In my weekly Earnings Trends report, I rank the 16 economic sectors on a wide variety of earnings and sales metrics. The report just looks at the 500 firms in the S&P 500, not the whole Zacks Universe. However, since it is organized by the individual metric, such as Annual Earnings Growth or P/E, it can be hard to get an overall picture of a given economic sector.
This is the fourth and final post in a series that tries to rectify that. Since there is a lot to write about in each sector, I will cover four sectors in each post. The data is based on the bottom up consensus estimates for each stock in the S&P 500 and is then aggregated into the economic sectors. As a base I present the data for the S&P 500 as a whole (same as in the earlier two posts, so you can skip it if you read it already).
S&P 500
To get an idea of how each sector will do, it is useful to have a common benchmark, such as the entire S&P 500. For the S&P 500 as a whole, earnings are expected to be up 19.83% year over year in the fourth quarter, down from 25.07% year over year growth in the third quarter.
Given that positive earnings surprises almost always out number earnings disappointments, the actual growth is likely to be somewhat higher than forecasted, perhaps even matching the third quarter level. What is true of the whole must be true for at least most of the component parts. In other words, of the sector estimates prove to be off, they are more likely to be too low than too high.
For the full year, earnings are expected to have soared 42.85% for the S&P 500 as a whole in 2010. Then again 2009 was not exactly a normal year, so it was working off some very easy comps. Growth is expected to slow to 15.13% in 2011, and then continue to fall to 11.97% in 2012 as the comparisons become more and more difficult. Still, even the 2012 growth is pretty healthy.
Revenue growth has been much slower and the market as a whole has been enjoying margin expansion, as have most of the sectors. Revenues are expected to grow 4.03% in 2010 and then actually accelerate to 5.38% growth in 2011 and to 5.58% growth in 2012. The revenue picture (and thus the net margin picture) is significantly distorted by the Financial sector, but the distortion should fade a bit over time.
Excluding the Financials, revenues are expected to have grow by 8.18% in 2010, and then slow to 5.88% growth in 201 and 5.58% growth in 2012. Net margins for the whole S&P are expected to rise from 8.80 2010 to 9.61 2011.
If one excludes the Financials, the margins are lower but still growing, rising to 8.83% in 2011 from 8.25% in 2010. The S&P 500 as a whole is selling for 15.5x 2010 earnings and 13.4x 2011 earnings expectations. The “per share” numbers work out to $82.18 for 2010 and $95.06 for 2011.
Financials
This is a huge sector, expected to account for 18.62% of all S&P 500 earnings in 2011, up from 17.38% in 2010. The earnings share of the sector has been extremely volatile in recent years. It was over 30% in 2007 before becoming negative in 2008 (i.e. the sector as a whole lost money), and it is now in the process of staging an extremely strong recovery.
Ample help from the government both direct through the TARP processes, and even more importantly indirect through a super-steep yield curve engineered by the Fed, have certainly aided the recovery. If you believe the numbers, earnings growth has been absolutely spectacular, although very lumpy.
In the fourth quarter, total net income for the sector is expected to be 187.43% higher than a year ago. That is a huge acceleration from the 25.72% growth in the third quarter. In fact, if the Financials are excluded, total net income growth in the fourth quarter for the S&P 500 as a whole would be just 5.9%, not the 19.8% that is now expected. For 2010 as a whole, earnings are expected to be up an astounding 314.90%, slowing to a still-above-the-index-level of 23.37% in 2011 and 15.31% in 2012.
Revenues in the Financials are different from other companies, as low interest rates cause revenues to fall, but also cause interest expense to fall. This can cause some big distortions, and is the reason that in the earnings trends reports, the revenue and net margin tables are sown both for the total S&P 500 and excluding the Financials.
Revenue growth for the sector is very poor as a result, with total revenues declining by 19.03% in 2010, and then expected to grow only 1.74% in 2011 and 5.87% in 2012. However, in the financial sector that is much less of a worry than it is in any other sector.
Massive growth in the bottom line and a shrinking top line can only mean one thing: massive growth in net margins. Net margins were actually negative in 2008 but recovered to 2.51% in 2009, and jumped to 12.88% expected for 2010. The net margin party is not over for the Financials as they are expected to grow to 15.62% in 2011 and 17.01% in 2012.
Why did I say, “if you believe the numbers?” Because early last year, under significant political pressure, the Financial Accounting Standards Board (FASB) suspended the mark-to-market accounting rules for the Financials. Honestly, I do not know if I should classify the books’ values of the Financials under fiction or non-fiction because of this. While that is focused on the balance sheet, it does flow through to the income statement as well.
Estimate momentum has been positive over the last month, but also clearly weaker than for the rest of the market, with a revisions ratio of 1.64 for FY1 and just 1.07% for FY2. This suggests that there are probably better opportunities elsewhere for short-term trading gains, but this is a very big sector, not just by total earnings but by number of firms as well with 78 firms in it, so there are plenty of opportunities for short-term trading if you want to play in this sandbox.
Valuations in the sector are quite reasonable (again, if you trust the numbers) with the sector trading at just 14.5x 2010 and 11.7x 2011 earnings. If you are willing to look out to 2012 earnings, the P/E drops down to 10.2x, the lowest of any sector. These numbers suggest that you should be massively overweighted in the sector, but I simply can’t bring myself to make an overweight call, simply because I don’t trust the numbers.
Let me be clear — I’m not questioning the competence of the analysts making the forecasts, or of our data collection. The analysts (and the companies) follow the FASB rules, and those are what I have an issue with.
Still, this is a sector that you simply can’t go naked in, like say the construction sector, it’s just too big and important. I would stick to firms where balance sheet integrity is less of an issue, such as Berkshire Hathaway (BRK.B). In general, those issues are going to be less of a big deal for the insurance companies than the banks.
If you want banking exposure, I would suggest looking North to some of the Canadian banks, where the banks are better regulated (The new Financial Regulation law was a good step in the right direction, but did not go anywhere far enough in my opinion).
On the other hand, I will admit that if I am wrong about the soundness of the banks’ balance sheets (and I’m more uncertain about them than certain that they are bad — a few years of good earnings and not paying out dividends or buying back stock can do wonders for bringing down the excessive leverage they had) then some of the big banks — especially the “too big to fail ones” — could be huge winners. Thus, market weight the sector.
Earnings growth in this sector — which includes the telecom companies like Verizon (VZ) and AT&T (T), not just the electric utilities — is expected to be an anemic 0.76% in the fourth quarter, down from an already low 6.37% in the third quarter. For all of 2010, total net income is expected to be up just 1.44%, with only a little bit of acceleration to 3.95% growth in 2011 and 6.52% in 2012.
Then again, it has been a long time since Utilities were a big growth sector (they were in the 1920’s when Sam Insull was playing his games, but not so much since then). They tend to be “Steady Eddie” performers and pay nice fat dividends.
For that reason, they are often considered to be bond substitutes. I’m not a big fan of bonds at the current level of interest rates, and that extends to the utilities. Net margins are slightly below average for 2010 a 7.93%.
The sector is one of only three where the net margins for 2010 and expected to actually be lower than in 2009 when they were 8.03%. Only a slight recovery to 7.94% is expected with an expansion to 8.20% expected for 2012. As with the bottom line, top-line growth is expected to be anemic, up just 4.07% in 2010 and slowing further to 2.44% in 2011 before showing a partial rebound to a still low 3.11% in 2012.
From a short-term trading point of view the sector looks downright unattractive, with more than twice as many cuts as increases for FY1 (ratio of 0.46) and four cuts for every three increases for FY2 (ratio of 0.74). Based on 2010 earnings, the P/E of 14.5x for the sector is below that of the overall index.
However, others are passing it by in terms of earnings, so the 2011 multiple only falls to 14.0x, and that is above the overall multiple for the index in 2011. This is a mid-sized sector, expected to account for 5.84% of total S&P 500 earnings in 2011, but that is down from 6.47% in 2010 and is expected to drop to 5.56% in 2012.
Unless you really need the income, I would be inclined to underweight the sector. I wouldn’t short it, I just think your money will work harder for you elsewhere.
Transportation
This is a small but growing sector, with its earnings share expected to grow from 1.50% in 2010 to 1.57% in 2011 and 1.62% in 2012. In the fourth quarter, total net income is expected to rise 33.08%, down from a scorching 60.83% in the third quarter, but still much better than the index as a whole.
For all of 2010, earnings are expected to be up 43.61%, slowing to a still-better-than-market 20.37% in 2011 and 15.49% in 2012. Much of that growth is expected to come from margin expansion, but not all of it.
Total revenues are expected to climb 10.70% in 2010, slowing to 9.23% in 2011 and 8.48% in 2012. For all three years, that is better than is expected for the overall market. Net margins are expected to climb from 5.87% in 2009 to 7.62% in 2010, to 8.39% in 2011 and 8.93% in 2012.
The estimate revisions picture is mixed, at a well below market revisions ratio of 1.15 for FY1, but a top of the charts 10.00 for FY2. The sample size is extremely small, so take those numbers with a grain of salt.
Valuations are on the high side with a P/E of 19.8x for 2010, but falling to 16.5x for 2011 and 13.2x if you are willing to look out to 2012. As far as making long-term investments is concerned, it really matters what part of the sector you are looking at.
I have always felt that Airline stocks are ones that you rent, not own: good for the occasional trade, but dangerous to your wealth if you try to hold them long term. The railroads could be solid long-term winners, though, especially if I am right about the long-term trend in energy prices being higher. Railroads are just super-efficient in moving stuff when it comes to energy consumption.
I like the growth prospects of the sector, but some of that at least looks priced in. I would go with a modest overweight to market weighting in the sector.
Business Services
This is another small sector, expected to account for 1.70% of total profits in 2011, unchanged from 2010, and then growing to 1.73% in 2012. Fourth quarter year over year growth is expected to be a below average 8.31% down from an also below average 15.95% in the third quarter.
For all of 2010, 15.16% growth is expected, and 2011 looks to bring more of the same with 15.19% growth and slowing slightly to 14.06% growth in 2012. Top line growth is sort of in the middle of the pack, up 5.62% for 2010, 6.14% in 2011 and 5.66% in 2012. This is one of the higher net margin sectors at 12.11% in 2010, rising to 13.15% in 2011 and 14.19% in 2012.
Estimate momentum is also sort of middle of the pack with revisions ratios of 2.36 for FY1 and 1.06 for FY2, but both are on some pretty thin sample sizes. Valuations are a bit on the high side at 17.9x for 2010 and 15.5x for 2011. In general, not a lot to get excited about here one way or another. Market-weight the sector.
This is the last in a series of four posts detailing the outlooks for each of the 16 Zacks economic sectors in the S&P 500. For the previous posts see: “Sector Watch: Consumer, Retail, Medical”, “Cyclical Sector Overview” and “Ranking Tech, Energy, Aerospace and Conglomerates”.
You can find the underlying numbers in the Earnings Trends report (see “Earnings Continuing to Grow”) to see how the sectors line up on each of the metrics discussed in this analysis as well as several others.
AT&T INC (T): Free Stock Analysis Report
VERIZON COMM (VZ): Free Stock Analysis Report
Zacks Investment Research
