At the time of this writing, 494 of the S&P 500 Index constituents had reported second-quarter 2020 earnings. The S&P 500 Index rallied strongly from its late March low and had its best August performance in 34 years. Since the beginning of September technology company shares, which led the market rebound, have given back some of their gains. Expectations for the future are an important factor in market direction. To that point, earnings surprise, or the rate at which actual reported company earnings beat the consensus analyst estimate, exceeded by an average of 23%. Obviously, this sounds like a huge, impressive number. In some ways, it is. My colleague George Cipolloni spent some time on earnings revisions in his last “Chart of the Week,” so I won’t repeat all of that here. With so many companies discontinuing guidance for the foreseeable future, many estimates were lowered too far. To that end, approximately 83% of companies beat earnings expectations during the second quarter, the highest level in more than a decade. These are headline-grabbing data points.
As a contrarian value investor, one of my goals is to pay attention to what’s not in the headlines. I see record levels and immediately wonder what the catch is and where things can go wrong. Clearly, earnings greatly exceeded market expectations, but one obvious hole currently is sales growth. This isn’t unexpected in the midst of a global pandemic. In fact, revenue growth was slightly better than anticipated for the quarter. That said, revenue is down nearly 10% from last year. Quarterly revenue growth for the S&P 500 Index has not exceeded mid-single digits since 2018.
In the current environment, how is the average company beating on the bottom line with low or negative top-line growth? One possible answer is they’re cutting headcount. A few weeks ago, there was an interesting piece in Bloomberg, where a strategist summarized 2020 as the "bear market for humans." That phrase leaves a lasting impression. It was used in several contexts, but can certainly be applied to labor-intensive businesses. We’ve seen the negative impact in the labor market numbers since April. Additionally, transcripts from company earnings calls this quarter mention the words “layoff” or “furlough” over 7,500 times. Those instances represent a higher count than the worst quarters of 2008. So while revenue continues to be a struggle, companies are navigating the current health crisis by becoming more efficient and nimble — but at the expense of workers. The impact this will potentially have on the overall economy in the long term has yet to be seen and is a topic for another day. In the meantime, look for the realization (or lack thereof) of sales growth to be the next piece of the expectations puzzle.
With the second quarter of 2020 earnings season largely behind us, the majority of companies beat expectations and the S&P 500 Index reacted by reaching new all-time highs at the end of August. I’d contend that how we got there matters. Sustainable corporate earnings can grow through higher revenue and/or margin improvement. While companies can cut expenses, including headcount, for a while, eventually the broad market will need to resume sales growth to maintain the upward price momentum. My focus will continue to be on dividend-paying equities with what I believe are reasonable paths to both sales growth and margin improvement.
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