May 2018 - Want to Buy a Business?

David L. Johanson |

SUMMARY

  • Profits rise 25% in Q1.
  • Markets are reasonably priced.

If I wanted to buy a business or franchise today, the critical factor would be the probable cash flow.  The cash flow a company generates, and is expected to generate, will play a big role in how much I might pay for the company.  While other factors play a role, the same holds true for a stock I might buy.

Publicly traded companies report their financial results after the end of each quarter.  Like with football or basketball games, companies break their year into four quarters.  Those earnings reports come out each week as little by little companies undress their financial affairs and profits.

Most Recent Reports

Over half of all companies that make up the broad-based S&P 500 Index, which is made up of approximately 500 companies, have reported earnings through the end of April 2018.  75% of the companies, thus far, have reported increased revenue and profit forecasts.  According to Thomson Reuters, profits are expected to rise an astounding 25% versus a year ago.

Just for perspective, anything above 10%, a double-digit increase, would be viewed as rock-solid.  A 25% increase is huge.

Companies are performing extremely well and strong growth is expected throughout 2018.  Sure, the cut in corporate taxes is adding luster to profits, but so are the fundamentals–economic growth at home and abroad.

Why Aren’t Shares Soaring to New Highs?

This is a great question.  I think there are a several factors in play.

Forecasts issued for Quarter One were quite strong.  It’s a sign of confidence, but it also raises the bar.  In other words, all the good news got priced into stocks in 2017 and sometimes great news can fail to move the needle.

There is an impressive surge in profits.  It sounds counterintuitive but let me explain.  Investors are interested in current numbers but more importantly, they also look to the future.  Profits are rising and are expected to remain strong this year.  Today’s numbers are going to be hard to keep growing this fast a year from now.  It is too soon to say profit growth is peaking, but it’s very likely we’ll see a slow-down to a more sustainable level next year.

Rising interest rates have also increased worries in stocks.  The Federal Reserve is expected to raise interest rates at least three times this year, and the yield on the 10-Year Treasury Bond has been ticking higher.

Investors become paralyzed with uncertainty.  Threats of a trade war with China coupled with the November mid-term elections are only two examples.

Speaking of the mid-term elections, a recent study conducted by Terry March, an emeritus finance professor at the University of California, Berkeley found that ever since the Dow Jones Industrial Average (DJIA) was created, it produced an annualized gain of just 1.4% in the six months before midterm elections.  In contrast, the DJIA increased 21.8% the six months after.

So all is not gloomy.  While stocks may not be cheap, markets do not appear as frothy as they were heading into 2018.  Additionally, odds of a bear-market-inducing recession remain low for the year.

Strong profit growth is not fueling new highs but, coupled with a growing economy, it has provided underlying support for the broader stock market.

Shares are now in a consolidation period.  Since peaking in late January, the S&P 500 Index is down a modest 7.8%, well within normal gyrations we’d expect in a year.  Volatility is the norm, so it's probably best to get used to it again.

If there is anything that you might take away from this newsletter, it's this: we are in the midst of the best earnings announcement season of my career which spans several decades.  As the markets sway backward, it should be a great time to be rebalancing and buying.

If you need anything at all, please give us a call at 408-404-0009.  Have a wonderful month of May!