Written by: Frank Caruso
As earnings season rumbles on, analysts remain fixated on the bottom line of company reports. But earnings tell only a partial story. There’s a better way to identify businesses that can generate long-term growth.
Just look at the news headlines and it’s clear that earnings are what matters most for many investors. “Time Warner earnings beat expectations.” “Whole Foods slides after missing on earnings.” “Coca-Cola earnings retreat 5%.”
ARE EARNINGS THE BEST BAROMETER?
Yet earnings might not really be the best barometer to gauge a company’s true economic prospects. Earnings can’t tell you how skillfully a management team deploys capital. They offer no insight into the quality of a company’s profit streams. And earnings alone can’t really identify companies that can generate long-term value for shareholders, in our view.
Fundamental returns—which are a way of looking at business profitability—are much more insightful. By putting returns on invested capital (ROIC) or return on assets (ROA) at the center of company research, we believe investors can discover whether a company is investing intelligently to generate its profits. That’s why US stocks with high ROA have consistently outperformed stocks with high earnings per share (EPS) growth—as well as the Russell 1000 Growth Index—over more than three decades (Display).
COST OF CAPITAL MATTERS
Conventional wisdom on Wall Street suggests that investor sentiment about future earnings determines a company’s stock price. We disagree. What we think matters most is the amount of capital—financial or physical—that a firm deploys to generate its earnings. After all, any dollar management invests is a dollar shareholders could have invested for themselves. So a firm’s ROIC must exceed a certain threshold, the so-called “cost of capital,” for its stock to perform well over the long term.
Cost of capital is elusive. Yet although it isn’t listed in a company’s reports, its influence is everywhere. For example, when a company’s shares plunge after announcing a large acquisition that’s “accretive” to EPS, investors are really reacting to an inefficient investment decision. Without a focus on cost of capital, companies seek to enhance value using all sorts of tricks—from aggressively buying back shares to rapidly growing assets. Ultimately, companies pursuing low-return/high-growth strategies like these are punished for their recklessness.
DON’T IGNORE THE BALANCE SHEET
Earnings are much more visible. But earnings growth can be driven by things that have nothing to do with a company’s business, such as a cyclical industry recovery, accounting changes or financial engineering. What’s more, earnings ignore balance sheets—which can provide vital signals on business health and long-term growth.
Under Armour (UA) is a case in point. From the end of 2013, the sportswear company’s stock rallied as earnings advanced by 20% a year on strong sales. But many analysts missed something: a 35% annual increase in UA’s asset growth. As a result, marginal returns were diminishing and profit margins were shrinking on every incremental dollar of sales. ROA dropped from over 16% at the end of 2013 to about 11% in 2016 (Display, left chart), while UA’s asset base doubled. Profit growth wasn’t keeping up and could not fund its expanding asset base (Display, right chart). Its return on incremental capital fell well below its cost of capital at 7%. In other words, the company destroyed value by growing earnings—and making bad investments. Eventually, the market caught up and the stock price declined from late 2015.
In contrast, Nike has maintained a very high level of ROA over the past decade. The company has generated solid returns by investing in new automated manufacturing technologies that bring customized products closer to consumers. By doing so, Nike saves on shipping costs, duties and tariffs, which helps support profitability. Its stock advanced significantly over the past few years.
MORE CASH FLOW = BETTER BUSINESS
Here’s another way of looking at it. Consider two companies with similar earnings growth. If all else is equal, the company boosting its earnings with less capital will clearly be the better business because it will generate more free cash flow. Shares of companies like these, with high returns on assets, tend to be relatively less correlated to traditional growth characteristics, offering another benefit for investors seeking to secure differentiated performance patterns (Display).
We’re not suggesting that earnings aren’t important. However, earnings shouldn’t be viewed in a vacuum. Profits must be put into the context of a company’s underlying income statement, balance sheet and business environment in order to reach meaningful conclusions about the quality of its earnings. By focusing on profitability and returns on investments, investors can differentiate between companies whose growth spurts will be fleeting and those with true long-term growth potential that can withstand the ephemeral effects of an erratic earnings season.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
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