Pollyannas Vs Chicken Littles: The Great American Profit Debate

Pollyannas Vs Chicken Littles: The Great American Profit Debate

Are company analysts Pollyannas or are macro-minded strategists Chicken Littles? That's becoming one the most vociferous debates in market circles ahead of second quarter earnings in the US. Many observers, myself included, expect across-the-board revisions to reflect an extremely onerous operating environment characterized by margin headwinds, Fed tightening and a decelerating economy. Despite retailer guidedowns, hiring freezes across industries and margin misses aplenty, bottom-up consensus
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4 thoughts on “Pollyannas Vs Chicken Littles: The Great American Profit Debate

  1. To be slightly Pollyannaish, the 1981 recession was caused by excessive tightening to combat inflation, like the one coming up, so maybe margin compression will be less than the median.

  2. A little detail about street company models. Almost all will model expenses (COGS, S&M, R&D, G&A, etc) as a percentage of revenue. That implies that expenses are all variable. Almost none build out the expense lines in detail from their variable and fixed parts. Often the fixed parts are the majority of the expense line. Therefore, street models typically underestimate operating leverage, on the way up and (more salient now) on the way down.

    1. jyl

      Sir, you have it on the nose! The media rarely figures out how much power operating leverage has in corporate performance. Healthcare, utilities, transportation, hospitality and cyclical manufacturing, among others, have high fixed costs and high operating leverage. Great when volume is rising and gross margins are at least steady, but terrible when volume is down and/or gross margins are compressed. The habitual error of treating all expenses as a percent of sales creates real performance surprises and frequent errors in management. Another place where errors are habitual is in retail and services like restaurants. Variable costs are only those which vary directly with sales. Clerks in stores, bank tellers, counter folks at MacDonalds are costs as soon as they are scheduled, whether or not they actually have work. This makes them fixed costs whenever they are on the floor. However, most analysts routinely treat them as variable costs, and this mispecification can lead to bad forecasts and poor management decisions.

      1. One thing I learned a long time ago is to watch the incremental margins. E.g. incremental gross margin = (change in gross profit) / (change in revenue). These provide quick-n-dirty “reality checks” on much margins will go up (down) as revenues increase (decrease), even if one doesn’t separately model the fixed and variable components of expense.

        In mid 2020, looking at incrementals led to margin and earnings forecasts for 2021/22 that were far above the then-consensus. Today, looking at incrementals will likely point to forecasts for 2023 that are far below consensus.

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