Recent spikes in energy and other input costs have many investors questioning the sustainability of corporate sales and profit growth.

Will margins for S&P 500 companies hold up ... or be pressured by rising producer price inflation?

Our view: It depends a great deal on which sectors of the S&P 500 you invest in.

A combination of strong international demand — particularly from emerging market economies — and a weak US dollar should continue to boost sales and profit growth for certain sectors of the market.

I’ll cover details about the sectors we view as best positioned for more profit growth in just a few minutes, but first, let’s take a closer look at what’s expected from overall results this quarter.

Expect Strong Results to Continue

S&P 500 profits should grow about 12 percent year-over-year this earnings season.¹ That appears to be a downshift from earnings growth of about 30 percent in fourth quarter 2010, but remember, comparisons get more difficult as corporate profits expand at a robust rate.²

Also, keep in mind that with a 12 percent growth estimate, the bar is not set particularly high. It’s quite possible many companies will once again beat estimates this quarter. In fact, that’s been the dominant theme in recent quarters.

Before last earnings season got underway, total net income growth was expected to be less than 20 percent year to year, but when all was said and done, the final number turned out to be 30.7 percent growth for the fourth quarter of 2010!³

These consistently positive profit surprises in recent quarters have helped propel share prices higher in spite of all the doubters.

This stellar profit growth is mostly due to the continued expansion of profit margins. While some investors wonder how much further they can expand from near-peak levels already, we see no evidence that margins have hit a ceiling yet.

So far, many companies have been able to absorb higher commodity prices due to productivity gains, without it hurting profit margins.

For example, fourth quarter 2010 net profit margins were 8.3 percent for the S&P 500, up from 8.2 percent in the third quarter, excluding financials ... and if current forecasts prove accurate, S&P 500 earnings should exceed the $100 per share level next year for the very first time.⁴

In a world where 10-year Treasuries yield just 3.3 percent, a price-earnings (P/E) ratio of 13.3 based on 2011 forecasts looks fairly attractive, in our view. And a P/E of just 11.7 based on $100-plus earnings next year looks even more appealing.⁵

Focus on the Right Sectors and Stocks

But if your investment goal — like ours — is to outperform the S&P Index, you’ll need to focus on the right sectors at the right time.

US companies do business in a global economy and the share of S&P 500 sales and income growth coming from overseas customers has risen sharply over the past decade.

As of year-end 2009, foreign sales accounted for fully 46.6 percent of total revenues for S&P 500 companies.⁶

Energy, industrials, information technology and materials are the S&P sectors with the highest share of sales coming from overseas.⁷

Materials sector stocks for example, garner 52 percent of sales from foreign markets, and for the tech sector, the mix is 56 percent international sales.⁸

Notice how the sectors with the most international sales growth have also been among the best performing sectors of the market in total return ... and that’s no coincidence.

Over the last 12 months:

The energy sector is number one in terms of performance — up 41 percent ...

Materials are in third place, with a 12-month gain of 23.6 percent.

And so far this year, the pattern is similar ...

Energy repeats as #1, with a gain of 15.2 percent.

Industrials are in second place with a 7 percent return so far in 2011.⁹

Materials, energy, industrials and technology are all sectors we have been consistently overweight in our equity portfolios at Banyan. And we continue to maintain a higher representation in these companies relative to the S&P 500 Index.

Likewise, these sectors are expected to post the best year-over-year profit results during the upcoming earnings season (See graph above) according to estimates. Energy sector stocks should achieve earnings growth of 26.7 percent, for instance, while profits for materials stocks expand 25.6 percent in the first quarter of 2011.¹⁰

Our advice: As earnings season gets underway, investors won’t want to focus as much on the actual results; we expect most companies will beat expectations. The key is to watch the margin by which they outperform estimates ... and most importantly ... what they have to say about the future.

The all-important, forward-looking guidance about next quarter, and later on this year, is the true test.

As first quarter 2011 reports start rolling in over the next several weeks, we will keep an eye on the sectors posting the best profit growth, to be sure, but we will also be watching to see that strong upward momentum in estimates and profit margins continues.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

P.S. We revealed details about some of our favorite sectors of the market in our webinar: Where to Invest Now: 5 Key Forces Driving Global Markets, but we cannot leave this timely video online for much longer. To watch it now while you still can, turn up your computer speakers and go here now.

¹ Bespoke Investment Group: S&P 500 and Sector Q1 Earnings Growth Estimates, 3/23/11
² Zacks.com: It’s All About Earnings, 3/21/11
³ Ibid.
⁴ Ibid.
⁵ Ibid.
⁶ Standard & Poor’s Outlook Market Insight, 8/20/10
⁷ Reuters: S&P 500 earnings look rosy on 2011 overseas sales, 12/25/10
⁸ Standard & Poor’s Outlook Market Insight, 8/20/10
⁹ First Trust Market Watch, 3/28/11
¹⁰ Bespoke Investment Group: S&P 500 and Sector Q1 Earnings Growth Estimates, 3/23/11