Looking for the Market’s Bottom? Tread Carefully & Lean on GARP

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Inflation Edition Bonus: 50 stocks that could thrive in this environment

Last week’s dreadful inflation report finally disabused equity investors of the notion that the Fed is going to orchestrate a soft landing while tightening monetary policy. The market is now repricing risk assets in anticipation of a less forgiving economic environment, as the Fed rolls the dice on a possible recession with its hawkish stance focused on restoring price stability. Worse yet, despite yesterday’s three quarters of a point increase in the fed funds rate, it is possible long-term rates, even at 3.5%, are still not high enough to lower the rate of inflation, which is now running at 8.6% annually. Investors also expect little policy support on the supply side, such as lower tax rates or greater deregulation, given the current political environment. As a result, a recessionary environment with sustained inflation, or stagflation, is now possible in 2023, spelling further trouble for corporate profits and share prices. So, now that the S&P 500 Index has fallen into a bear market, are investors being more adequately compensated for the additional risk they are taking? Simply put, if they’re buying the benchmark, the answer is “not yet.”

Last month we suggested that investors look closely at earnings yields as a practical gauge of adequate value in equities in the context of a rising rate environment. Since then, despite falling share prices, earnings yields have barely budged, with the S&P 500’s yield rising to 4.8% from 4.6% in early May. In other words, even though the S&P 500 Index has fallen almost 23% year to date, its earnings yield has only improved marginally from 4.5% in December, still well below its historical 7% average. Put differently, earnings seem to be falling along with share prices, negating a cheapening of shares in S&P 500 constituents. When looking ahead to projected earnings for the next 12 months, constituents in the S&P 500 Index are still trading at an average multiple of 21.1 times earnings per share.

Upcoming Earnings Season: Look Beyond Profits

With clarity about the Fed’s stance following its June open market committee meeting, the upcoming earnings season has gained greater importance than usual. It will give investors a closer look at how companies have done during a quarter where economic conditions, including the cost of capital, have clearly taken a turn for the worse. Our advice to investors in preparation for the upcoming season is to focus on the relationship between sales and profits rather than on profit growth alone. More specifically, in an inflationary environment it’s useful to see where sales and earnings expectations are heading to understand the degree to which companies’ earnings power is being eroded by higher costs. Companies with high fixed costs, high capital intensity, and poor pricing power will have a harder time navigating the current environment, leading to larger than average declines in their share prices. On the other hand, companies that can limit their profit decline to the rate of decline in their sales, or better yet, improve earnings in the face of declining sales, will likely be rewarded by investors as their actual reports roll out. And of course, companies where both sales and earnings growth are expected to grow should do best in a market where it pays to be selective.

To better understand the impact of inflation and higher costs of capital across corporate America, MarketGrader measured the degree by which analysts have adjusted their fiscal year 2022 sales and earnings estimates for all companies in the S&P 500 in the last six months. We then compared the number of companies with lower sales estimates to those with lower earnings estimates to understand where inflation might be having the greatest impact on companies’ bottom lines.

Almost a third of all companies in the S&P 500 have lower fiscal year 2022 estimates today than they did six months ago. However, closer to half of all companies have lower earnings estimates compared to six months ago. Put differently, about 11% of all companies in the index are struggling to either cut costs of production or pass on the higher costs to their customers (because they do not have pricing power) even as their sales erode. Additionally, although 67% of all companies have higher full year sales estimates today than they did six months ago, only 56% of companies have higher earnings estimates today. This means that even companies with rising sales are having a hard time maintaining their profit margins due to increasing costs as a result of inflation. Figure 1 illustrates this dynamic.

Figure 1. Some S&P 500 Companies Are Struggling to Maintain Profit Margins – FY 2022 Forecasts

Sources: MarketGrader (analysis), FactSet (estimates)

We did the same analysis for all constituents of the Barron’s 400 Index (B400), our preferred benchmark of U.S. equities, in which companies are selected based on MarketGrader’s GARP methodology. For readers unfamiliar with MarketGrader, we grade companies across 24 fundamental indicators that are divided into four categories: Growth, Value, Profitability, and Cash Flow. Each indicator is assigned an individual grade (A+ to F), and all 24 grades are summed up in a final numerical score between zero and one hundred (0 – 100). Our objective is to identify companies with strong and sustainable growth, trading at reasonable prices (Growth and Value indicators), with strong quality characteristics (Profitability and Cash Flow indicators). The Barron’s 400 Index selects, every six months, the best 400 companies in the U.S. (about 8% of the total U.S. publicly traded universe) according to this methodology.

Our analysis found that only 19% of all B400 constituents have a consensus fiscal year 2022 sales estimate that is lower today than it was six months ago. And 21% of all companies have a lower 2022 earnings estimate from six months ago, a much narrower spread than the S&P 500 Index. Likewise, while 81% of all B400 companies have a higher full year sales estimate today than they did a semester ago, almost all of them, or 79%, also have a higher EPS estimate. In other words, not only are many more companies in B400 seeing rising sales estimates in fiscal 2022, but most of them are expected to convert those extra sales into higher profits compared to what analysts expected six months ago, as may be seen in Figure 2. It is also worth noting that B400 companies have an average gross margin of 52%, compared to 41% for the S&P 500.

Figure 2. Most B400 Companies with Rising Sales Are Also Forecasting Higher Profits in Fiscal Year 2022

Sources: MarketGrader (analysis), FactSet (estimates)

Lastly, we broke down both indexes’ constituents into further categories based on how analysts’ estimates for fiscal year 2022 sales and earnings have evolved in the last six months. These allow us to better identify each index’s exposure to companies that investors might want to avoid in a recessionary environment with sustained high inflation. The categories and the results of our analysis appear in Figure 3.

Figure 3. Breakdown of Companies in B400 and S&P 500 Indexes Categorized by 6-Month Change in Fiscal Year 2022 EPS and Sales Estimates

6-Month Change in Estimates Companies in B400 Index % Avg. MarketGrader Score (out of 100) Companies in S&P 500 % Avg. MarketGrader Score (out of 100) Risk Level
Declining EPS and Sales Estimates 49 13% 64.2 123 25% 51.6  
EPS Decline Smaller than Sales Decline 36 10% 63.8 98 20% 52.1 High (Some Pricing Power & Declining Demand)
EPS Decline Greater than Sales Decline 13 4% 65.2 25 5% 49.5 Highest (Poor Pricing Power Declining Demand)
               
Declining EPS Estimates, Improving Sales Estimates 31 8% 63.7 92 19% 49.9 Medium (Low Pricing Power, Increasing Demand )
Improving EPS Estimates, Declining Sales Estimates 20 5% 62.8 41 8% 52.8 Medium (Strong Pricing Power, Declining Demand)
               
Improving EPS and Sales Estimates 269 73% 72.0 236 48% 60.1  
EPS Improvement Smaller than Sales Imp. 52 14% 69.2 80 16% 58.0 Low (Pricing Power but Increasing Demand Conditions)
EPS Improvement Greater than Sales Imp. 217 59% 72.7 156 32% 61.2 Lowest (Pricing Power with Increasing Demand)
               
Total High or Medium Risk Companies 100 27%   256 52%    
Total Low Risk companies 269 73%   236 48%    
Sources: MarketGrader (analysis), FactSet (estimates)

Conclusion

The stock market has entered a perilous phase in which high valuations in some areas are exacerbated by the impact that a deteriorating economic environment could have on future company earnings, especially those projected far into the future. As investors re-price risk they should focus on identifying companies with pricing power, sustainable margins, and increasing top line growth. In our view investors should avoid value traps by focusing purely on finding cheap stocks. Growth and quality will be at a premium in the current environment. The Barron’s 400 Index not only has a better mix of companies that seem to be holding up better as sales and earnings estimates decline, but it offers investors a 9.3% earnings yield. This is an adequate risk premium with bonds yields climbing rapidly, inflation at 8.6%, and the S&P 500 offering an earnings yield that is still below real interest rates. It also trades at an average forward P/E of 13.2 times earnings per share, giving investors a greater margin for error than the S&P’s average forward P/E of 21.1 times estimated EPS.

Below is a list of the 50 companies in the Barron’s 400 Index with the highest MarketGrader scores in the “Lowest Risk” category from Figure 3 (Improving EPS estimates greater than improving sales estimates for fiscal year 2022). Investors who wish to access the entire Barron’s 400 Index may do so through the Barron’s 400 ETF (NYSE Arca: BFOR)[1].


[1] This is not an endorsement or recommendation to buy a security. MarketGrader and Barron’s earn licensing fees paid from the management fee collected by the fund manager of the Barron’s 400 ETF.

Appendix – 50 Companies with Highest MarketGrader Score and Rising EPS and Sales Estimates

SymbolNameMarket CapSectorChg in EPS Est.Chg in Sales Est.MG Score
LPXLouisiana-Pacific Corporation5,312Materials93%27%93.2
SAFMSanderson Farms, Inc.4,529Consumer Staples138%33%92.0
WLKWestlake Corporation15,740Materials68%35%91.6
ATKRAtkore Inc4,621Industrials102%23%90.7
GOGLGolden Ocean Group Ltd2,684Industrials12%6%90.0
MATXMatson, Inc.3,237Industrials176%38%90.0
VIRVir Biotechnology, Inc.3,061Health Care1129%99%89.1
MBUUMalibu Boats, Inc. Class A1,146Consumer Discretionary12%5%88.8
VSTOVista Outdoor Inc1,985Consumer Discretionary9%4%88.6
MGYMagnolia Oil & Gas Corp. Class A6,397Energy78%40%88.1
QDELQuidelOrtho Corporation4,080Health Care112%83%88.0
BCCBoise Cascade Co.3,045Materials149%23%87.8
BXCBlueLinx Holdings Inc.745Industrials176%30%87.0
ONON Semiconductor Corporation26,131Technology50%12%86.9
PFEPfizer Inc.280,377Health Care11%9%86.9
FANGDiamondback Energy, Inc.27,598Energy48%37%86.5
MTDRMatador Resources Company7,705Energy75%45%86.1
CECelanese Corporation15,783Materials13%13%86.0
STLDSteel Dynamics, Inc.13,988Materials57%22%85.9
MOSMosaic Company19,316Materials101%48%85.4
RSReliance Steel & Aluminum Co.11,573Materials84%29%85.4
DDSDillard’s, Inc. Class A5,302Consumer Discretionary30%4%85.3
NUENucor Corporation31,973Materials58%24%85.1
XUnited States Steel Corporation5,773Materials16%9%85.0
EXPDExpeditors International of Washington, Inc.16,517Industrials23%21%84.9
CFCF Industries Holdings, Inc.18,299Materials94%46%84.9
BBWBuildABear Workshop, Inc.286Consumer Discretionary52%11%84.4
SKYSkyline Champion Corp.2,936Consumer Discretionary44%9%83.5
THOThor Industries, Inc.3,958Consumer Discretionary33%7%83.4
ACLSAxcelis Technologies, Inc.1,910Technology29%12%83.3
FBPFirst Bancorp2,745Financials10%3%83.2
BLDRBuilders FirstSource, Inc.10,395Industrials92%21%83.1
PXDPioneer Natural Resources Company65,539Energy62%26%83.0
HZOMarineMax, Inc.853Consumer Discretionary12%9%82.9
MRVIMaravai LifeSciences Holdings Inc Class A3,687Industrials20%9%82.6
DOWDow, Inc.45,048Materials26%14%82.4
BOOTBoot Barn Holdings, Inc.2,430Consumer Discretionary30%22%82.2
ABGAsbury Automotive Group, Inc.4,053Consumer Discretionary22%4%82.0
ODFLOld Dominion Freight Line, Inc.28,019Industrials12%8%81.7
CVCOCavco Industries, Inc.1,879Consumer Discretionary27%10%81.5
FCXFreeport-McMoRan, Inc.58,275Materials8%6%81.4
SAIASaia, Inc.5,050Industrials14%9%81.2
OCOwens Corning8,668Materials23%9%81.0
OLNOlin Corporation9,263Industrials15%8%81.0
PLABPhotronics, Inc.1,312Technology84%16%80.6
CTRACoterra Energy Inc.27,647Energy31%25%80.4
LSTRLandstar System, Inc.5,394Industrials23%18%80.2
MNRLBrigham Minerals, Inc. Class A1,683Miscellaneous113%63%80.2
WGOWinnebago Industries, Inc.1,537Consumer Discretionary8%2%80.2
KFYKorn Ferry3,025Industrials22%9%80.1
Source: MarketGrader (constituents, grades), FactSet (estimates)

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