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Can US Profits Survive a Stalled Economy?

Chief Investment Officer—US Large Cap Value Equities and North American Value Equities; Global Head—Diversified Value Services
August 26, 2011

Bottom-up S&P 500 consensus estimates call for earnings-per-share (EPS) growth in the low teens this year and next, but investors aren’t buying it. With the economy sputtering, many say that US profitability near record highs is unsustainable. Stock prices are baking in a drop of more than 15% in the S&P 500’s EPS next year, which implies a recession. But our research suggests that EPS are more resilient than that.

A sensitivity analysis conducted by my colleague, Brian Lomax, found current consensus estimates reasonable, even assuming abnormally weak GDP growth. Factoring in stagnant GDP growth and a decline in net margins to 2010 levels, his model indicated that the S&P 500’s EPS would decline only about 3%, to $96, from the consensus 2011 forecast of $99. That’s far less dire than market valuations suggest.

There are three important factors at work here: First, S&P 500 sales should grow faster than the economy, as they have historically. Second, US companies still have tremendous operating leverage at their command. For nonfinancial firms in the S&P 500, the incremental margin—the potential profit produced for every extra dollar of sales—is currently 12%, more than double the 6% historical average. Net margins should continue to be buoyed by higher foreign profits, pricing power (as indicated by the pickup in year-over-year producer prices since 2010) and subdued labor-cost growth.

The third factor, which gets little attention from investors, is the enormous untapped financial firepower in cash-rich, low-debt US balance sheets. With companies under intense pressure to put their low-returning cash hoards to more profitable use, we expect spending on initiatives that could boost EPS, such as acquisitions and share repurchases, to accelerate.

Indeed, M&A activity and buybacks continued in the face of the market’s extreme volatility in recent weeks. Apparently, corporate managers aren’t as shaken by world events as equity investors are. By our analysis, the EPS of the S&P 500 could increase by $5 if companies were to simply pare cash balances to a more reasonable 5% of assets from their record level of 8% today, and use the cash to buy back stock.

This exercise has been useful in guiding our search for value opportunities, which became more abundant with the recent market sell-off. But earnings growth is slowing and the near-term risks have increased. In this environment, careful, company-by-company research is as essential to ultimate investment success as ever.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.

This article first appeared on Institutional Investor.com as part of its Global Market Thought Leaders section.

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