The earnings conundrum

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By Neels van Schaik

We have already witnessed a significant recovery in stock prices globally and the All Share Index has rallied more than 100% in US dollar terms. It is important to note that the rally has thus far been mainly a rerating in stocks while profits continued to go backwards.

The market rating or the price to earnings ratio has increased from 8 to its current level of 14.7, while profits continue to decline. This rating is the same level that we reached after the initial rerating between 2003 and 2004. Post 2004, the rally continued though with significant force, but that was a function of an exceptionally strong surge in profits. This is evidenced by the steep increase in the blue line after the dip between 2001 and 2004.


All Share Index earnings, in real terms doubled, between 2004 and 2007, reaching its peak in September 2007. Earnings have already dropped 21% since the September 2007 peak, and are likely to fall further in the near term. The question that keeps being asked is what will happen to earnings going forward, as this is the main driver of share prices in the long run? Given the low base that is currently being set by various companies and industries, it is logical to expect a significant recovery off this very depressed base.

We do however have two real concerns:

Firstly, at what rate will earnings growth be sustained once inflation is thrown into the mix? Real earnings are still at very lofty levels. It is important to remember that as inflation rises off its current low base, real profits could fall or remain flat, even whilst nominal profits remain high. This is important to understand as equity markets respond best to rising real profits. Inflation adjusted earnings grew by 126% between May 2004 and September 2007, an achievement that we believe will not likely be repeated in the next four years, which is why we continue to expect much lower real returns compared to the last five or six years.

Our second concern is the quality of earnings. As mentioned earlier, we do expect a bounce in earnings off a depressed base for the ALSI, but a significant part of the earnings recovery will be as a result of the cost cutting that various management teams have undertaken during recent months. Cost cutting is a short-term patch-up job and we prefer to be invested in companies that have the ability to consistently grow the revenue line at rates higher than inflation and that will result in sustainable real earnings growth in the long run. We warn our investors to be careful to focus too much on a short term earnings recovery at the expense of the growth rate that a company can sustain in the long run once costs have been cut-out of the system.

In conclusion, we are cautious on real earnings being sustained and we expect dividends to become an even more important part of investor’s total returns in the next few years as capital returns will be restrained. This makes it crucial to own businesses that have the ability to maintain dividend payments.

Source:  Neels van Schaik, Alphen Asset Management, September 28, 2009.

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