By Amey Stone The economy is clearly in recovery, but for the past two weeks the bears have been growling louder than ever. The explanation for this paradox is that the pickup in economic activity is happening so gradually that a major jump in corporate profits this year seems less and less likely. The prospect of yet another disappointing earnings season, combined with worries over escalating global political risks, is keeping most investors out of the game.
However, they may be making the mistake of confusing a tepid economic rebound with a weak earnings recovery. The former doesn't necessary lead to the latter. Even though sales at most companies aren't about to suddenly take off, corporate earnings still can. The financial markets seem loath to recognize this fact, but smart investors who get in early will reap the rewards if they remember the concept of "operating leverage."
Operating leverage is the idea that companies can make more money from each additional sale if they don't have to increase fixed costs to produce more. "The benefits of operating leverage are immense," says Jay Mueller, chief economist at Strong Funds. "That's because the minute business picks up, the existing workforce and the existing plant and equipment can do a whole lot more without adding additional costs." Profit margins expand, and profits boom.
BACK FROM THE BOTTOM. Right now, the broad economy is rife with operating leverage. Companies have cut costs to the bone. "For two years, all they've been doing is cutting," says Bob Kippes, portfolio manager of AIM Aggressive Growth (AAGFX). "When the top line improves, companies are so lean and mean that it will all go straight to the bottom line," he predicts. As for the impact on earnings, "it should be explosive."
The best evidence of that operating leverage at work is the very low rate of industrial-capacity utilization. That figure bottomed in December, 2001, at 74.4% -- a 19-year low -- and has ticked up this year to April's 75.5%. Despite the modest improvement, utilization is still at levels not seen since the 1982 recession -- and is much lower than the 1990-91 recession's bottom of 78.1%.
On one hand, that's a sign that businesses continue to suffer from overcapacity. Looked at another way, however, that low-but-improving rate of capacity utilization is probably the best indication that profits can jump later this year, says John Lonski, chief economist at Moody's Investors Service. The last time rates were this low, profits of nonfinancial companies jumped 34% annually, on average, one year later, he says.
INFLATION BUFFER. "Investors might be surprised by the earnings growth later this year," says Lonski. "Why not go ahead and assume more risk, either as a business or an investor?" Given that capacity utilization is already ticking up, he thinks earnings could rise 15% year over year in the fourth quarter over 2001 (albeit off a low base) while gross domestic product likely will rise at only about a 5.8% annual rate by that time.
Investors can also see low capacity utilization as good news since it means there's little near-term risk of demand getting ahead of supply, sparking inflation. And that means the Federal Reserve shouldn't have to raise interest rates for quite some time. Says Lonski: "Large amounts of unused production capacity acts as a buffer that diminishes the inflation risks implicit to rising demand."
The other clear sign of operating leverage at work in the U.S. economy is the jump in productivity, says Mueller. A measure of business efficiency, productivity grew 8.4% in the first quarter (the largest jump since exiting the 1982 recession). That more than offset the 2.8% rise in hourly compensation and resulted in a 5.2% drop in unit labor costs. More reductions like that, and a profit jump can't be far behind.
COMING ATTRACTION. Of course, for productivity increases and low capacity utilization to work their magic on corporate profits, business sales still need to pick up. As Fed Chairman Alan Greenspan keeps pointing out, final demand has to increase.
It's coming. A recent stream of economic reports show that business in both the service and manufacturing sectors is picking up faster than expected. Retail sales and durable-goods orders are growing. Home sales continue to be robust, and consumer sentiment is improving. "It has already begun to turn the corner," says Mueller.
Spurring greater demand for U.S. goods is the falling dollar. In recent weeks, the greenback weakened substantially against the euro and the yen. That should result in more demand for American products overseas, since they'll be more price-competitive. Meantime, the monetary and fiscal stimulus put in place in 2001 is still kicking in.
"CHANGE IN SENTIMENT." Of course, for the economy to really soar, businesses have to start spending again -- on hiring workers, new technology, and capital improvements. And they will, once the evidence clearly shows that profits are perking up. "It's these improvements in profitability that lower the risk aversion of Corporate America," says Lonski. Then, companies will spend more, and investors can feel good about buying stocks again.
Thanks to operating leverage, it shouldn't take much of a pickup in sales to get that. "We don't need a global economic recovery," says Kippes. For the small companies he invests in, "All we need is a subtle change in sentiment, and these companies are going to do well."
He notes that investors are so disenchanted with the stock market that they don't really care that the signs of an earnings recovery are clear. "Eventually, they'll respond as the weight of evidence builds," he says. "It's not a matter of 'if' but 'when.'" Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column