For the first time since 2016, U.S. corporate profits in the first quarter are expected to decline on a year-over-year basis. The rationale has many factors but largely boils down to foreign exchange risks and higher wages. While it is generally assumed that 2018 was a positive year for earnings, an analysis of true cash flows reveals a much different story.
Economic Earnings vs. Reported Earnings
Unlike reported per-share earnings, “economic earnings” reveal the true cash flow of an underlying business. Simply put, economic earnings are the amount of money a company expects to make assuming there are no changes in its capacity to do business.
As Forbes recently pointed out, publicly-traded U.S. companies saw their reported earnings grow 23% in 2018. But economic earnings expanded just 18%. Worst yet, economic earnings are said to have declined by 2% once the impact of the Trump tax cut is removed. (In 2018, President Trump’s Tax Cuts and Jobs Act came into effect, lowering the corporate income tax rate to 21% from 35% previously.)
Basically, without the tax cut, 2018 was a dismal year for corporate profits if we use the measure of economic earnings as our guidepost. But the picture is actually much worse than it appears to be.
Even if we don’t subtract the corporate tax relief, only two of 11 S&P 500 sectors reported significant growth on an economic earnings basis. Those two sectors were energy (a segment of the market that is rebounding from a multi-year collapse in oil prices) and information technology (the major driver of the bull market). Forbes crunched the numbers and found that these two sectors improved their economic earnings by up to $50 billion combined in 2018. The other nine sectors saw their economic earnings plunge by as much as $50 billion.
Big Tech Still Leads the Way
Not taking anything away from the energy-sector recovery, but economic earnings reveal that information technology is still the go-to segment for investors looking for big returns.
Using economic earnings as our guidepost, it’s easy to conclude that investors should be pouring more money into energy and information technology shares. But as we touched upon earlier, energy stocks remain highly volatile and in a state of constant flux over oil prices and the impact of renewable energy on fossil fuel consumption. Case in point: the International Energy Agency (IEA) expects there to be anywhere from 125 million to 220 million electric vehicles on the road by 2030.
Information technology has also experienced its fair share of volatility amid sharp cyclical rotations in recent years. However, on the whole, it remains one of the most consistent in terms of innovation, scalability, and economic earnings.
Even within tech, investors need to tread carefully. In 2018, all of the economic earnings in technology came from 25 of 430 companies. As Forbes notes, just four of these companies – Micron (MU), Apple (AAPL), Microsoft (MSFT), and Facebook (FB) – accounted for more than half of the sector’s economic earnings growth.
Investors unwilling or unable to buy big-ticket tech stocks can still diversify into small and micro-cap companies. The TSX Venture Exchange and Nasdaq Composite Index are home to several budding companies focused on emerging technologies such as artificial intelligence, robotics, big data, and cleantech. Below is a rundown of some resources that can help you get started: