All-cap and sector index: 1Q22 surge in economic earnings not sustainable

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Economic earnings rose year-over-year (YoY) for all but two sectors in the last twelve months (TTM) ended 1Q22 for the NC 2000, my company’s All Cap Index. The NC 2000 consists of the 2000 largest US companies by market capitalization under my company coverage. The components are updated on a quarterly basis (March 31, June 30, September 30 and December 31). I exclude companies reporting under IFRS and non-US ADR companies.

This report is an abbreviated version of All Cap Index & Sectors: 1Q22’s Soaring Economic Earnings Aren’t Sustainable, one of my quarterly reports on fundamental market and sector trends. This report is based on the latest available audited financial data, which is 1Q22 10-Q in most cases. Price data as of 05/16/22.

Economic profits provide a more accurate picture of a company’s true underlying cash flows than GAAP profits.

Economic profits nearly doubled in 1Q22

NC 2000 economic earnings fell from $563.4 billion in 1Q21 to $1.0 trillion in 1Q22, while GAAP earnings fell from $1.3 trillion to $2.1 trillion in during the same period. Economic and GAAP earnings are only marginally below calendar year 2021 levels – the highest since 1998, which is the first time my analysis is available.

However, the surge in NC 2000 economic earnings should soon reverse the trend.

Indeed, a major headwind to economic earnings is the rising WACC, which in the TTM ended 1Q22 added $104.1 billion to the cost of capital. The onset of rapid inflation artificially increases profits under GAAP because profits on current sales are calculated using historical inventory costs. Once inflation cools, the process reverses and GAAP earnings become artificially depressed. However, investors can protect themselves from these false signals by using economic earnings, which take into account expected inflation as reflected in the company’s WACC.

Key details on certain CN 2000 sectors

While all sectors saw a year-over-year increase in GAAP earnings, economic earnings in the real estate and basic materials sectors fell in 1Q22.

The energy sector saw the largest year-over-year improvement, $158.0 billion, in economic profits, which rose from -$112.1 billion in 1Q21 to $45.8 billion in 1Q22.

The technology sector generates the most economic revenue of all sectors and increased its economic revenue by 30% year-on-year in 1Q22. On the other hand, the real estate sector has the lowest economic revenues and saw a $1.3 billion year-over-year decline in economic revenues in 1Q22.

Below, I highlight the industrials sector which saw its economic profits improve by $54.9 billion year-on-year in 1Q22.

Example of sector analysis: industrial products

Figure 1 shows that industrial sector economic profits increased from -$5.5 billion in 1Q21 to $49.4 billion in 1Q22, while GAAP profits increased from $67.7 billion to 162, $8 billion over the same period.

Figure 1: Economic income of industries vs. GAAP: 1998 – 1Q22

The analysis of economic benefits is based on aggregated TTM data for the constituents of the sector during each measurement period.

The period of May 16, 2022 incorporates financial data from the 1Q22 10-Q schedule, as this is the first date for which all 1Q22 10-Q schedules for NC 2000 constituents were available.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, style, or theme.

Appendix: Calculation methodology

I calculate the economic profits and GAAP profits metrics above by summing the individual NC 2000 constituent values ​​for the past twelve months for economic profits and GAAP profits in each sector for each measurement period. I call this approach the “Aggregate” methodology.

The Aggregate methodology provides a simple overview of the entire industry, regardless of market capitalization or index weighting, and is the way S&P Global (SPGI) calculates metrics for the S&P 500.

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