Expectations had been downgraded significantly over the last month, with fourth quarter 2018 consensus earnings growth forecasts falling from 3.9 per cent to -1.7 per cent year on year in less than a month, meaning that more companies are beating expectations than missing. We are also seeing a sharp acceleration of downgrades for calendar year 2019 and consensus probably has further to come down from here given concerns over Brexit, trade wars and global growth.
Source: MSCI, IBES, Morgan Stanley Research, 31 January 2019
Beyond headline numbers
Whilst fourth quarter 2018 earnings are now on track for a net beat, they are still lagging sales results. This suggests a continuation of the margin pressure we have been seeing since last summer where the emerging theme was rising costs. Companies across industries and geographies were surprising negatively on margins.
While this margin pressure remains, we are now seeing diverging comments on costs. For instance, Crest Nicholson reported that cost increases in UK construction - especially outside of London - were moderating as large projects were coming to an end and labour supply was improving. Similarly, Royal Dutch Shell noted a fall in oil service costs saying the pressure relative to the first half of 2018 had abated.
Other companies such as British multinational contract food servicing group Compass, which was facing pressure from rising US labour costs, have successfully managed to offset increases. This clearly emphasises the importance of stock picking and being able to identify the companies that have pricing power and an ability to pass on rising costs to their customers.
An interesting gauge of investor sentiment is how share prices react to a company’s earnings, and particularly whether the share price reaction to a miss is stronger than a beat.
For the third quarter 2018, reaction was very asymmetric - with misses being very aggressively punished and beats being greeted with a muted share price reaction. This suggested that investors were probably overly optimistic. This time, reaction has been evenly balanced - EPS beats outperforming by 1.6 per cent on the day of results and misses underperforming by 1.8 per cent- reflecting a greater sense of realism from investors.