Optimism In Estimates At Odds With Economic Pessimism
As we look forward to 2013 we see the usual early optimism in company earnings estimates, which to us appear to be at odds with the economic reality. In the Industrials and Basic Materials Sectors, the lowest growth estimate is for Capital Goods, which is below 7%. For all other sectors expectations are for earnings growth above 10%. This is at odds with projections for the markets as a whole. Consensus estimates for the S&P500 expect earnings growth of 7.4% in 2013, which is only slightly below the long-term average of 8%. As shown in the chart, only the Capital Goods sector has an earnings growth estimate lower than the S&P 500 currently.
In research published last night we took a look at how good the different industries are at predicting their own fortunes, recognizing that in any given year, extraneous events might cause estimates to be wrong, but that over the long-term companies should have a handle on their underlying growth potential. It is not surprising that the Capital Goods space has the lowest expected growth in 2013 as the sector is a the most consistent “low-baller” of the group, on average underestimating annual earnings by around 3.5% over an 11 year history. Over-estimators over both a 5 year and an 11 year period are the Packaging sector and the E&C sector. See the research for more detail.
But should we be forecasting any growth at all?
Today the OECD have lowered their forecast for global economic for 2012 to 2.9% and for 2013 to 3.4%. Prior estimates for were 3.4% for 2012 and 4.2% for 2013. These are some very steep revisions, and while the 2012 number may not be much of a surprise, given the news flow of the last few months, the 2013 revision is significant.
The higher estimates for the Industrials space for 2013 rely on revenue growth – it cannot rely on raw material declines as this would be inconsistent with estimates for the raw material suppliers, which are flat to up for the Energy companies and up meaningfully for the Metals companies (as indicated in the chart above). Revenue growth will be challenged by one obvious factor and one that could be much more damaging.
The obvious factor is volume – lower growth leads to lower than expected demand – whether that is simply lower than expected activity or compounded by a greater sense of uncertainty that reduces forward investment.
The bigger wild card is price. In a slower growth environment, companies with significant surplus capacity might be tempted to start competing on price in an attempt to improve operating rates. All of these industries have high returns on capital today – in many cases above trend – which means that there is plenty of room to give up pricing.
These are generally higher beta sectors and so any estimate reductions we might see for the broader market, because of lower economic growth expectations, should be amplified here.