Profit margins will be down during earnings season. When buying beat stocks makes sense.

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Shares of Lulu Lemon Athletica fell 12% this year before reporting earnings, then climbed 10% after the company beat earnings estimates.

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The good news is that business sales are expected to grow rapidly in the first quarter, up from expectations at the start of the year.

The bad news is that corporate profits are expected to grow about half as fast as sales. This margin compression does not bode well for stock prices in the earnings season, especially as the market has accelerated in recent weeks.

Earnings should show an economy that continues to grow, despite runaway inflation and the war in Ukraine. Analysts expect first-quarter sales of S&P 500 companies, in total, to have risen 10.7% year-over-year, up from 9.7% growth expected at the start of the quarter. year, according to FactSet. The rise in revenue estimates comes even as Russia’s invasion of Ukraine – and Western sanctions on Russian energy – have driven up commodity prices. On top of that, the Federal Reserve has already started raising interest rates to curb economic demand and high inflation. Earnings per share for the S&P 500 are expected to rise 4.8% year-over-year, compared with growth of 5.7% expected at the start of the year.

When sales growth is faster than profit growth, it means that companies’ costs are rising faster than sales and their profit margins are shrinking. For some companies, rising commodity prices are hurting margins. Others suffer from shortages of steel and other metals. And companies on all sides are paying workers higher wages. “We’re seeing a real headwind on margins for the average business,” says Christopher Harvey, chief U.S. equity strategist at Wells Fargo.

The decline in profit margins is particularly noticeable in the industrial sector.


caterpillar

(CAT), is expected to see its operating margin fall to 13.4% in the first quarter from 15.3% in the first quarter of last year. Same


Deere & Co.
.

(DE), which is usually able to significantly increase the prices of its agricultural equipment when its costs rise, is expected to see its operating margin fall to 20.9% from 22% in the same quarter last year. 3M (MMM) should see its operating margin drop to 20% from 22.5% last year. Indeed, the industrials sector saw the largest year-to-date drop in first-quarter earnings estimates of any S&P 500 sector, according to FactSet.

Meanwhile, the broader stock market, hit hard earlier this year, has rebounded in recent weeks. The S&P 500 is up about 7% from its low at the end of the year, reached on March 8. A frothier market only makes future gains harder to come by.

So, with stocks becoming more expensive, they are less likely to post big gains after reporting earnings. The overall S&P 500 futures earring multiple is now around 19.3x, down from a low of just under 18x last month. Share prices now reflect a large stream of expected earnings in the future.

When stocks are trading at such a high multiple, companies typically need to exceed earnings estimates by a large percentage to drive stock prices higher. “You’re setting yourself up for an earnings season that has to be good, both in terms of numbers and forward guidance,” says Dave Donabedian, Chief Investment Officer of CIBC Private Wealth US. “The bar is set high. It will be hard to cross the bar. »

That doesn’t mean stock investors should give up hope of finding good buys during earnings season. Companies whose shares have already been battered before reporting earnings could see their shares rise after reporting less than stellar results. They could be attractive purchases at the right time. “How did the company trade its profits?” Harvey said. If a stock is down, it has “a little more risk/reward because it’s priced in to some of the bad news.”

Lulu Lemon Athletica (LULU) is a good example. The company posted a mixed quarter, missing sales expectations and beating EPS estimates. The stock gained nearly 10% on the trading day after reporting earnings in late March. It had fallen 12% for the year to the day before the results.

It’s a delicate market. Finding beaten names in earnings reports is a viable strategy.

Write to Jacob Sonenshine at [email protected]

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