3 Factors that Drive Earnings Growth

Many factors go into improved earnings results and better sentiment than just revenue

   

Stocks are off on a great run here at the start of the year, which is a bit of a shock to a lot of people. That’s because when the year started there was a lot of concern about the potential for stocks to crater at the start of earnings season due to weakening trends in revenue growth and reports of weak holiday spending. Plus in December we heard that companies were not spending because they feared to invest ahead of a fiscal cliff.

But now that we are a week into fourth quarter earnings season, we are learning that while this assumption of an earnings squeeze made sense at the time of all the fear last month – but it is not actually valid. And if you listen to some of the companies’ earnings conference calls, as I have, you can see why.

The reality is that there are a lot of levers that companies can pull to improve their earnings growth.

Stock Buybacks

Every time companies buy back their own stock with the money they have essentially printed with cheap bond sales, they reduce the number of shares. When they reduce the number of shares, their earnings per share automatically goes up even if earnings are actually flat. It’s like magic, and investors fall for this trick every time.

Doing More With Less

Also we heard something very important this week in Goldman Sachs‘ (NYSE:GS)earnings call. They said that lower compensation expenses was the biggest driver of the upside in their earnings per share in the fourth quarter. That is important because labor costs are typically the single most expensive line item at a company. If wages are flat or shrinking, it may be bad for employees but it is great for companies. Increases in productivity – which means getting more out of each worker, but not paying them more – is the way companies will boost earnings in a low growth environment. And the best companies are doing this brilliantly.

Corporate Restructuring

And lastly we are seeing that corporate restructuring is playing a large role in the improvement of companies’ balance sheets. As an example, Hewlett Packard rose 4% on Wednesday after announcing that it is receiving interest in its Autonomy and EDS units. When companies shed unproductive assets they get credit for that idea right away by the market. Which is pretty funny because they also tended to get credit for making the acquisitions in the first place. In other words, they got a boost in the market for making mergers and then when they don’t work out they get a boost for unmerging!

In summary there are a lot of factors that go into improved earnings results and better sentiment than just revenue and we are seeing that quite vividly now. Stocks still have upside at least to the 2007 levels, which is the 1560 level of the S&P 500 as long as the debt ceiling debate does not get too nasty. And even if stocks do go down amid a standoff, it will likely be another buying opportunity because the market has discounted every similar harsh debate so far.

Among the top stocks on my list for recovery this year are Intel (NASDAQ:INTC), Hewlett Packard (NYSE:HPQ), McDonald’s (NYSE:MCD) and Caterpillar (NYSE:CAT).

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