Every three months, public companies on stock exchanges around the world report their quarterly earnings.
Sophisticated institutional investors and hedge funds keep a close eye on corporate earnings and the trends that are contained within them.
The average investor, however, often doesn’t either watch or understand corporate earnings reports and can be swayed to make a decision based on headlines that appear in the media.
“Aggregate earnings for a broad benchmark such as the S&P 500 or the TSX Composite Index tell us how the overall economy performed for the period while aggregate earnings for a sector, such as financials or energy, give us an insight into how that sector performed in that period,” explained Patricia Lovett-Reid, senior vice-president of TD Waterhouse.
For example, in the second quarter of this year, profits of S&P 500 companies surged 49 per cent, the third straight increase after nine consecutive quarters of a profit slump.
Seventy-five per cent of S&P 500 companies beat consensus earnings expectations and topped analysts’ expectations by 10 per cent.
In Canada, the majority of reporting TSX companies also met or exceeded analysts’ expectations, yet North American and global stock markets were lower.
Good corporate profits can tell investors whether a particular business, sector and the economy in general is growing, but it doesn’t necessarily say much about the outlook for financial markets.
Good corporate profits contribute to healthy corporate balance sheets, Lovett-Reid said. When companies make more profits, it’s easier to fund projects, spend more on research and development and innovation, and stakeholders such as employees and shareholders earn more money and potentially spend more, which helps economic growth.
Government revenues also increase as a result of higher corporate and personal income taxes and indirect taxes.
“Overall, a virtuous cycle of earnings growth fosters economic growth,” Lovett Reid said. “The reverse is true if corporate profits are in decline. However, reported earnings on their own can’t tell us much about the outlook for financial markets. Reported earnings are a look back on the performance of a past period, while financial markets are forward-looking.”
“Investing on the basis of reported earnings headlines is like driving a car while looking in the rear view mirror,” she said.
Investors need to take a logical approach to earnings reports, said Paul Taylor, chief investment officer with BMO Private Banking.
They should find out how companies beat expectations. Did they do it by cutting costs, which could indicate weaker revenues and/or profits, or by increasing revenue?
Also determine where the economy is in the business cycle — is it in or out of a recession — and which sectors could benefit.
“If we’re coming out of the recession you would favour sectors like commodities, energy, materials, technology and discretionary consumer goods, all of which do well out of recession,” Taylor said. “Conversely, in a recession you would favour utilities, health care, consumer staples and avoid other sectors.”
Another indicator is a company’s sales.
“By looking at the trend in sales over the past few quarters and adjusting for seasonal factors, you can see if the business and economy is growing or stalling,” said Lovett Reid.
Earnings reports of some specific companies can act as indicators of overall economic health.
In the U.S., those bell-weather stocks include General Electric for the global industrial economy, Intel for the technology hardware business and Walmart for U.S. consumer goods.
In Canada, Canadian Pacific and Canadian National Railways are considered good indicators for Canadian commodities.
“If you see volumes and prices move upward, those are pretty interesting signs of growth,” said Taylor.
Talbot Boggs is a Toronto-based business communications professional who has worked with national news organizations, magazines and corporations in the finance, retail, manufacturing and other industrial sectors. He can be contacted at boggsyourmoney@rogers.com.