Learnings from Earnings
A Look Back at 3Q 2024 Earnings
Corporates delivered a solid set of results overall in the third quarter of 2024. S&P 500 earnings per share (EPS) growth came in above consensus estimates at +6% year-on-year (implied EPS surprise factor of 5%). 76% of the index “beat” EPS expectations and 53% “beat” sales estimates. While “beats” were getting bigger and were back to above average, earnings growth was sequentially lower this quarter both in the US and Europe. Earnings delivery in the US continues to be stronger than Europe and relative sales beats in the US picked up again. However, the number of companies beating top line estimates was soft in both regions. Profit warnings increased, notably in the consumer discretionary sector, with majority of companies calling out weak end-market demand as the main reason. "Beats" were barely rewarded while "misses" were significantly penalized.
The US corporate landscape saw some broadening in earnings delivery, where the EPS growth of the S&P 500 ex-Magnificent 7 was +2% year-on-year. However, the gap with the Magnificent 7 remains wide. These seven dominant mega-cap stocks delivered 25% year-on-year EPS growth in Q3, showing further deceleration from the last few quarters pace, but better than the consensus expectations. More than half of the upside surprise was still concentrated within mega tech. Domestically oriented cyclicals (discretionary, industrials, financials) and small caps have been delivering strong results relative to sectors with more exposure to international end-markets (energy and materials) and certain defensives (large cap healthcare and staples).
Affordability in focus for consumers
Companies continued to deliver mixed messages about the health of the consumer. The theme of bifurcation featured in 2Q 2024 and remains prominent. While persistent wage growth and low unemployment may be supportive of spending, consumers continue to seek value. The word “affordability” was used during 3Q calls by nearly a fifth of consumer-facing companies, highest proportion in over ten years.1 Bifurcation is evident across the world economy, but the retail sector is experiencing acute dichotomy regarding consumer behavior. While the National Retail Federation forecasts a modest growth in holiday sales,2 companies are responding by adjusting pricing strategies and focusing on value-oriented product lines to attract cost-conscious consumers.
AI adoption and competition is evolving
The competitive landscape is evolving, with “hyperscalers” (cloud providers that AI workloads run on) such as Meta, Amazon, Google and Microsoft all giving bullish capex indications heading into 2025. These companies are set to produce their own AI semiconductors, potentially impacting Nvidia’s market share. Despite these challenges, Nvidia remains optimistic about the future, with new scaling methods and performance improvements in the firm’s Blackwell graphics processing units (GPUs) expected to drive further growth.
Source: Bloomberg, consensus estimates as of December 9, 2024. Note: Microsoft capital expenditure numbers includes capital leases.
Energy demand and power generation
In our 2025 Outlook, we highlighted how AI, the clean energy transition, robust economic growth and industrial reshoring are driving strong increases in demand for power and electricity. AI data centers represent a significant and growing source of energy demand. They require vast amounts of power to support the computational needs of AI applications, including machine learning and data processing. The energy consumption of AI data centers is expected to increase exponentially as AI technologies become more prevalent. Capital spending in AI infrastructure is robust, with tech giants and cloud service providers leading the charge. Amazon Web Services and Google Cloud are expanding their data center capacities to meet the growing demand for AI services.
Source: International Energy Agency (IEA), Euro Stat, and British Department for Business – Energy & Industrial Strategy. Latest data available as of December 31, 2022.
Source: Goldman Sachs Asset Management and BP Statistical Review. The economic and market forecasts presented herein are for informational purposes as of the date of this material. There can be no assurances that the forecasts will be achieved. Please see additional disclosures at the end. For illustrative purposes only.
Looking ahead
Attempts to anticipate the new US administration’s policies are likely to drive corporate behavior in the near-term. We are already seeing evidence of companies’ accelerating imports, cases of inventory build-ups, shipping capacity is tightening. Investors are looking for more visibility on taxes and tariffs to identify potential opportunities. We believe the theme of broadening is playing out. In the small cap area, for instance, earnings and sales growth is returning, and we are potentially approaching an inflection point. Magnificent 7 earnings growth is starting to normalize and the rest of the market’s growth is accelerating. We will be closely watching the pace of interest rate cuts. Some policies may be inflationary, and we are likely to see more gradual easing, with rates not coming down as fast. The key question is whether strong economic growth, and its translation into earnings momentum, will ultimately outweigh the effects of rates staying higher for longer.
Spotlight on Small Caps
As part of our 3Q 2024 Learnings from Earnings, we sat down with Greg Tuorto, portfolio manager focused on US Small Cap Growth Strategies, to discuss earnings dynamics among smaller companies, the outlook for capital markets activity, and the investment case for small caps in 2025.
Q1. Small caps have underperformed large caps for over a decade. While sporadic small-cap rallies occurred in the second half of 2024, there has not yet been a period of sustained outperformance. Are we reaching an inflection point as earnings and sales momentum turn positive?
The latest phase of large-cap outperformance stretches back to 2011—the longest period since 1926.3 Returns of the S&P 500 have since been driven largely by multiple expansion. Small cap returns, on the other hand, have consistently relied on earnings growth and dividends. Since 2022 small caps have also experienced significant macroeconomic headwinds—high inflation and high interest rates have hit smaller companies hard. Earnings and sales growth slowed and, in 2023, turned negative. In 2023, small caps’ earnings growth was a negative 12% compared to nearly 10% for S&P 500,4 driven by decelerating revenues and inflationary pressures.
We are now in a different environment and we see potential for a small cap reversal of fortune, potentially resulting in a more sustained period of outperformance. We believe that small cap earnings and sales growth momentum is turning positive. The Russell 2000 delivered bigger “beats” against earnings expectations than large- and mid-caps in 1Q and 2Q 2024. As the 3Q reporting cycle draws to a close, we observe encouraging trends. Forecasts for 4Q 2024 are somewhat muted, partly due to seasonality and question marks around the energy sector’s recovery. However, full-year earnings expectations for 2025 are holding up better than they did last year.
Q2. What will be the key small cap areas to watch in 2025?
We believe the Russell 2000 will be driven by solid earnings, revenue growth and multiple expansion in 2025. We expect financials to lead in terms of the return contribution as valuations have already started to rise and there is room for further expansion. Financials may attract the higher multiples traditionally associated with technology and healthcare.
Within healthcare, we believe the medtech sector warrants closer attention. Medtech experienced a setback in 2023 largely due to excitement around anti-obesity drugs. GLP-1 was expected to help prevent weight-related health conditions and therefore inhibit growth in highly innovative cardiovascular procedures. However, we are now seeing an overall recovery in procedure volumes.
We also see greater demand for different medtech devices and innovative businesses with strong product portfolios are gaining market share. For example, a maker of wearable cardiac monitoring devices stands out as a strong innovator set to benefit from a new product cycle and its ability to rely on cost leverage to drive earnings. The company’s stock price has seen some volatility as the market swung away from anything potentially threatened by obesity drugs. In our view, it’s critical to stay close to management teams during such times, gain confidence around the fundamentals and ride out short-term market trends. We also view many pure plays in the small cap medtech space as being ripe for acquisition, with an appetite for deals coming from larger names.
We are also watching the software space, as enterprise demand is picking up again. The market for core financial software solutions, for example, is primarily served today by legacy vendors with outdated, on-premises software. Providers of software geared to the office of the CFO (focusing on financial close and consolidation, financial planning and analysis, forecasting and analytics) that can deliver a cloud-based, AI-powered, software stack are at an advantage. Their products are superior in functionality, innovation, and ease of use. This should enable them to deliver above-average market growth and gain market share from legacy incumbents, especially as we expect AI to drive a broader software refresh cycle over the next 5-10 years.
We also expect industrials to display strong earnings momentum and believe the sector is full of potential. We see interesting investment opportunities in aerospace, for example, given the need to overhaul and repair fleets around the world.
Q3. Capital market activity (IPOs and M&A) could accelerate in 2025. What would this mean for small caps?
One of the biggest challenges for the small cap space in recent years has been the dearth of initial public offerings (IPOs) which “feed” the small cap universe on the listed side.
Equity market rallies are usually accompanied by an eventual boost in IPO activity. However, we did not witness a flurry of companies going public in 2024. We see multiple potential reasons behind this. The growth of passive investing in equity markets favors larger companies; a viable public market cap in listed equity is not $1 billion any longer, it’s closer to $10 billion. Some companies therefore go from private markets straight into mid- and large-cap indices. Several recently floated companies are trading below their listing price, despite a buoyant equity market, which may discourage management teams from going public. We view these dynamics as partly a result of the overhang of the COVID-era IPO boom driven by supportive monetary policies, which have now largely washed out of the system.
We expect greater IPO activity in 2025. Private equity firms will need to look for exits to distribute capital and the market environment is supportive of this trend—public equity returns are at all-time highs, the large cap cycle has now grown “old” by historical standards, the S&P 500 itself is highly concentrated, and small caps are at historically low relative valuations. Private equity firms would also not want to miss out on a sustained Russell 2000 rally, so we may see private market investors increasingly taking their portfolio companies public.
We have also seen some benefits of companies’ staying private for longer, having the time to properly develop their business model and come to the public market as a more mature yet still fast-growing business. One example we have observed relates to a company providing early childhood education and childcare services. In this industry, scale, sophisticated enrollment and staffing models, and pricing power are of paramount importance—the operating environment is challenging, with higher labor costs vs pre-COVID and the sunsetting of COVID-era government funding for providers. For the past five years, while in private hands, the company has been investing in technology, people, and brands. This has put the business in a position to benefit from efficiency gains relating to labor and operating cost, potentially boosting earnings growth and setting them up for public market success.
M&A activity is also an important tailwind for small caps. So far 2024 has been a good year for M&A—US M&A activity has rebounded by 22% versus 2023.5 Expectations for 2025 are positive, with cash M&A predicted to increase by 20%.6 When M&A picks up year-over-year, small caps tend to deliver better-than-average performance.7 Private equity sponsors currently hold “dry powder” of almost $1 trillion and the global M&A volume in the technology sector alone is estimated to be as high as $465 billion in 2025.8 The valuations in some areas are so low that they are attracting interest from both private equity and larger industry peers.
Q4. Despite lower IPO activity in recent years, there have been some interesting listings. How do you assess the attractiveness of companies that come to the public market? And how do you capitalize on opportunities?
Technology is a sector where you would typically expect a higher level of private-to-public activity, and where deep technical knowledge and understanding of sector dynamics is critical when evaluating companies and their leadership teams. In the software segment, for example, not only do products have to be superior, but management teams are expected to be highly familiar with their competition and customer needs. We have watched a finance software company that recently IPO’d evolve from a single solution provider into a fully-fledged finance and operations platform with AI at its core. We have observed the management team’s successful track record of execution over many years, and that gives us confidence in the company’s ability to transition to a publicly traded company.
There have also been some interesting businesses coming to the market in other areas, but a lot of eyes and feet on the ground are needed to uncover less obvious potential opportunities. In the industrials sector, for instance, a company that designs and manufactures mission-critical, highly engineered niche aerospace and defense components IPO’d earlier in 2024. The business has strategic partnerships with leading aerospace and airline customers worldwide and has executed successful M&A deals over the past decade. The management team is laser-focused on high demand markets across general aviation, defense and commercial end-markets. The company "beat" consensus expectations in 3Q 2024 and has raised its growth estimates for 2025. We got to know the company’s management team when it was still in private hands, and we have confidence in its focus on operational efficiency and ability to implement a high growth strategy.
Having the depth and breadth of resources to look beyond obvious sectors can unearth great assets that can become serious return compounders over time. Quality of leadership and the management team’s ability to execute on its vision are also key criteria when assessing companies in the small cap market. This can only be achieved by following key people at a company’s helm over time, tracing their careers, meeting them at events and in one-on-one settings, developing close relationships and ultimately understanding what drives them and whether they can make a company a success story.
1 Goldman Sachs Global Investment Research, S&P500 Beige Book, As of November 15, 2024.
2 National Retail Federation, Monthly Economic Review. As of December 2024.
3 Jefferies Equity Research. As of October 21, 2024.
4 Furey Research Partners. As of August 16, 2024.
5 Goldman Sachs Global Investment Research. As of October 18, 2024.
6 Goldman Sachs Global Investment Research. As of October 18, 2024.
7 Jefferies Equity Research. As of October 21, 2024.
8 Coatue, EMW, As of 2024.
