Earnings Distortion Analysis Reveals Opportunity In Defensive Sectors by David Trainer
Summary
- The earnings recession is worse than it looks on the surface.
- However, there are sectors that are more profitable than they appear because earnings distortion is much lower or negative.
- The Consumer Non-Cyclicals sector has the least earnings distortion, earns an Attractive rating, and provides value for investors.
- Looking for a helping hand in the market? Members of Value Investing 2.0 get exclusive ideas and guidance to navigate any climate. Get started today »
The earnings recession is worse than it looks on the surface. While GAAP earnings are down 1% over the trailing 12 months, core earnings are down 6%. The difference is earnings distortion, which just hit levels not seen since the last two market crashes. However, as is always the case, investors should not throw the baby out with the bathwater. There are sectors that are more profitable than they appear because earnings distortion is much lower or negative.
The Consumer Non-Cyclicals sector has the least earnings distortion. In fact, earnings distortion levels are negative – meaning core earnings are higher than GAAP net income. It also earns an Attractive rating according to our sector rating methodology. The Consumer Non-cyclicals sector – and specifically General Mills (GIS) – is this week’s Long Idea.
Earnings Distortion Varies by Sector
Figure 1 ranks all 11 sectors by earnings distortion as a percentage of total assets. Seven of the 11 sectors have negative earnings distortion, i.e. understated earnings. However, the three sectors that make up the largest portion of the market – Financials, Consumer Cyclicals, and Technology – all have positive earnings distortion, or overstated earnings.
Figure 1: Earnings Distortion Rankings by Sector as of December 3, 2019
Sources: New Constructs, LLC and company filings. The takeaway is that while the largest, high-profile sectors have hidden risks. There are opportunities to be found in some of the less hyped, more defensive areas of the market.
In particular, the Consumer Non-Cyclicals sector, with -2.3% earnings distortion as a percent of assets, stands out as having the most understated earnings.
Understated Earnings in Consumer Non-cyclicals
Investors who look at GAAP earnings would think the Consumer Non-cyclicals sector is in a crisis. Average GAAP earnings for the 128 companies we covered in the sector fell from $870 million per company in 2017 to $729 million per company in 2018, a 16% decline. Average GAAP earnings per company declined another 29%, down to $516 million, between 2018 and the trailing 12-month period. On the other hand, average core earnings were up 2% between 2017 and 2018, and down just 5% from 2018 to TTM.
Figure 2: Consumer Non-cyclicals Average Core Earnings vs. GAAP: 1998-TTM
Sources: New Constructs, LLC and company filings Asset write downs are the main driver of earnings distortion in the Consumer Non-cyclicals sector. Kraft Heinz (KHC) famously took a $16 billion write-down earlier this year that accounts for nearly a third of the earnings distortion in the sector overall.
As we wrote when we put Mondelez (MDLZ) in the Danger Zone in April 2019, many large companies in the Consumer Non-Cyclicals sector have a declining competitive advantage due to the rise of e-commerce and shifting consumer tastes. There are real challenges facing companies in this sector, which is why KHC and others have taken significant write-downs.
Still, these write-downs may be leading some to believe that the profits in this sector are falling off a cliff, when in reality they are still fairly stable. Don’t let the headlines trick you into painting the entire sector with the same brush.
Sources: New Constructs, LLC and company filings. The takeaway is that while the largest, high-profile sectors have hidden risks. There are opportunities to be found in some of the less hyped, more defensive areas of the market.
In particular, the Consumer Non-Cyclicals sector, with -2.3% earnings distortion as a percent of assets, stands out as having the most understated earnings.
Understated Earnings in Consumer Non-cyclicals
Investors who look at GAAP earnings would think the Consumer Non-cyclicals sector is in a crisis. Average GAAP earnings for the 128 companies we covered in the sector fell from $870 million per company in 2017 to $729 million per company in 2018, a 16% decline. Average GAAP earnings per company declined another 29%, down to $516 million, between 2018 and the trailing 12-month period. On the other hand, average core earnings were up 2% between 2017 and 2018, and down just 5% from 2018 to TTM.
Figure 2: Consumer Non-cyclicals Average Core Earnings vs. GAAP: 1998-TTM
Sources: New Constructs, LLC and company filings Asset write downs are the main driver of earnings distortion in the Consumer Non-cyclicals sector. Kraft Heinz (KHC) famously took a $16 billion write-down earlier this year that accounts for nearly a third of the earnings distortion in the sector overall.
As we wrote when we put Mondelez (MDLZ) in the Danger Zone in April 2019, many large companies in the Consumer Non-Cyclicals sector have a declining competitive advantage due to the rise of e-commerce and shifting consumer tastes. There are real challenges facing companies in this sector, which is why KHC and others have taken significant write-downs.
Still, these write-downs may be leading some to believe that the profits in this sector are falling off a cliff, when in reality they are still fairly stable. Don’t let the headlines trick you into painting the entire sector with the same brush.
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