Corporate earnings update – Uncertainty reigns supreme, and valuation really matters

According to ThomsonReuters, the forward 4-quarter earnings estimate fell this week to $109.55, down from last week’s $111.88 and down from early July’s $110.94, even though the S&P 500 rose this week by 0.43%. The S&P 500 is now trading at 12.5(x) forward earnings with expected 5% earnings growth for 2012.

Here is the progression for full-year 2012 consensus earnings estimate for the S&P 500 in terms of expected year-over-year growth:

July 20  +5.4%

July 1 +6.3%

Apr 1 + 8.5%

Jan 1 +10%

From the data, it looks like analysts are expecting S&P 500 earnings to trough in q3 ’12, with q3 ’12 earnings currently expected to growth just 1.3% versus q2 ’12 current expectation of 5.7%. The 4th quarter of 2012 is expected to show the strongest year-over-year earnings growth for 2012, currently projected at +12.1%, although all quarterly growth estimates are seeing downward revisions.

By quarter, here is how the S&P 500 earnings are expected to track through the year (y/y growth):

q1 ’12 +8.1% (actual)

q2 ’12 +5.7% (estimated as of July 20, and assume 5% for simplicity)

q3 ’12 +1.4% (estimated as of July 20)

q4 ’12 +12.1 (estimated as of July 20)

What retail investors sometimes forget is that the stock market is a discounting mechanism, and looks forward 9 – 12 months, much like the forward earnings estimate. From this, we can infer that the market is trying to glean what 2013 is going to look like, but i think the Presidential election and the binary political climate (either far left or far right) has left the market and investors in an unusual state of ambiguity and uncertainty. All this has resulted in what seems to be a modest valuation for the S&P 500, which is trading below historical norms on any number of measures, including the long term p/e, dividend yield, earnings yield, etc. etc.

Having modeled this ThomsonReuters data for some time, the last few week’s forward estimate has been more volatile than historical patterns suggest, and I dont know why this is the case. Perhaps just analyst (bottom-up estimates) and strategist (top-down annual estimates) uncertainty rules the day, and the prospects for a more opaque-than-usual future given the Fiscal Cliff, the tight Presidential race, the uncertainty of QE3, the barrage of negative headlines and constant cacophony about Europe, have the bottoms-up and top-down analysts pulling in their horns, all of which should make for conservative estimates.

In fact we saw that combination with tech stocks this week: Intel rose 1.07% on the week, IBM rose 3.46%, Google rose 5.95% and Sandisk (one of our 2nd quarter underperformers) rose 15.08% this past week, and the one commonality for all these stocks was that expectations were quite low coming into their respective earnings reports, while the fundamentals for all were very reasonable. (Long IBM, Google, SNDK and Intel)

The familiar refrain continues i.e. “horrible macro, but decent micro.” (Horrid headlines but passable and even decent company earnings results when companies do report earnings).

To conclude, here is how 2012 is expected to unfold by sector earnings growth:

Financials +23.9%

Cons discr +11.3%

Industrials +9.2%

Cons stples +6.2%

Technology +6.1%

S&P 500 +5.4%

Healthcare +2%

Materials -3.5%

Telco -1.6%

Utilities -7.2%

Energy -9.7%


Trading update:

Our three largest sector overweights within client accounts are technology, industrials and financials. In what might come as a surprise to some, technology is back to a 20% weighting within the S&P 500 (thanks in large part to Apple). Remember, tech peaked at 33% of the S&P 500 in March of 2000, but with the sector having a much much higher valuation. Financials peaked at 30% of the S&P 500 in q3, 2007. (Long AAPL)

Looking at the above sector earnings growth data, two sectors jump out and those are financials and healthcare. We still like financials with JP Morgan and Goldman Sachs below tangible book value (Goldman is trading at a 27% discount to tangible book value (TBV) at $95 per share) although the stocks are universally disliked. Judging from the headlines and stock action, you wouldn’t guess that financials are expected to have the best growth of any sector in the S&P 500 by a factor of 2(x) this year. Visa is a growing position in client accounts. Technically you think of it is a financial, but it could also be classified as a tech stock or a consumer discretionary stock. (Long JPM, GS, V, SCH, and CME)

Healthcare has been a strong performer this year, and well under the radar. Large-cap pharmaceutical is seeing its best relative performance in years. I remember when large-cap pharma started to break down in early 1999, and the first thought was “what the bleep is happening ?” given Viagra was a Pfizer mainstay and since the prospects for an aging America and more demand for healthcare, made the sector a no-brainer. The sector went through a 13 year bear market that looks to be on the verge of becoming a bull market, per John Mendelson, ISI Group’s crack technician. John has been pounding the table on the large-cap pharma group since last fall, and thinks the sector is poised for a major breakout. ISI’s fundamental pharma analyst is Dr. Mark Schoenebaum, and he does a fantastic job on the group. Mark thinks MRK’s intrinsic value is in the high $40’s and PFE’s intrinsic value is in the high $20’s. There are other names that Mark likes but our two largest l/c pharma holdings for clients are Merck and Pfizer. We are building a position in Amgen too.

Pfizer broke above its April, 2012 high of $23.30 on decent volume this week and is trading at a multi-year high. We wont add more until we see PFE’s q2 ’12 earnings.

The key attributes around large-cap pharma are similar to the S&P 500 in general: investor expectations are low, technicals are improving, and valuations are very attractive. Hard to beat that combo. (Long PFE, MRK and AMGN).

We wouldnt touch telco and utilities here, given their overbought nature, and since i believe they have attracted a lot of money for their defensive characteristics. Note also where telco and utilities rank in terms of 2012 expected earnings growth. I think the “dividend trade” is also getting overdone, especially with the fiscal cliff and higher tax rates looming in 2013. However almost every day on CNBC i hear someone saying invest in the dividend stocks. I cant honestly say they are wrong, but i wonder if that action is a function of low Treasury rates too. The “dividend trade” seems to be a crowded trade. When looking at dividend stocks, make sure there is some earnings growth or some future catalyst around it too.

Materials and energy are a function of China and BRIC growth. The jump in crude oil prices since late June has really caught us off guard. We are underweight energy now, focusing on natural gas and the undervalued oil services group.

Valuation matters – some higher p/e stocks got slammed this week, like Chipotle, (CMG) down 21% on Friday, Intuitive Surgical (ISRG), down 8% Friday and for the week, and Whole Foods (WFM), down 11% for the week. Whole Foods was the only drop not earnings related. In the “it is better to be born lucky than smart” category, we sold half of our Whole Foods on Thursday at $90.50. We’ll ride the remainder out, since i do believe WFM will continue to gain share against the rest of the grocery segment. Whole Foods and Starbuck’s report this week. We are long both – both could have issues given their lofty valuations, but both are long-term holdings (for now anyway). WFM should have long-term support at the 2007 high of $78. (Long WFM, SBUX and a small position in ISRG).

Finally, i think industrials are setting up positively this week, like technology did last week – low expectations and attractive valuations. A number of our industrial holdings report this week. We write our earnings previews over on Last week we looked at IBM, Sandisk and JNJ. We had all three pretty well pegged, prior to earnings. This week look for us to preview Texas Instruments (TXN), for Monday night, Ford (F), Boeing (BA) and Whole Foods for Wednesday (WFM), CME (CME), United Technologies (UTX) and Amgen (AMGN) for Thursday and Merck (MRK) for Friday. (Long a lot of the names just mentioned, but not all.)

Apple reports Tuesday night after the bell. It will be the most watched earnings report this week, and so much will be written about it, we wont say much here other than expectations are low, given the expected lull before Iphone 5 is released this fall. The iPad will likely be key to the quarter. The secular growth of the iPad is formidable, with 30% growth per year expected for a while, with Apple expected to maintain a 50% market share. (Long AAPL)

The large-cap and mega cap names are showing signs of life, which have a big influence on the indices. The headlines could stay bad, but the market will advance if the mega-caps and the larger-caps get a bid.

By the end of next week, the majority of the S&P 500 will have reported. It is bad out there from a sentiment perspective, but companies are adapting, and many are delivering good results.

Thanks for reading,

Trinity Asset Management, Inc. by:

Brian Gilmartin, CFA

Portfolio manager




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