Pay Attention to Pricing Power in 2013

Revisions to earnings forecasts started to improve in late 2012 as analysts’ worst macroeconomic fears eased. But this year, global companies may find it tougher to boost profits while their pricing power remains weak.

Downward revisions began to abate as fading fears of recession offered hope of healthier earnings in most developed and emerging markets (Display). Although revisions remained weak in Asia, the rebound spanned regions. A sharp bounce in Europe—especially among the most volatile stocks— provided an encouraging sign of corporate resilience from the crisis-stricken continent.

But will it continue? The big question investors must ask today is whether companies are capable of growing their profits ahead of expectations in a challenging market environment.

Consensus forecasts shed little light on this question. According to consensus estimates, nominal GDP growth for 2013 is expected to be almost exactly the same as last year in almost every region. That means investors shouldn’t hold their breath expecting economic growth to fuel sales. Indeed, analysts expect sales growth to decelerate—yet they also forecast an acceleration of earnings (Display). In other words, the market thinks companies are capable of boosting profit margins.

But for companies to improve margins when sales are slowing, they must have other ways to generate earnings. In a sluggish sales environment, we think pricing power—the ability to increase the mark-up on materials and labor— is really the key to unlock more earnings from every sales dollar, euro or yen.

This may be easier said than done. According to our analysis, inventories have been building up across the globe, and in almost every industry from autos to telecom. As inventories build up, the supply glut makes it much harder for companies to charge more for their products.

To make matters worse, pricing power was already generally bleak late last year. We look at the year-over-year change in percent gross margins (excluding depreciation costs) as a proxy for pricing power. Our analysis shows that in North America, Europe, Asia and Latin America, the pricing power of large-cap stocks (excluding energy) had declined during the third quarter of 2012 (Display). Most sectors were struggling to improve gross profit margins without being able to increase prices, and the inventory buildup suggests that it won’t be any easier in early 2013.

In this environment, we would be especially wary of stocks in sectors that have been spending capital aggressively and may struggle to increase margins when sales are slow, such as commodities, energy and industrial stocks.

At the same time, investors who understand the underlying pricing power challenge can gain an edge. Stock pickers should focus on companies that are able to increase prices in their sectors and thereby have a much better chance of achieving their margins and surprising the market, and which are likely to be rewarded disproportionately for beating expectations.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Vadim Zlotnikov

Chief Market Strategist; Co-Head—Multi-Asset Solutions; Chief Investment Officer—Systematic and Index Strategies
Vadim Zlotnikov is Chief Market Strategist, Co-Head of Multi-Asset Solutions and Chief Investment Officer for Systematic and Index Strategies. As Chief Market Strategist, he provides macro and quantitative research that helps identify thematic investment opportunities. As Co-Head of Multi-Asset Solutions, Zlotnikov manages the development and implementation of integrated investment portfolios for the retirement, institutional and retail markets. As CIO for Systematic and Index Strategies, he is responsible for ensuring that individual products meet investment objectives. Zlotnikov served as CIO of Growth Equities from 2008 to 2010. From 2002 to 2008, he was chief investment strategist, responsible for developing portfolio recommendations for the US market and for separate quantitative analysis and money-management research products. Prior to that, he was an analyst covering the PC and semiconductor industries; he launched the technology strategy product in 1996. Before joining the firm in 1992, Zlotnikov spent six years as a management consultant with Booz Allen Hamilton, where he conducted a broad range of strategic and operational studies for technology companies. He also worked for Amoco Technology Company as a director of electronic ventures and spent two years as a research engineer with AT&T Bell Laboratories. He has been named to the Institutional Investor All-America Research Team in the semiconductor components, strategy and quantitative research categories. Zlotnikov holds a BS and an MS in electrical engineering from the Massachusetts Institute of Technology and an MBA from Stanford University. Location: New York

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