Encouraging News from Earnings:

SUMMARY

• When it comes to earnings, we believe Estimates Matter, Surprises Matter, and Trends Matter.
• 2nd Quarter earnings were better than expected.
• Estimates for Q3 and beyond have also improved, which supports our bullish positioning.

Earnings are instrumental in measuring a companies’ health and profitability. Quarterly earnings reports provide investors with crucial insight into whether a company is delivering value to its shareholders. And right now, diverging views on earnings are what separates the ‘bulls’ from the ‘bears’.

Earnings, after all, can be controversial; there are many ways to analyze them, confusing jargon abounds, and an opaque relationship exists between current earnings and future trends. As earnings season wraps up, we wanted to spend some time explaining the tools we use to interpret the second quarter, and what we are expecting for earnings for the rest of the year.

Our Earnings Analysis Framework: Before we can interpret S&P500 earnings or an individual company’s earnings, we first need to establish a framework for such an analysis. Specifically, at RiverFront, there are 3 basic principles that guide our analysis of earnings:

1. Estimates Matter: Analysts’ expectations matter because they can represent “the wisdom of the crowds”. While these forecasts are not perfect - or even always directionally correct – we believe there is wisdom in understanding the range of opinions, and the variables affecting those forecasts.
   1. How we apply it: While we try to think beyond analysts' consensus earnings estimates, we like to use these estimates as a starting point from which to challenge our own assumptions. We can use our views in comparison to consensus to gain a sharper opinion of a stock's intrinsic value. It’s a way to leverage “the Wisdom of the Crowd,” without fully joining the crowd.
2. Surprises Matter: Surprises can move markets, whether those surprises are a major difference in current earnings vs. expectations, or in management’s forward guidance.
   1. How we apply it: Like the market, we are often surprised by an earnings report or a press conference. World-class portfolio management teams aspire to be right 60% of the time, which means being wrong 40% of the time. Instead of beating ourselves up for a missed forecast, we move quickly to incorporate how these surprises have changed our investment thesis and views on intrinsic value.
3. Trends Matter: Historic growth is critical as a “track record” of success in growing earnings. There is evidence of earnings having ‘momentum’, where companies find ways to maximize their competitive advantage, and then exploit it over subsequent quarters.
   1. How we apply it: We also understand that one bad quarter or press conference is not the ‘be-all and end-all’ for a company. Instead, we digest each earnings report within the context of a long-term track record and the macro conditions a company is facing. Taking this long-term view helps give us perspective.

Q2 Earnings Recap For S&P 500: Earnings Growth Better than Expected.

Using the framework we established above, let’s apply our 3 principles to the 2nd quarter results for the aggregate S&P 500.

• Estimates Matter: Analysts’ expectations have been steadily increasing for both the second quarter and the next couple of years. This can be seen in the chart on the right. The lines represent analysts’ aggregate earnings forecasts for the calendar years 2023, 2024, and 2025. As you can see, each line has started trending upward. We believe this increase can be viewed as the market beginning to believe in an economic ‘soft landing’. Companies appear to be handling higher rates and higher inflation better than expected. Importantly, earnings and commentary were good enough to cause analysts to revise earnings estimates for the S&P 500 up for this year, as well as 2024 and 2025.
• Surprises Matter: Across all the sectors in the S&P 500, earnings surprises were positive on average. Consumer discretionary, technology and communication services experienced especially strong surprises, driven by AI-related increases to earnings estimates. However, with the Fed still concerned about the strength of the economy, the positive of strong earnings might portend further Fed rate hikes.

• Trends Matter: S&P500 price action has stalled since June, which is not surprising given its large upward move year-to-date. What we think is important is that aggregate revenue has grown more than expected, what the chart to the left shows us is that, after a soft patch of deceleration in 2022, the S&P500 is now expected to resume its multi-year upward trend in earnings growth.

Taking these three principles together, and looking ahead to the third quarter, we believe earnings are painting a relatively constructive picture for U.S. stocks.

Conclusion: Constructive Earnings Trends Supports Our Preference for Stocks Over Bonds

The second quarter earnings season highlighted the importance of earning analysis, while demonstrating that this analysis cannot be performed in a vacuum. The macroeconomic context of higher interest rates and elevated inflation are key to understanding company stock performance, as much as the earnings that were delivered, and the guidance given. While earnings growth in the second quarter was somewhat concerning given elevated inflation costs, we were encouraged that companies were still able to surmount analysts’ expectations. Looking to the third quarter and beyond, we believe earnings reports will show continued resilience, with upside potential coming from further taming of inflation and leveling of interest rates.

From a portfolio perspective, we are currently favoring stocks over bonds, reflecting a cautious optimism. Digging deeper, we prefer sectors where growth is evident, such as mega-cap technology, and sectors with valuations that are less stretched, such as energy. As always, we stand ready to risk-manage should earnings or the economy take a turn for the worse.

News Vs Noise: Looking at a Single Company’s Earnings to Help Explain Our 3 Principles

An index like the S&P 500 is a collection of companies, and one of the things that creates a lot of confusion in the market is the number of ways analysts aggregate individual companies into index-level estimates. With hundreds of companies, there is also a mix of signals – some companies are performing well, and others less so. To dig into how we evaluate estimates, surprises, and trends a little more clearly, we are going to analyze an individual company’s earnings report. In this case, we chose to use the Q2 earnings of the world’s largest company– Apple Inc. - as an illustrative example.

Apple traditionally reports in the middle of earnings season (August 3rd for the second quarter of 2023). However, let’s step back in time to the end of the earnings period. On June 30th, analyst expectations for Apple’s earnings release were for an Earnings per Share (EPS) result of $1.19 (see first table, below). Despite not having an actual earnings number for another 34 days, we can infer that Apple is expected to have hit the same “soft patch” that the overall of the S&P 500 did.

Now, August 3rd arrives, and Apple is set to report its earnings after market close. Ahead of the announcement, analysts raised their EPS estimate to $1.21, which is positive for Apple. Even better from an earnings standpoint, Apple reports an actual EPS of $1.26. At first glance, this is a good number, beating what analysts expected by 4.6% (see second table, below). This is what we refer to as a positive ‘earnings surprise’:

Comparing Actual growth over the last year is also critical to our ‘trends matter’ analysis, since earnings grew 5% over this tough period, versus the minor contraction that was expected at the end of the quarter (see third table, below):

However, there is still more information to digest; along with headline earnings, Apple will provide in-depth financial information and management comments (guidance). Additionally, externally, analysts will revise their estimates for subsequent quarters (earnings revisions). It is the totality of this information that the market will react to over the next couple of days.

In Apple’s case, while their earnings beat in Q2, non-core divisions (i.e., not the iPhone) drove those earnings surprises. Since the iPhone is viewed as the most important driver of long-term profit, the continued slowdown of iPhone sales led to investors reassessing their longer-term growth rate of earnings. Analysts increased near-term earnings based on the other segments’ strength, but that was not enough to overcome concerns about longer-term growth. With all of this being considered, Apple ended up down -4.8% the next day despite what, to a casual observer, seemed to be a good earnings report.

From the example of Apple, we can lean on our three earnings principles espoused earlier to provide context:

1. Estimates Matter: In this earnings report, the crowd’s estimate was in the ballpark, but it underestimated non-core services income near term, and over-estimated iPhone sales and sales trends, in our view.
2. Surprises Matter: In this case, we believe the guidance from the company overpowered the upside earnings surprise.
3. Trends Matter: In this case, we believe iPhone segment sales created a perception of a negative track record in the earnings trend for Apple.

We would also point out that long-term fundamentals are critical to owning a stock… but we believe Apple’s most recent report is an example of how a company with strong fundamentals could experience a price setback, despite overall positive earnings results. Sometimes macro uncertainty and guidance can overwhelm the current results.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.