Strong earnings take analysts by surprise

Despite their notorious over-optimism when forecasting company earnings, sell-side analysts have had to get used to issuing earnings upgrades rather than downgrades in recent years.

Graham Mason, CEO of Prudential Portfolio Managers in South Africa, says until about 2004, as reporting dates grew closer, sell-side analysts regularly had to downgrade their earnings forecasts as a result of their over-optimism.

"Until about three years ago earnings constantly disappointed, forcing analysts to issue downgrade after downgrade. However, in recent years this trend changed and earnings upgrades are now the norm rather than the exception."

The graph below shows the ratio of upgrades to downgrades that is the number of companies where the earnings have been upgraded by analysts divided by the number of companies where the shares have been downgraded. Looking at the period from 1993 to 2004, the graph clearly shows that in this period analysts were constantly downgrading their forecasts.  

But what is also very clear from the graph is that from about the end of 2004, the number of upgrades started to exceed the number of downgrades that is analysts started to be surprised by the strength of the earnings being produced by
companies.

Source: Merrill Lynch

Mason comments that: "For the first sustained period in observable history analysts keep having to upgrade their earnings forecasts. We get e-mailed earnings revisions daily, not because analysts have lost their optimism, but because earnings over the past three years have started to consistently surprise on the upside."

And since earnings drive the stock market, the JSE All Share Indexs surge to new record highs comes as no surprise.  It is very much this upward revision of earnings which has been behind the constant appreciation of the equity market over the last few years.

The strong earnings trend is not unique to South Africa, but has been a feature of equity markets worldwide.

According to Mason, the underlying reason for the unexpectedly strong increases in company earnings has been margin expansion both locally and globally.

"Margins in South Africa are at their highest level since the 1960s, and it is this increase in margins which has lead to the very strong earnings growth. Profitability increases with wider margins. The local environment of strong commodity prices, strong growth in fixed investment, and strong consumer spending is very supportive of wider margins.

"Globally margins are also at multi-decade highs.  The high levels of profitability globally are as a result of increased global labour supply and heightened microeconomic efficiency."

Mason says internationally there is an intense debate about whether margins are too high and will soon revert to the long-term mean, or whether the higher margins are sustainable over the medium term.

"Globally many investors are skeptical about earnings going forward, and as a result equity markets are priced for subdued earnings. This is not the case in South Africa, because the local environment allows investors better insights into what is driving earnings. Our market has been running hard based on that."

Mason believes that the key drivers of earnings growth are here to stay, both globally and in South Africa.

He says that despite the recent run in the market, the JSE remains fairly priced at a forward P/E of around 13.

"Until now the equity market has been trading on a P/E ratio of less than 13, meaning that equities offered good value. This is the first time in three years that the market is more or less fairly priced on a P/E basis, and despite continued strong earnings growth, returns going forward are likely to be more muted than investors have enjoyed over the last three years."