Author: Bob Gay, GEARS
Covestor models: Earnings Surprise, Speedboat, Luxury Liner
The Global Equity Analytics and Research Service (GEARS) team has completed the update of the fundamentals for US companies for the 2011 annual period with the appearance last week of the Security and Exchange Commission 10-k filings for companies (mostly retailers) with fiscal years ended January. Sales growth is high and profit margins are up, indicating that overall corporate wealth continues to accelerate. Our report on the fundamentals of the broad market is here.
There were two important developments in numbers we extracted from the 2011 annual financial statements. First, the average gross profit margin improved for the first time since 2009, and 45% of the total market index achieved an improvement in gross profit margins – up from 37% last quarter. This is an important uptick, since over the long term, the price of stocks is 78% correlated with the direction of the average gross profit margin.
Second, capital expenditures advanced again relative to sales, producing a modest drop in free cash flow. This has been an important development historically. Corporations are shifting from defensive mode to investment mode. That shift in demand for capital goods can be isolated in the long term experience of U.S. business cycles and is associated with a peak in the consumer durables.
That leadership transition is underway now. In the consumer cyclicals sector, average sales growth is lower, gross profit margins are down and SG&A expenses are up relative to sales. Inventories are rising for the third consecutive quarter and the sector average EBITD margin is the highest in the record and unchanged over the prior period. This has been a popular sector since the post crisis low and the sector average share price is near to historical highs with valuation extended. There is a good opportunity now to reduce portfolio exposure to consumer cyclicals.
Stronger corporate capital expenditures supports profit growth among basic industrial companies and energy. These two sectors have been market laggards in the recent rally. The average energy company sales growth rate is 26% in the recent period and 84% of the sector achieved an improvement in sales growth compared to the prior period.
Lower SG&A expenses and lower financing costs have accelerated cash flow relative to sales. Energy companies continue to invest aggressively in capital expenditures which were unchanged in the recent period at the highest level relative to sales in the long term record. Despite the strong numbers, energy shares have lagged the market and valuation is more broadly depressed in the energy sector.
The basic industrial sector has also been an investment performance laggard in recent quarters despite stronger fundamentals. In this group of commodity and industrial companies, average sales growth is very high, the average gross profit margin is up, SG&A expenses and interest costs are lower and the average net profit margins is the highest in the long term record and rising.
The sector exposure conclusion is: reduce consumer cyclicals and increase basic industry and energy. The persistent question is “where does the technology sector fit in the late cycle leadership rotation.” The technology sector has staged a strong improvement in growth but it is narrowly distributed and dominated by large companies. Smaller technology companies have lagged and now on average are trading at historical lows with near to the lowest valuation in the long term record. Sales growth of smaller technology companies is low and down in the recent period and profits margins are falling.
In the next few weeks we will collect financial statements from companies for the first quarter period of 2012. Average sales growth is very high and likely to fall again. We will be watching for the sales growth rate of small companies to increase more broadly. The improvement in the proportion of the total market accounted for by rising gross profit margins is an important shift in the most recent quarter.
We will be watching closely to verify that the improvement is sustained. Interest costs to sales have been falling for two years and have been an important contributor to the acceleration of cash flow relative to sales. With interest rates at historical lows, financing costs may fall further, but with capital expenditures advancing and free cash flow falling, companies are reducing cash balances.
Cash and securities on hand is still a high proportion of sales and companies can internally finance the increased capital expenditures for a few more quarters. By the end of this year, we will see increased demand for capital to finance the growing gap between capital expenditures and internal cash flow. Historically this higher late cycle demand for capital has been associated with higher interest rates.
For now, the conclusion from our analysis of corporate fundamentals is to sell bonds and buy stocks – sell defensive stocks and consumer cyclicals and buy energy, basic industrials and large cap technology.
