Despite continuing doubts about the health of the economy, the earnings picture remains as robust as ever. With more than one third of the reports in, we see no evidence of an impending slowdown in earnings growth. Some sequential deceleration is there, but that wasn’t unexpected. At this stage of the earnings cycle, you would expect some level of growth deceleration.
Earnings are up more than 40% for the firms that have already reported, with positive surprises dominating negative surprises by a wide margin. The trend on the top line is similar, though admittedly less so than on the earnings front. Even so, more firms have come ahead of revenue expectations than have come inline or below expectations.
There has been a disconnect in the market’s response to surprises; companies with negative surprises, particularly on the top line, have been punished severely, while companies with positive surprises haven’t really received comparable appreciation.
The takeaway from the earnings season to-date is that the recovery picture remains intact. When all is said and done on second-quarter reports in the coming weeks, we should see gains in excess of 23% on the earnings front and 7% on the revenue front. For the full years, current expectations put the growth rates at 34% and 19% for 2010 and 2011, respectively.
Solid Earnings and a Tentative Market
It is not easy to reconcile this robust earnings picture with the market’s current tentativeness. By conventional measures, the market appears to be cheap with P/E multiples of 14.1x and 11.8x 2010 and 2011 consensus earnings estimates, respectively.
One possible explanation could be that current earnings expectations are on the higher side. We clearly don’t see any evidence of that in the earnings announcements, though the softening macroeconomic indicators would point in that direction. Not only have companies been coming ahead of expectations, but they have by and large been giving reassuring guidance. This flies in the face of the well documented historical conservatism of company managements, who are more used to under-promising and over-delivering.
While almost all of the earnings growth last year resulted from better cost controls, we have been seeing top-line gains this quarter, as well as last quarter. The more than one-third of the S&P 500 firms that have already reported have revenue gains in excess of 7%. Almost 60% of the firms have come out with better-than-expected revenue numbers, with more than 75% reporting higher revenues than the year-earlier quarter.
Earnings Recovery Sustainable
Admittedly, the second-quarter earnings season is young, and we may still see some evidence of an impending earnings slowdown. But with a fairly representative sample of companies comprised of more than a third of the S&P 500 already out with their results, making such an argument will not be easy.
Some moderation in the economic scene appears to be underway at present, though the odds of an outright double-dip recession are very low if not altogether nonexistent. But given the global orientation of U.S. companies, a modest deceleration in the economic growth trajectory may not affect the earnings picture that much. What this means is that we shouldn’t be surprised of solid and sustainable corporate profits in an otherwise ‘middling’ economic growth landscape. We have seen this in the past and there is no reason to believe otherwise now.
The key takeaway is that investors need to be skeptical of these doom and gloom pronouncements. The U.S. corporate sector is solidly and sustainably profitable and in excellent financial health. What has been keeping the markets in check is an over-cautious response to a host of global and domestic headwinds, ranging from European sovereign debt issues to China’s growth prospects. While we may not get outsized gains like 2009, and may essentially remain range-bound for a while, there should still be gains to be made. I am looking for a continued up-drift in the market in the coming days and weeks.
Portfolio Update
We made five changes to the portfolios last week; adding two each to the Focus List and Growth & Income portfolios, while deleting one from G&I. There were changes to the Timely Buys list as well.
We added Verifone Systems, Inc. (PAY) to the Focus List to gain exposure to the solid earnings profile of this $1.8 billion market cap provider of electronic payment solutions. The company reported solid results in the last quarter, with an average earnings surprise of 27% over the last four quarters. Estimates for both this year and next have been trending up in recent days.
Another addition to the Focus List is the generic drug maker Par Pharmaceutical Companies, Inc. (PRX), given the sector’s favorable attributes and the company’s attractive valuation. This Zacks #1 Rank (‘strong buy’) stock has a good earnings surprise track record with a 27% four-quarter average surprise.
We added ALLETE Inc. (ALE) to the Growth & Income portfolio to gain exposure to a stable utility operator with a safe and attractive dividend (currently yielding around 5%). This company has regulated utility electricity, natural gas and water operations in northeastern Minnesota and northwest Wisconsin.
Another addition to the G&I is Greif Inc. (GEF), a $2.8 billion market cap package and container board manufacturer, which has a solid earnings profile and pays out an attractive dividend (currently yielding around 3%).
We were forced to delete PetSmart (PETM), given the constraints of the Zacks investment framework after the stock was downgraded to a Zacks #4 Rank (‘sell’). We like the defensive posture of PetSmart’s business and wouldn’t mind taking another look at it if the Zacks Rank improves in the coming days.
