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Written by: James T. Tierney, Jr.
It’s been a tumultuous year for investors, with inflation and rising rates roiling US financial markets. But as the Federal Reserve inches closer to a terminal fed funds rate, equity market participants could start to place more emphasis on corporate earnings rather than broad macroeconomic issues and monetary policy.
There’s a battle brewing over 2023 earnings expectations between top-down and bottom-up forecasters. For perspective, top-down analysts consider the S&P 500 in aggregate, and their estimates are largely a function of the macro economy and broad margin assumptions. Bottom-up forecasters, on the other hand, incorporate company-by-company estimates for all the constituents of the S&P 500.
Which Earnings Forecasts to Believe?
As it stands now, recent top-down forecasts are predicting S&P 500 earnings per share (EPS) of around $200 for 2023, while bottom-up forecasts are closer to $235. By comparison, S&P 500 EPS estimates for 2022 have converged at $220. This spread—a projected earnings decline of roughly 9%, or an increase of 7%, depending on whom you believe—is meaningful.
In times of economic stress, we generally find the relatively conservative top-down forecasts to be more reliable, particularly since bottom-up analysts often wait until fourth-quarter earnings reports in February to “true up” their numbers. Given continued economic uncertainty, we think bottom-up estimates need to come down for 2023.
Regardless, we believe investors should consider several critical elements when reviewing their US equity holdings: inelastic demand, strong pricing power and the ability to control costs. These competitive advantages could be a cushion against economic turbulence, and position companies well for earnings success in the coming year.
Inelastic Demand Supports More Stable Revenue Growth
Companies with inelastic demand—that is to say, demand that doesn’t change much in response to economic weakness—have a distinct advantage when discretionary spending takes a nose dive. A good example is a “toll booth” business model, which benefits from nondiscretionary spending that consumers and companies can’t easily avoid.
Consider, for example, contact lenses. If you wear contacts, an economic slowdown is probably not going to prompt you to give them up to save money. Could you wear glasses more frequently instead of contacts? Maybe, but that isn’t the pattern we’ve typically seen. Or consider a power management company whose economic prospects depend heavily on US infrastructure spending. How about a manufacturer of gene sequencing machines that drive innovative, cost-saving medical advances? In all these cases, such companies are relatively insulated from economic headwinds.
Recent earnings reports from the retail sector underscore the importance of inelastic demand. For Walmart, nondiscretionary sales such as groceries comprise a relatively large percentage of revenues. While discretionary items (think furniture, electronics and clothing) have been pressured by consumer inflation, Walmart has been able to replace lost discretionary sales with nondiscretionary demand. By contrast, retailers such as Target that rely more on discretionary sales appear to be more vulnerable to the impact of consumer spending decisions.
Strong Pricing Power Can Be a Buffer Against Inflation
In today’s inflationary environment, pricing power is another helpful attribute for businesses. Companies with products that command customer loyalty and have relatively few substitutes are better positioned to maintain or raise prices without sacrificing demand, even in an economic downturn.
Consider Microsoft, ADP and Mastercard. Even if these firms raise their prices, we doubt customers would replace their Office 365 suite, payroll systems or card networks. In most cases, the switching costs are significant and discourage making big changes. Conversely, businesses that are vulnerable to readily available substitutes could lose pricing power in a downturn.
Cost Control Will Be Key in 2023
Going into 2023, one of the most uncertain elements is cost control. Every company is facing different dynamics, including return-to-office policies and rising labor and input costs. There’s no single solution, but seasoned managements normally find a way to execute against these margin pressures.
A good example is Amazon.com. The company has been facing margin pressure and will need to demonstrate its ability to execute broader cost cuts to support profitability in a tough retail environment. Likewise, Iqvia, which runs clinical trials for drugmakers, has seen its costs increase in this important segment of the healthcare industry, and must innovate to bring its expenses down to deliver on margin expectations. Not every company has these levers to pull, but successful cost control will be vital for many businesses to deliver earnings growth in 2023.
Some companies’ share prices and earnings forecasts may reflect these competitive realities, but in many cases they don’t. That’s why aggregate market earnings forecasts may be a red herring. Investors should focus squarely on individual company fundamentals to spot market mispricing, while identifying management teams that can harness a company’s core strengths and deliver on earnings expectations.