No More Earnings on the Cheap?

The slow growth rate of the current economic expansion has been well documented. Only once in the past ten quarters has the domestic economy grown faster than the 3% long-term average. Yet for all the hand-wringing about if, or when, business activity will finally hit its stride, companies have reaped rewards of the measured acceleration in the form of higher profits.

The tepid pace has allowed companies to meet demand without taking on costly investments for additional capacity and machinery. As the chart shows, subdued capital expenditures (capex) have helped protect margins even though pricing power has been soft for many industries.

The Earnings/Capex Connection
Core Constitutents of the S&P 500 Index*
Growth Rates in Earnings and Capital Spending

Earnings Per Share and Capex Bar Chart

Source: Empirical Research Partners Analysis of Corporate Reports and Standard & Poor’s, First Quarter 2013 to Fourth Quarter 2016. *The Core of the S&P 500 Index is a proprietary definition by Empirical Research Partners and excludes financials, energy and industrial commodity sectors. Past performance does not guarantee future results.

However, as the expansion approaches its eighth year, companies that have been able to get by with aging equipment and facilities may need to start dedicating more revenue to keep up with demand. Additionally, wages continue to creep higher and could further erode margins and profits.
 
We have long been hesitant to take a stake in businesses facing significant capex needs. Instead, we favor buying companies after the spending is done and valuations are often depressed due to the margin hit associated with the added costs of expansion. We believe this approach is sound regardless of the economic backdrop and is particularly prudent given the number of businesses that may need to upgrade facilities in the months and years ahead. 
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Author

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 16 years of industry experience, 13 at Heartland.

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