EPS Revisions for S&P 500 Companies

Here is a brief summary of data I collected from Yahoo Finance for companies in the S&P 500 Index.

EPS Estimates for the current fiscal year compared to estimates 90 days ago:
UP: 166 (33%)
DN: 306 (62%)
UNCH: 24 (5%)

In aggregate, current year estimates were revised down 4.7%.
The average upward revision was 4.2%
The average downward revision was 9.9%

Not much of a surprise as to which type of companies received the largest revisions: Energy & commodities-Up and Financials & consumer goods-Down.

Out of the 496 companies I could find estimates for (current & 90 days ago), 479 have positive EPS estimates and 17 negative, up from 11 negative estimates 90 days ago.

I eliminated the negative EPS companies when calculating the revisions to consensus estimates since percentage changes for negative values do not make sense. Therefore, the 9.9% figure for average down revision is slightly understated.

Back in February, when the market was trading at 13.7x estimates I theorized that investors were thinking estimates were too high and would be revised down, opposed to the market being relatively cheap. (see low multiples mean market cheap?) Currently, the S&P 500 is trading slightly higher than it was in February when I made those comments, yet according the data from the WSJ, the estimated P/E has risen to about 14.5x. It appears logical, the multiple has risen close to 6% and estimates have fallen close to 5%, and the market price level has increased a touch as well.

The question remains: “Are earnings estimates still too high?”

The S&P is still trading at low multiple considering that the 10-year currently yields 3.48%, and that multiples have generally been in the high teens for the past couple decades. So, does suggest more downward revisions? Well, if the investors were to think the economic slowdown will be brief and shallow, it would stand to reason that the S&P would be trading at a much higher multiple- reflecting the expectations of a strong rebound and higher future earnings.

Many do believe that the economy will strengthen considerably in the second half of this year and that earnings will return to double-digit growth rates. However, the S&P’s P/E multiple doesn’t convincingly confirm that sentiment. Perhaps another explanation exists.

A point I touched on in my February commentary was the increase to the equity risk premium, or ERP. Investors require a premium to hold risky equities over holding risk-free assets, such as Treasury Bills. The ERP over history has been 5.5-6.5%, but in recent times it has fallen to 2-4%, depending on which method used and which expert one asks.

In the last several months to almost a year, that risk premium has definitely increased. Using the price level of the S&P 500 index and expected earnings growth to calculate the ERP, the current implied ERP is somewhere around 5.5%. A higher ERP translates into lower price multiples. On the margin, when investors perceive increased risk to holding equities, they will pay less for $1 of EPS, hence a lower P/E multiple.

Investors have been less willing to pay up for equities. There has been an explosion of market volatility. Volatility is another way of saying uncertainty, which could be described as risk, actually it's the definition of risk.

Current conditions make the future impossible to predict. Times such as - when today was like yesterday, which was like the day before that, and so on, with static market and economic conditions, then it’s easier to assume that the future will be similar to the present. Volatility in the market is absent; investors perceive there to be less risk, hence P/E multiples are higher.

Currently, today is rarely anything like yesterday, and tomorrow is anyone’s guess. Will there be another big bank write-down? Which market will seize up next? We’ve had mortgages, auction-rate, muni’s, Libor, etc. Bear Sterns saw something like more than 10 billion in liquidity evaporate in the span of a day. It’s been an extremely uncertain and volatile period.

Getting back to the earnings estimates question- Does the market think estimates are not too high? That there will not be a rash of revisions? It’s hard to say. What isn’t hard to say is that even if investors think earnings forecasts are reasonable, they have a low degree of confidence (or certainty) that those estimates will prove accurate. Whether estimates are too high or not, or if a recession will be shallow or deep- actually may not be the question. Either way, investors are not willing to take that bet, instead they are paying low multiples for equities and buying low risk assets yielding negative returns (after factoring in inflation).

I have included tables for the 25 largest (pct) revisions- Up and Down

TOP 25 UPWARD REVISIONS (90 Days)


TOP 25 DOWNWARD REVISIONS (90 Days)

Buffet: Bond Investor in the Equity Market

Warren Buffet’s strategy, in its simplest form, is buying stocks with equal or less risk than treasury bonds. He bought financial instruments with the amount of risk as bonds, the amount of return achievable with equities, and at prices that over-compensate the actual risk entailed by delivering greater returns.

In Essence, Buffet is a bond investor who does his shopping in the equity market. Sometimes Mr. Market gets confused and sells “equity-bonds” at a discount to Treasuries, because he feels the risk outweighs the potential return. Buffet knows that in the long-run there are select stocks that actually provide much greater returns than bonds with less risk.

How is it possible that a stock could be less risky than bonds? Especially given that the market has always valued equities with a risk premium over bonds? Well, if one finds stocks with a solid historical record of always paying a steady dividend, and increasing payouts with earnings growth, then those stocks can be considered “bond like.” Buffet’s prefers to look at stocks as “equity-bonds.” His goal is to find firms with solid economic moats so that dividend payouts are never a risk of decreasing, much similar to coupon payments Treasuries provide.

In this aspect, a stock is very much the same as a bond. Second, Buffet searches for those companies that can increase their dividend at a rate at least equal to inflation + GDP, but ideally, those firms that can grow at even higher pace. This growth ability of dividends provides the equity characteristics of “equity-bonds.” In summary, Buffet likes to find stocks that are no different than bonds in regard to safe, predictable cash flows, yet the equity or “ownership” component allows the investor to share in firms’ success as shareholder payouts increase.

Bonds have fixed cash flow payments. Whether a firm is an average or top performer makes little difference to bondholders. Since the upside potential is limited for bondholders, the amount of risk of their investment is lower due to “first in line” claims on assets over equity holders.

But, if one buys a solid enough business where the possibility of default is so infinitesimal, does it really matter who is at the head of the line ? in a situation that will never occur? If the cash flows are not at risk to neither debt nor equity holders then there should be no need for an equity risk premium. Additionally,bondholders actually face more risk over the long-term than equity holders.

First is inflation risk.
Since interest payments on debt are fixed, higher future inflation eats up bond returns. Yet, for stockholders, companies can increase their dividends to keep pace with inflation. Since inflation stems from companies charging higher prices, then sales and income will be higher resulting in higher dividend payments.

Second is re-investment risk.
If interest rates fall resulting in robust economic growth, bond payments are re-invested at lower current interest rates, whereas public firms can re-invest the dividends internally to capitalize on the favorable growth environment. In sum, debt holders face re-investing at lower return opportunities contrary to equity holders.

Third is interest rate risk inherent in bonds.
This risk increases with maturity. If the economy is robust and interest rates rise due to demand for capital and loanable funds, previously issued bonds lose value. If a bondholder has been receiving a 6% semi-annual coupon and rates move to 8%, then the investor loses out on higher coupon payments currently available in the market since the interest payment is fixed.

Additionally, if the bond is sold before maturity then it would be sold at a discount to face value, hence a loss. On the other hand, robust economic activity benefits firms as revenues and profits grow. This allows the stockholders to participate in economic windfalls by increased dividends.

Over a long time horizon, It is evident that stocks have much less risk than in a comparison of bonds and stocks over a short time horizon. It is also fathomable that a few, select stocks may be less risky than bonds over the long-run. In essence, there should then be a negative equity risk premium since bonds carry more risk relative to Buffet’s “equity-bonds” and additionally provide larger returns.
So what does all this mean? When the market applies risk premiums greater than the actual inherent risk, those stocks are undervalued. The market makes risk adjustments to stocks by taking down the stock price, thus lowering price-earnings multiples to increase required return. When investors perceive lower risk they bid up prices and multiples resulting in lower required rates of return.

Buffet dislikes bull markets. Rising stock prices make him anxious. Buffet only cares about the price paid- NOT the current market price due to his intention of holding the shares forever. He seeks to buy stocks that are solid enough he would never sell thus making current market prices of holdings irrelevant.

Since he only cares about the price he pays, upward markets mean Buffet has to pay more for an “equity-bond” resulting in lower future returns. Falling markets allow Buffet to buy attractive investments at a lower prices which, in itself, adds to the attractiveness. Stock prices fall to increase required returns resulting from higher risk premiums being priced-in by the market. If the long-term risks remain unchanged, then investors are getting higher returns without the additional risk. This is how Buffet views investing.

Warren Buffet was able to capitalize on the mispricing of risk in the market. Especially the price of risk viewed from a long-term vantage point. He bought stocks that traded at multiples much too low for the risks involved and the firm’s future growth prospects. Additionally, the market as a whole traded at a 5% - 6% premium to Treasuries when Buffet started BRK. That premium has fallen to the 3% range today, and will probably fall even further.

Buffet understood that there are stocks that are less risky than bonds when viewed from the long-run approach. He saw much of the time markets assigned too large of risk premiums creating investment opportunities.

Today, it is much more difficult. The market applies higher multiples to stocks that have “equity-bond” characteristics resulting in lower returns. Buffet has demonstrated to the investor class that superior returns can be earned of the long-run with minimal risk. Having become apparent, most Buffet type stocks command a premium making it tougher to attain outsized “Buffet-like” returns.

Many investors have adopted Buffet’s philosophy in hopes of achieving his high returns, eliminating much of the opportunities underpinning the advantages of the Buffet philosophy. Even Buffet himself admitted it has become harder for him to invest with as much “Buffet Savvy”