Thursday, October 29, 2009

Third Quarter Earnings Derby: The US of A Gets in the Act

Third quarter S&P 500 earnings results for the first three weeks of the season continue running far ahead of Street estimates. Importantly, however, recent weakness in some economic data has overshadowed the better-than-expected earnings and caused stock prices to fall sharply. The pullback in stocks was largely erased today as third quarter US GDP showed growth of 3.5%, the first positive economic growth in four quarters and also beating Wall Street estimates by nearly 10%. Even with some oil stocks reporting disappointing earnings, stocks soared by nearly 200 points on the Dow Jones Industrial Average. The beat-rate for S&P 500 companies' earnings for the third quarter is running at a rate that I have never seen before. With 60% of companies reporting, 84% have reported earnings higher than Wall Street estimates, and 60% have reported better-than-expected sales. Here's a short breakdown of the results thus far for the S&P 500 companies: Earnings Reported through Thursday Positive Surprises: 258 Negative Surprises: 45 % Positive Surprises: 84% The beat ratio of 84% so far this quarter is far higher than we expected, and we were as optimistic as anyone that earnings would again be better than Street estimates. Revenues for Reporting Companies Positive Surprises: 183 Negative Surprises: 118 % Positive Surprises: 60% The common thread among the good earnings reports continues to be cost control. Early this week, the markets appeared to begin looking past the good news on earnings, as some economic reports showed that the economy continues to struggle with housing and employment headwinds. The good news on US GDP growth for the third quarter, however, appears, at least for the moment, to have assuaged investors' concerns that the recent gains in the economy might stall out. I'll update next week. Data courtesy of Bloomberg.

Friday, October 23, 2009

Third Quarter Earnings Derby: The Beat Goes On

Third quarter S&P 500 earnings results for the first two weeks of the season are running far ahead of Street estimates. Importantly, sales are also faring much better than expected. Here's a short breakdown of the results thus far for the S&P 500 companies: Earnings Reported through Friday Positive Surprises: 146 Negative Surprises: 25 % Positive Surprises: 85% Year over Year earnings growth for reporting companies: -14% This is just short of remarkable. Last quarter the beat ratio was 75%, the highest in many years. The beat ratio of 85% so far this quarter is far higher than we expected, and we were as optimistic as anyone that earnings would again be better than Street estimates. In addition, the growth for all reporting companies stands at a minus 14%. Just prior to the beginning of the reporting period, the consensus estimate was for a negative 20% year over year earnings growth rate. Revenues for Reporting Companies Positive Surprises: 112 Negative Surprises: 60 % Positive Surprises: 65% Year over Year revenue growth: -2.8% The picture for revenue surprises is far less striking than earnings surprises. However, overall, revenues are much better than expected. The most important data, perhaps of the whole list is that average year over year revenues are down only 2.8%. Prior to the reporting period, revenues were expected to be down more than twice that amount. Two weeks do not a season make, but thus far, with many important companies reporting, S&P 500 companies are knocking the socks off of Street earnings estimates. The common thread among the good earnings reports is cost control. American companies are just doing an amazing job of right-sizing costs. If this beat-ratio continues, I believe that stocks will continue to move higher in the weeks and months ahead. I'll update next week. Data courtesy of Bloomberg.

Friday, October 16, 2009

John Burr Williams' Lament

John Burr Williams is widely credited as being the father of dividend investing and the creator of the forerunner of today's dividend discount models. Williams was also a first rate economic strategist.

Williams was already a successful Wall Street investor, when in 1937 he went back to Harvard. Williams sought to earn his PhD in Economics with the hopes of learning what had caused the stock market crash of 1929 and the subsequent economic depression of the 1930s. By the end of his time at Harvard, Williams had concluded that the primary causes of the depression were high stock market volatility, which he believed was caused by a lack of an accurate method for valuing stocks; and ill-conceived government actions and inactions in the economy.

Williams’ doctoral dissertation, which was published as a book, was entitled “The Theory of Investment Value.” In it he explained that the prevailing (then and now) method of determining the value of a company by analyzing earnings was inherently inaccurate. Instead, he urged, that dividends should be the primary determinant of a stock’s value because dividend payments were far less volatile than earnings.

The following is a brief excerpt of the formula, which would later become known as the dividend discount model, that Williams proposed as a more accurate method for valuing stocks.

“The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [risk less] interest rate demanded by the investor.”

Williams’ Lament:

Williams' lament was that the volatility of the stock market in the 1930s was not justified by the long-run dividend growth prospects of the underlying companies. But because most investors focused on short-term earnings and not long-run dividends, they got caught up in running from and chasing after illusory earnings-driven prices. In doing so, they met themselves coming and going and began to question whether or not there was a true underlying or intrinsic value to stocks. When they came to this conclusion, it was only a matter of time before they were willing to turn the whole thing over to the government.

Williams believed that in abandoning the free markets in favor of more government control of the economy, investors helped usher in a period of sub par growth for the economy and share prices. He explained that the government is neither a good allocator of capital nor is it geared toward innovation. In his mind, where there was a lack of efficient capital allocation, there would be a shortage of innovation, and where there was a shortage of innovation there would be a shortage of growth and profits.

Williams’ also voiced great skepticism toward the theories of John Maynard Keynes and President Franklin Roosevelt's "New Deal," both of which promoted the idea that government spending could lead to prosperity. Williams was convinced that the government’s “mismanagement” of the economy was partly responsible for the depression of the early 1930s.

While his disdain for the theories of Keynes was universally criticized by the dons of Harvard, Wall Street, at first, ignored Williams’ book, not realizing that he took aim at them in its pages, as well. Eventually, however, the investment elite were to learn that Williams’ heaped some of the responsibility for the depression of the 1930s on them.

“The wide changes in stock prices during the last eight years, when prices fell by 80% to 90% from their 1929 peaks only to recover much of their decline later, are a serious indictment of past practices in Investment Analysis [Wall Street]. Had there been any general agreement among analysts themselves concerning the proper criteria of value, such enormous fluctuations should not have occurred, because the long- run prospects for dividends have not, in fact, changed as much as prices have. Prices have been based too much on current earning power, too little on long-run dividend-paying power. Is not one cause of the past volatility of stocks a lack of a sound Theory of Investment Value? Since this volatility of stocks helps in turn to make the business cycle itself more severe, may not advances in Investment Analysis prove a real help in reducing the damage done by the cycle?”

If John Burr Williams were alive today, he would be, undoubtedly, be lamenting the markets' volatility over the past three years and its effect on the economy. During this time, the Dow Jones Industrial Average rose from about 11,000 to near 14,000, then collapsed to near 6,500, before rallying recently to just over 10,000. He would say (as we would) that during this time the long-run dividend paying ability of companies did not fluctuate nearly as much as did either earnings or prices. He would also say that in light of this stock market volatility and its impact on the the economy, it is not surprising that the citizens of this country are questioning the merits of the free markets. However, he would also be warning anyone who would listen that to think that the government can produce sustainable economic growth is an illusion. He would point to the 1930s and remind us of the last time that the government sought to supplant the private sector in stimulating economic growth. It didn't work and there is not much optimism that it will work this time either.

It is because of the slow-growth environment that we see unfolding in the US, that we have been moving more and more of our clients’ assets to stocks either domiciled outside the US, or domestic companies that do a preponderance of their business in developing nations. This move to more international stocks is still focused in high quality companies that have a history of sharing their prosperity with their shareholders through dividends. Indeed, it is this dividend-history that, as John Burr Williams would say, shows us where the values are.

Friday, October 09, 2009

The 3rd Quarter Earnings Derby Is About to Begin

Next week 3rd quarter corporate earnings reports will begin in earnest. We project that this quarter's earnings will, again, beat expectations by a wider margin than is now anticipated by most investors. We said the same thing just prior to second quarter releases and the earnings results even outdid our best guesses as 75% of S&P 500 companies beat their Wall Street estimates. We know all the arguments that last quarter companies beat earnings on "cost saves" and not on truly better business. Indeed, S&P 500 earnings were nearly 25% lower than 2nd quarter 2008 earnings. Our view, however, is that the cost saves were so sharp and accomplished so swiftly that corporate America is to be commended for their flexibility and dexterity in right-sizing their cost structures. This means that as the economy begins to turn higher, which we believe will happen this quarter, that earnings will be highly leveraged to the economic uptick. Third quarter earnings are also projected to be lower than a year ago. But that is not what will drive stock prices. That will be determined again by how 3rd quarter earnings compare to the Street estimates. In this regard, we believe investors will like what they see. Our best guess is that 65%-70% of companies will beat their estimates. This will be a lower "beat rate" than the second quarter, but higher than the five-year average. We expect earnings in the techs, consumer cyclicals, materials, and industrials will lead the "beat" parade on a percentage basis. While we are optimistic that earnings will be better than expected, we do not predict that the markets will rally another 1000 points on the DJIA as they did in the two weeks from July 15 to August 1. We would be very surprised, however, if the stock market were not able to push through DJIA 10,000 by the end of the earnings season. In short, we believe the run up in stock prices is anticipating an uptick in the economy, which will, ultimately lead to higher year over year earnings. When that finally happens, many of the holdout bears will be forced to capitulate and begin buying. We would guess that that is when the stock market will go into a long pause and bore the new bulls half to death. We'll keep you posted for a few weeks on how the Earnings Derby is unfolding.

Thursday, October 01, 2009

Survivor's Bounce About Over

I recently completed a simple analysis of the S&P 500 that argues strongly for a shift in leadership in the market. I computed the 6-month total returns of all stocks in the S&P 500 and then compared the top 250 performers with the bottom 250. Here are my findings. Performance Metrics Total Return Last 6 Months: The top 250 performers, a preponderance of which are cyclical stocks, produced a median total return of 75.2%, compared to a median total return for the bottom 250 (mostly stable-growth companies) of 15.8%. This amazing performance of the cyclicals (consumer cyclicals, financials, industrials, materials, and techs) over the last six months needs some clarification. Randy Alsman, one of our portfolio managers, coined the term "survivors' bounce" in the early days of the current upturn in stocks. At one of our investment meetings, after it was clear that the market had turned, he noted that the stocks that were performing the best week after week were the same stocks that had fallen off the cliff from October of 2008 through March 2009. His line of thinking went like this: When investors thought that another 1929-type depression was a sure thing, they abandoned almost all cyclical stocks. As the Fed pulled out all the stops to under gird the banking system, and as it became clear that the big banks were not going to fail, investors returned to the bombed-out cyclical sectors and began to buy. Thus, the incredible performance of the cyclical stocks as revealed in the performance of the top 250 stocks over the last six months has been a rebound from their incredibly bad performance in the prior six months. This can be seen in the next data point. Total Return Last 12 Months: Holding constant the stocks in the top 250 and bottom 250 groups over the last 6 months and extending their performances to 12 months, we see a very different picture. The top group produced a total return of -9.3% compared to a median return of -9.4% for the bottom group. The remarkable performance that the cyclical stocks have achieved over the last six months has only brought them back to equivalency with the more stable-growth stocks (consumer staples, health-care, energy, and utilities) for the 12 month period. The twelve month data vividly show how badly the cyclical stock got banged up from October of 2008 through March of 2009. But if the last six months has been so good for the cyclicals, why can't it continue? The reason is in the valuation metrics. Valuation Metrics Trailing PE: The median trailing PE for the top 250 stocks is currently 23.7, while the PE for the bottom 250 stocks is 15.8. The top group would appear to be pricing in an awful lot of good news. Let's look at the long term earnings estimates to see if it is justified. Long Term Earning Growth Estimates: Analysts are estimating the top 250 stocks will achieve median earnings growth over the next 3-5 years of 9.6% per annum. That is virtually identical to the predicted growth rate for the same period of the bottom 250 stocks of 9.5%. The bottom line on my analysis is simple. The cyclical stocks, which have been leading the S&P 500 in its remarkable run over the last 6 months, are running out of valuation gas. For the cyclical sectors to continue to lead stocks higher from here would require dramatic increases in their predicted 3-5 year earnings rate of growth. I don't believe that will happen. In my judgment, that means that savvy investors may soon begin to move back to the much cheaper stable-growth sectors. There are question marks in some of these stable-growth sectors, particularly in health care and utilities. Both sectors have been held back by the uncertainties in the ongoing debates on health care and cap and trade, respectively. I believe in both cases, however, the final legislation will be less damaging to these two industries than is now priced in. Stable-growth companies are where you find the great long-term dividend growers. Our Dividend- Valuation models indicate that companies like Procter and Gamble, Johnson and Johnson, McDonalds, Abbott Labs, Pepsico, and Nestle are as much as 35% undervalued. They performed much better than the average stock last year but have been idling most of this year. I believe that will change as more and more investors become aware of the valuation gap between the stable-growth and cyclical-growth stocks. As Randy Alsman recently said, "The survivor's bounce" is coming to an end. We own all the stocks mentioned here. See the Terms and Conditions.