For the second earnings season in a row, we have had blowout results. After an amazingly strong first quarter, the results for the second quarter are coming in even better. As of the end of last week, according to FactSet, 9 of 10 companies (91 percent) had reported. Of these, almost 7 of 8 (87 percent) beat expected earnings. These are the highest levels of beats on earnings seen since the start of records in 2008 and slightly above what we saw last quarter.
When you look at the absolute performance, the news is just as good—and just as surprising. For the second quarter, so far earnings are up by almost 90 percent (89.3 percent), which is well above last quarter and the highest growth since 2009—and substantially better than the 63 percent analysts expected at the end of the first quarter. Also, note that this outperformance is after analysts upgraded earnings estimates given the strong first quarter. For both expectations and absolute performance, this is an extraordinary gap between what analysts expected and what companies produced.
What’s the Story?
The growth was widespread. Financials were the largest contributor to earnings growth, with the sector as a whole showing a blended earnings growth rate of 176.8 percent, almost double expectations. Technology was the second-largest contributor, up by 46.6 percent, with the usual suspects leading the charge. Communications was the third-largest contributor, with growth rising to 75.8 percent. Other sectors showed significant gains as well.
In all, the 87 percent of companies beating expectations was well above the five-year average of about 75 percent; the average beat was 17 percent, well above the five-year average of 7.8 percent. More companies are beating estimates and beating them by more. No wonder the market has been responding.
But why have companies been outperforming so much, and what does that outperformance tell us about the rest of the year?
What’s Behind the Outperformance?
On an absolute level, one reason for the outperformance against expectations has been that analysts simply underestimated the recovery, for the second quarter in a row. Not wanting to get caught short again, on an absolute basis, analysts have pushed estimates up for the rest of the year.
On a relative basis, however, much of the strong growth has been due to how much demand collapsed in the second quarter of 2020 rather than absolute performance. While performance has been strong, it looks especially strong measured against that low standard. So, while analysts are upping their absolute earnings numbers, going forward, the year-on-year comparisons will look less favorable. Right now, expectations are for earnings growth of 27.8 percent in the third quarter and 21.3 percent in the fourth quarter, for a total 2021 earnings gain of 42 percent.
That would be a great year-on-year result, if we get it. But, as noted, those large percentage gains are largely due to the collapse of demand through 2020. When comparisons start to normalize, next year, even as earnings continue to grow on an absolute basis, the reported growth rate is expected to drop back to normal levels, of approximately 10 percent. This result, however, will be something to celebrate, as it signals a return to normal.
The real question, though, is should we believe these numbers?
Too Good to Believe?
Let’s start with the top line, sales/revenues. Seven of eight companies (87 percent) are beating expectations so far for the first quarter. Both the beats and the beat amount are the highest level since records started in 2008. More, this very strong performance comes from a second quarter that was economically strong but that also had significant weaknesses. This suggests that companies have learned how to keep selling in a pandemic environment and will likely take advantage as the economy improves. It is a very positive sign going forward, as the economy continues to recover and grow.
But as we move down to earnings, the news is even better. Earnings growth is expected to significantly exceed revenue growth for the next three quarters, as companies scale their operations with the recovery. This expectation looks plausible, as companies will benefit from rising consumer income and greater internal efficiency, demonstrated by the all-time-high net profit margins reported last quarter. Companies are both selling more and making more money from each sale. The strong expectations are rooted in actual performance—performance that is likely to continue.
The economy is growing and companies are selling more, which is great but not really news. The news is how much more companies are making and why. What this quarter’s earnings data shows is that companies are able to wring out more profits from every dollar of sales, and that is a good sign for markets as sales continue to rise. Analysts are still working on quantifying that growth. As investors, we can see that with valuations holding steady, higher margins and earnings should give us more market upside through the rest of the year. That is a good message from this quarter’s earnings season.