500 EPS over the course of the 2014-2015 time frame. When combined with a mild multiple expansion to reflect increased confidence in the economy, we think there is good possibility for +15-20% equity investment returns by this time next year. Therefore, current valuations appear attractive to us.
Conviction In Earnings The Key
As usual, there is a wide disagreement between analysts, strategists and economists what the EPS for the S&P 500 will be in 2014 & 2015. The major concerns lie in accelerating revenue growth projections, doubt in the continued rise (or even sustainability) of corporate profit margins and nebulousness of cash redeployment options. We believe all of these components are in place and pointed in the right direction, collectively adding to the strong earnings growth. A major disappointment in any of these categories would put our EPS estimate at risk, but we feel that is a low probability in the current economic environment. We would also need to miss badly in all three components to still not have a decent investment return outcome in the next 12-18 months.
We Project Upbeat +9-13% EPS Growth 2014-2015
We have high confidence in a 9-13% EPS growth rate, tied to an accelerating world economy, corporate cash management (buybacks, mergers & acquisitions, increased leverage) and increasing operating margins. While the consensus estimates are notoriously rosy, they reflect the general positive macroeconomic outlook and strong long-term trends. Our estimates are roughly 2-8% below current consensus as reported by S&P Indices.
Table 1: SWM Projected S&P 500 Earnings Per Share
|Sales Per Share||$1,117||$1,174||$1,235|
|Baseline Sales Growth||4.60%||4.70%|
|Total Y/Y Growth||5.10%||5.20%|
|SWM S&P Estimate||$107.29||$119.09||$132.23|
|Y/Y % Growth||11.0%||11.0%|
|S&P 500 Consensus Est||$107.29||$122.42||$143.52|
|SWM Est. vs. Consensus||same||(2.7%)||(7.9%)|
Sales Growth Will Boost EPS Gains
Our forecast looks for revenue to take a larger part of EPS growth in the 2014-2015 period. In Q3 2013, +11.9% EPS growth was comprised of: +8.0% margin expansion, +3.3% revenue growth and +0.6% share count reduction. We are looking for revenue to uptick to +4-5% Y/Y, operating margins +5-6% and share count reduction to contribute +0.5%.
Figure 2: Components of S&P 500 EPS Growth
Source: JP Morgan Asset Management
Baseline Sales of +2-4% Should Pick Up +3-5% in 2014-2015
When we weight S&P 500 sales by country/region, we calculate an estimated sales growth rate of +4.6% for 2014. This would represent a significant acceleration over the +2-4% rate of the past 12 months. The World Bank economic forecast sees worldwide growth accelerating from +2.4% in 2013 to 3.2%-3.4% in 2014-2015. Economic growth is anticipated in almost every major country and region in the world, with the exception of China & Japan, which are both decelerate by only 0.2% in 2015. S&P 500 companies derive approximately 45-50% of sales from outside of the United States. Of this number, 30% represents European exposure with approximately 70% in the rest of the world. European GDP, which contracted in 2013, is estimated to be +1.1% in 2014, a positive +1.5% change.
Table 2: World Bank Forecast of Annual GDP Growth %, by Region
Source: World Bank
Share Count Reductions Help Boost Sales Per Share Growth:
S&P Indices, the organization that tracks S&P 500 statistical data, has seen a decrease in the number of shares issued by corporations in the last few quarters, which stems from share buy backs, M&A, fewer option grants and other balance sheet mechanisms. We understand that 15-20% of companies in the S&P 500 are seeing 1% sequential reduction in shares outstanding per quarter, or 4% annualized decline. Over 20% of securities in the S&P 500 index now have EPS growth that is 15% higher than net income growth. If 2014 share repurchases start to look less attractive than last year, corporations will likely consider using other tools & options - mergers & acquisitions, capital expenditures and dividends.
Figure 3: Cash Redeployment Opportunities for S&P 500 Companies
Source: JP Morgan Asset Management
Operating Margins Expanded During 2013, +8.1% Y/Y
Over the course of 2014, operating margins for the companies in the S&P 500 dramatically expanded, due to continued focus on cost cutting, balance sheet efficiency, declining commodity prices and relatively slack labor markets. Going forward, we believe the current operating leverage in a growing economy may provide additional upside.
Table 3: S&P 500 Operating Margin Analysis, By Quarter
|Dec -13E||Sep - 13A||Jun-13A||Mar-13A||Dec-12A|
|S&P 500 Operating Margin||9.76%||9.63%||9.51%||9.52%||8.04%|
|Last 12 Months Margin||9.60%||9.17%||9.00%||8.99%||8.88%|
|Y/Y % Change||+8.17%||+1.43%||(2.12%)||(2.06%)||(3.08%)|
Source: S&P Indices
We Believe Margins May Have Room for Further Expansion:
Our upbeat earnings forecast factors in operating margins that expand past the recent records. The Q4 2013 LTM operating margin of 9.60% was 73 basis points higher than the year ago figure of 8.88%, +8.1%. In 2013, the quarterly operating margin increased steadily on a sequential Q/Q basis, from 8.04% in Q4 2012 to 9.76% in Q4 2013. We believe this is due to three positive factors:
Figure 4: Historical Corporate Profit Margin & Y/Y % Growth
(click to enlarge) Source: Federal Reserve
- Operating Leverage in a Sweet Spot - An accelerating economy (without large CAPEX spending to build new capacity) will drive operating asset efficiencies. The total industry capacity utilization ratio, now at 78%, has room to increase before there is pressure to build additional capacity. At the current rate of change, capacity utilization will be 80-81% by the end of 2014. At this time companies may choose to examine their capital spending plans. If corporations increase CAPEX spending in late 2014, we believe that the positive effect on GDP growth & confidence in the economy would outweigh potential margin inefficiencies & tightness in labor pricing.
Figure 5: Capacity Utilization Ratio Still Below Recent Peaks
Source: Federal Reserve
- Labor Costs +0-1% Y/Y- Low new hiring, low labor participation rates, and international liquidity of labor service markets will keep overall labor pricing in check. The only segments of the labor market that are getting tight are in oil & gas, trucking and housing industries.
- Producer Pricing +1-2% Y/Y - New technology for energy extraction (fracking), a slowing Chinese economy, and less lax monetary policies in the U.S. all add up to a tame commodity environment. In addition, we believe that the Chinese demand for commodities is going through a long-term secular down shift, as this important economy moves away from infrastructure investment and towards a less material intensive consumer goods & services.
Figure 6: Producer Price Index and Hourly Wages, Y/Y % Change
Source: Bureau of Labor Statistics
Valuations Look Reasonable Relative to EPS
The market's current valuation on 2015 EPS is 14.1X, up +11.9% from 12.6X at this time last year. While this multiple expansion reflects increased confidence in the economy, it is still (15.0%) below our "adjusted" 25 year average of 16.6X. This suggests to us there is room for multiple expansion in 2014-2015. (We took the Jan-Dec 2000 and June 2007-Dec 2008 P/E multiples out of our calculation, as we believe those statistics are outliers).
Figure 9: SWM S&P 500 Earnings Per Share Estimates
|S&P 500 Index & EPS||1865||107.29||119.09||132.23|
Market Returns of High Teens Possible
Placing a forward P/E multiple of 16.0-16.6X on EPS of $132.23 would deliver a price target of 2,111-2,195, +13-17% in capital appreciation + 2% yield = 15-19% total return.
Figure 10: S&P 500 Forward P/E Multiples & EPS (Actual and Estimated)
Source: S&P Indices
Other Valuation Metrics In Line
Currently the market is selling for approximately 2.6X book value, 1.9% yield and 1.6X sales, all close to the historical averages. Therefore, while the markets have appreciated nicely in the prior year, it has mostly been to a normalizing of valuation ratios, rather than "over exuberant" investor interest.
Major Risks Are Manageable
We believe earnings disappointments are the biggest risk to our thesis, but lack of alternatives will keep investors from fleeing the equity market. We believe political confrontation on the budget or debt ceiling is a losing issue for both sides of the isle prior to mid-term elections, so the brinkmanship that caused market jitters in prior years will not be present in 2014. Geopolitical tensions remain, but there is little appetite for military action and a distinct preference for process and coordinated economic sanctions. We think a hard landing in China is unlikely, as the country is well capitalized to take on the challenge of an economy in transition. 29 of 30 banks in US were deemed by the Federal Reserve as strong enough to withstand a severe economic downturn, reducing the odds of financial contagion from a major problem somewhere else in the world. A worrisome risk in our eyes are the multi-country currency driven economic strategies targeted to boost exports, which bears watching.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.