INSIGHTS

On October 18, 2021

AAM Viewpoints – Keeping an Eye on Earnings…And Profit Margins

A highly anticipated earnings season is underway as equity markets balance an economic recovery that has been slowed by the delta variant with stretched valuations that need continued earnings growth to be supported at these levels. The current price-to-earnings ratio of the S&P 500 is 26.1, well off its peak of 32.7 set back in the first quarter, but still 38% above the 20-year average of 18.9. Aggregate analyst estimates according to FactSet are calling for 27% earnings growth (year over year) for the S&P 500 in the third quarter with lots of attention on profit margins. Profit margins are at record highs but are faced with several inflationary pressures including input costs, labor costs, as well as other non-labor costs all on the rise.

Source: FactSet, AAM | EBIT = Operating Margin | Past performance is not indicative of future results.

Input costs are rising due to supply shortages, surging commodity prices, and shipping constraints making supply chain problems the most cited issue negatively impacting quarterly results. The biggest cost for most companies is labor, and average hourly earnings have increased 4.6% over the last year as companies compete for workers. Non-labor costs are also heading higher including a resumption of capital expenditures (CAPEX), interest expenses that will climb with interest rates, as well as taxes (both direct and indirect) if any infrastructure or budget reconciliation packages ultimately come out of Washington.

These issues have been evident in the inflation data for some time. This past week we had fresh readings with September Consumer Price Index (CPI) rising 5.4% year over year, and the Producer Price Index (PPI) rising 8.6%. Add it all up and we believe margins have likely plateaued, if not peaked. This could potentially cause downward pressure on profitability, and ultimately earnings and valuations if growth begins to moderate.

A business has several ways to manage profit margins (easier said than done) including cost controls, increasing revenues while maintaining costs of goods sold (efficiency gains), or passing increases in costs of goods sold onto the consumer (pricing power). The low hanging fruit of cost controls and efficiency gains have likely been exhausted and pushed margins to the currently high levels, leaving companies with pricing power better positioned at this point in the cycle to navigate the inflationary pressures currently in the market.

Here is a look at current profit margins at the sector level, as well as the year-over-year change.

Source: NDR, AAM | Past performance is not indicative of future results.

As third quarter earnings start to roll in, consider exposure to high-margin businesses with the ability to maintain – or preferably increase – profit margins despite the inflationary headwinds as we believe this could be a good indicator of equity performance going forward.

CRN: 2021-1004-9501 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.