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Winners in a can't-win earnings season
Companies with predictable earnings, small caps with momentum and techs with rising earnings estimates are the few bright spots for investors looking for hope in a gloomy parade of reports.
By Michael Brush
About halfway through this earnings season, companies are clearly posting some of the best results anyone has seen in a long time. But you wouldnt know it from the ugly market.
Why the disconnect?
Its all about the future, not the past. Ominously, many executives have simply clammed up about the quarters ahead, declining to offer guidance to investors. But those who do speak give you a handle on why the others may be keeping mum. Based on the corporate projections that have come out, expectations for the first two quarters of 2003 already have been slashed much more than normal for this time of the year. Further downward guidance is likely.
Whats more, companies in sectors that normally do well early in an economic recovery -- such as basic materials -- are turning in bad results. In short, this earnings seasons numbers suggest the hoped-for economic recovery may be postponed yet again.
That said, investors who look carefully can find intriguing signs of hope -- and some promising stock buys -- in this woeful earnings parade. Among them:- Some key retailers -- such as Amazon.com (AMZN, news, msgs), eBay (EBAY, news, msgs) and Starbucks (SBUX, news, msgs) -- have posted impressive results and raised their outlooks.
- Certain storage and software companies -- such as Western Digital (WDC, news, msgs), Hutchinson Technology (HTCH, news, msgs) and Symantec (SYMC, news, msgs) -- look surprisingly strong.
- Small-cap companies in general are quietly surging in performance. This development may be the most interesting of all, as their strength may signal a turnaround; small-cap companies typically lead an economy out of a recession.
With about 45% of companies reporting profits so far, here are the main themes and how to invest in them.
Small-caps are strong
So far, fourth-quarter profits at small-cap companies are up by about 24%, compared with average gains of 16% at large-cap companies. Encouragingly, that earnings growth can be traced back to decent revenue growth of 8.3%, the best since the first quarter of 2001, says Steven DeSanctis of Prudential Securities.
Besides strong earnings growth, there are a couple other reasons to favor small-cap stocks:
First, DeSanctis has found that small-cap stocks typically outperform big ones after a war, even though they underperform during the buildup to a conflict. In the 12 months following the last Gulf War, small-caps beat the large-caps by 18.2%, DeSanctis says.
Second, small-cap stocks may be less prone to pension shortfalls and accounting issues.
The best performers in this vast group are likely to come from among those with strong upward revisions in profit projections. So far this quarter, that list includes Citrix Systems (CTXS, news, msgs), Macromedia (MACR, news, msgs), Coach (COH, news, msgs), SanDisk (SNDK, news, msgs), Emmis Communications (EMMS, news, msgs) and Watson Pharmaceuticals (WPI, news, msgs).
One caveat: Be aware that late spring often brings a slowdown in the flow of money into the market. Thats when many pension funds and retirement investors begin to taper off their buying. Any such pullback could hit the small-cap names the hardest. Even though small-cap growth stocks have the best fundamentals, there is a big liquidity risk there, says Louis Navellier of Navellier & Associates.
Visibility is everything
Harley-Davidson (HDI, news, msgs) blew out earnings, but they didnt guide higher, says Navellier. So they got shot, because investors want a sure thing. So Navellier is focused on companies with the most predicable earnings. He cites companies such as Anheuser-Busch (BUD, news, msgs), Coach, Chattem (CHTT, news, msgs), Immucor (BLUD, news, msgs) and Stryker (SYK, news, msgs).
Other analysts put the lack of guidance down to little more than the caution you would expect just ahead of a war with an uncertain outcome. Some companies -- Coca-Cola (KO, news, msgs) is an example -- are fed up with investors who are too focused on the short term. They have simply abandoned guidance as a matter of policy.
These excuses aside, it is a little ominous when companies that have raised and matched guidance for quarters, such as Southwest Airlines (LUV, news, msgs), are now holding back. Perhaps we are a tad cynical, but we suspect this would not be the case if chief executives expected forthcoming guidance to be positive, says Phil Erlanger, of the newsletter Erlanger Squeeze Play.
Erlanger may have a good point if the decimation of the earnings guidance for the first half of 2003 is any guide. Last fall, analysts started cutting estimates for the first half of this year, and the question was, Will it abate? says Chuck Hill, director of research for First Call. It has not.
Since October, estimates of 16% to 17% growth for the first and second quarters of this year have been steadily whittled down to 9% to 10%. Thats troubling, because its way more than you would normally expect at this point in the game. It certainly says we have hit a soft spot in earnings here, says Hill. Whether it is temporary remains to be seen.
A ratio of negative to positive earnings guidance tracked by Joe Kalinowski, investment strategist at EKN Securities, Long Island, N.Y., tells the same story. It has deteriorated to 2 for the first quarter, from 1.6 for last quarter. That suggests more bad guidance ahead. Analysts are still expecting 14% growth for 2003. But I think that will come down to single digits, and I dont think the market is reflecting that, says Kalinowski.
Rebound leaders remain weak
Companies whose business tends to pick up at the start of an economic upturn are still surprisingly fragile. Investors traditionally look to financial companies such as Citigroup (C, news, msgs), J.P. Morgan Chase (JPM, news, msgs) and Lehman Brothers (LEH, news, msgs) for signs of a rebound. But these corporate giants continue to struggle. And so do their smaller brethren, the regional banks.
To be sure, its not all gloom and doom among economically sensitive stocks. In the banking sector, contrarian performers can be found by those who look carefully. Case in point: UCBH Holdings (UCBH, news, msgs). This bank keeps getting impressive upward earnings estimate revisions as it continues to win over a primarily Asian clientele in California. The bank expects to see profits grow by 20% next year, says Ben Zacks, of Zacks Investment Research, who has the stock on his "buy" list.
Among consumer-oriented companies, the sellers of certain cyclical products -- furniture and appliances in particular -- have turned in strong numbers. Thats because American consumers, unlike their corporate counterparts, still havent harshly curtailed spending.
But too many economically sensitive companies are posting poor results. Basic materials companies such as Alcoa (AA, news, msgs), Alcan (AL, news, msgs), Georgia-Pacific (GP, news, msgs) and Boise Cascade (BCC, news, msgs) have posted weak numbers or guided down. Both Intel (INTC, news, msgs) and AT&T (T, news, msgs) cut their capital spending forecasts.
Where there is earnings strength this reporting season, it often comes from sources that cant provide growth forever. Cost-cutting is the primary source, says Zacks. Then theres the falling dollar. Companies such as Caterpillar (CAT, news, msgs) are getting a lift from the currency shift, which artificially boosts overseas profits. But the key contributor to growth -- stronger revenue -- remains elusive.
Techs surprising strength is misleading
The fact is, technology companies are turning in many of the biggest earnings surprises. But dont take that as a sign that tech is back. Its not. Yes, there are some impressive pockets of strength, but the larger tech engine has yet to rev back up.
Among the companies that recently guided estimates up dramatically: Symantec, Western Digital, Hutchinson Technology, EMC Corp. (EMC, news, msgs), McDATA (MCDTA, news, msgs), CheckFree (CKFR, news, msgs), Macromedia, Citrix Systems, SanDisk and Silicon Laboratories (SLAB, news, msgs).
Plenty of other tech names have turned in strong results. But most of this strength has come from sources that dont suggest sustained growth. Many tech companies were simply building inventory that ran too low. Or they were winning contracts from customers who needed to spend the rest of their 2002 tech budgets at the end of the year, says Zacks.
Moreover, the mixed signals from this earnings season dont inspire confidence in an economic recovery that would boost tech stocks in any sweeping way. Weak corporate spending remains a problem. And lower interest rates still havent enticed companies to spend more. Many companies simply have too much capacity already.
This recession is very different from any other, so the recovery will be very different, says Hill. We are all kind of feeling our way as to how this will unfold.
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