SUMMARY: As 22V’s economist Gerard MacDonell has pointed out, so far index level margins have been supported by rising inflation. Incremental pressure on margins is growing, but large-cap companies in general are well positioned to maintain high profitability because of their higher operating leverage and relative under-reliance on labor. Looking across GICS sectors, net margin sentiment is still positive. In part that is due to surging demand and a strong consumer leading to strong pricing power.
That is not to say that the path for ongoing strong profitability is an easy one. At the company and industry level, supply chain headwinds, labor shortages, and rising wages threaten to derail margins. Producers of intermediate and end-use goods can pass higher prices onto buyers. The deterioration in margin commentary (forward looking) sentiment, which we track using the Amenity natural language processing (NLP) tool, expressed during 3Q earnings conference calls is a clear sign that company managers are increasingly worried about the profit outlook.
As we have shown, companies that missed earnings during 3Q reporting season saw much greater than normal underperformance. One way to reduce of the risk of earnings-miss driven blow-ups is to focus on stocks where management was most confident about pricing as of the end of 3Q.
At the end of this report we detail the constituents of our Pricing Power portfolio. Though supply chain issues appear to be easing, they will remain a headwind for a few quarters. Companies that can pass long input cost increases are better positioned to weather actual and perceived production and distribution issues.
PRICING POWER FOCUS: Equity market gains over the past two years have been exceptional and are set to slow going forward, but fundamental supports remain strong. S&P EPS grew over 40% y/y in 3Q, putting the index on track for nearly 47% EPS growth in 2021. In 2022/23, earnings are forecast to grow 8.5% on an annualized basis. As slower pace of gains should be expected over the next few years, but equity prices remain underwritten by strong EPS.
Earnings growth has remained strong in part due to high corporate profitability. As 22V’s economist Gerard MacDonell has pointed out, so far index level margins have been supported by rising inflation. Incremental pressure on margins is growing, but large cap companies in general are well positioned to maintain high profitability because of their higher operating leverage and relative under-reliance on labor.
That is not to say that the path for ongoing strong profitability is an easy one. At the company and industry level, supply chain headwinds, labor shortages and rising wages threaten to derail margins. Top line growth remains firm, insulating earnings, but the deterioration in margin commentary (forward looking) sentiment expressed during 3Q earnings conference calls is a clear sign that company managers are increasingly worried about the profit outlook.
Though margin sentiment has weakened, it is important to keep in mind that it remains at a high level. Looking across GICS sectors, net margin sentiment is still positive. In part that is due to surging demand and a strong consumer leading to strong pricing power. Producers of intermediate and end-use goods can pass higher prices onto buyers.
Supply chain bottlenecks have been, at the margin, improving. Our Negative Supply Chain sentiment portfolio, which holds the companies where management was most negative on supply chain issues in 3Q, has been outperforming over the past few weeks (let us know if you would like a list of the constituents). We also track supply chain news sentiment using the Amenity NLP tool. News sentiment has weakened recently but remains well above its 3Q reading.
As we have shown, companies that missed earnings during 3Q reporting season saw much greater than normal underperformance. One way to reduce of the risk of earnings-miss driven blow-ups is to focus on our Pricing Power portfolio, which contains stocks where management expressed the most positive sentiment about pricing as of the end of 3Q.
Below are the constituents of our Pricing Power portfolio. These are the stocks where management was most confident about pricing as of the end of 3Q. Though supply chain issues appear to be easing, they will remain a headwind for a few quarters.
