Earnings season begins today--here's how to look for bargains (and when to decide to head for the hills)

04/10/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Everybody “knows” that first quarter earnings growth for U.S. stocks will be anemic this year. The projection for year-to-year earnings growth on the Standard & Poor’s 500 stocks is just 0.93%, according to Standard & Poor’s Capital IQ. That compares to 19.68% earnings growth in the first quarter of 2011.

Logically this means stocks are headed for a correction as companies report their first quarter results beginning with Alcoa (AA).

“Logically,” that is, for most realms outside the stock market. In the logic of the stock market, however, the result is by no means so certain. What everyone knows is frequently discounted in share prices. But sometimes what everyone knows in his or her head isn’t really believed by investors. Intellectually, investors may know that projections for first quarter earnings growth are extremely low, but in their heart—and in their investment actions--they may remain much more optimistic. And, anyway, the earnings results of last quarter are history. For stock prices going forward, the important numbers are companies’ projections—guidance--for the second quarter and the rest of 2012. It’s expectations for future growth that make investors buy or sell.

So what will it be—Up? or Down?—for the market this earnings season?

And what strategy do I recommend? I wouldn’t recommend any big directional bet on the markets as a whole—I think that the uncertainties are just too high. But I would like to be sitting on some cash so that I can jump on any sell off because of a short-term disappointment in a stock that I’d like to own for the long-term.  (Jubak’s Picks finished December with almost 40% in cash and despite some recent buys I’ve still got a hefty cash position; so do you if you did some selling into the rally. Otherwise, you might need to do some selective selling now to be ready for any opportunity.) The second half of 2012 looks better in global macroeconomic terms than the first half of the year and I’d love to pick up some fundamentally strong long-term buys at temporarily depressed prices.

So let me explain how I calculate the risks and uncertainties of this first quarter earnings season.

The current projection of just 0.93% year-to-year earnings growth doesn’t capture how rapidly pessimism about earnings set in this quarter. In September Wall Street was looking for 10% growth in the first quarter of 2012. By January projections were down to 4.5%, according to S&P Capital IQ. And now we’re at 0.93% with earnings season set to start today.

For the first quarter of 2012 earnings per index share are projected at $23.85. In the first quarter of 2011 earnings per index share came in at $23.63.

Of course, the S&P 500 Index finished the first quarter of 2012 at 1408.47, up from 1325.83 on March 31, 2011. The index is, thus, 6.23%, higher than it was a year ago when growth in the quarter just completed is projected as 18.75 percentage points lower than in the first quarter of 2011.

Add in the sentiment and macroeconomic background and it looks like we’re headed for an almost certain sell off. This rally was up 28.1% from the October 3 low through March 31. Many investors are sitting on big profits—exactly the situation that leads to profit taking as sellers decide to protect their gains. After the disappointing jobs number for March—just 120,000 when the market was looking for 205,000 new jobs—on Friday, April 6, voices calling the market overbought and in need of a correction have gain in numbers and volume. Sinking Spanish and Italian bond prices—and rising yields on Spanish and Italian bonds—have raised fears that the EuroZone is facing another round of its apparently never ending debt crisis. Higher than expected inflation from China in March—a 3.6% annual rate instead of the 3.4% expected by economists—announced by China over the weekend, which has increased worries about growth in that economy, certainly haven’t helped.

I think the odds are that meager first quarter earnings growth against a background of macroeconomic worries and sentiment looking for a correction will produce a drop in the market indexes.

But I don’t think that’s by any means as certain as a backward looking analysis of the market and the economy would suggest. Guidance for the second quarter and the rest of 2012 will be key.

Let’s use Alcoa, which reports today April 10, as an example. Even if you don’t care a penny about Alcoa, the stock is a perfect template for how the earnings season is likely to play out this quarter.

The consensus among Wall Street analysts is that Alcoa will report a first quarter loss of 3 cents a share. That would match the loss of 3 cents a share, after one time items, for the fourth quarter, but it would represent a big drop from the 28 cents a share recorded in the first quarter of 2011.

The earnings pattern here isn’t very encouraging. From 32 cents in the June quarter earnings at Alcoa have dropped to 14 cents in the third quarter to a 3 cents a share loss in the fourth quarter. Analysts have cut their projections for the first quarter of 2012 from 10 cents a share 90 days ago to the current consensus of another 3 cents a share loss. The spread isn’t very encouraging either with a high analyst estimate of 7 cents a share to a low estimate of an 11 cents a share loss.

All that information is already out there and is part of the reason that the shares have fallen 9.2% from March 19, the March high, to the April 6 close.

Nobody is going to be very surprised if Alcoa actually reports a 3 cents a share loss today. Oh, the stock might drop if some of the folks who currently hold the shares are among the optimists hoping for 7 cents a share and decide to sell on a report of 3 cents.

The surprise might indeed be if Alcoa beats by a penny or two. That might push the shares up in after-hours trading.

But the make or break on the shares, the thing that might make them move up or down substantially—and that might actually generate a trend in the stock that might last more than a day or two—is what Alcoa says about the second quarter and the rest of 2012. When the company reported fourth quarter 2011 earnings in January of 2012, it said that it expected aluminum consumption to grow by 7% in 2012, down from 10% growth in 2011. According to the company, China would continue to grow faster than the global economy as a whole at 12%.

The decline from 10% growth in 2011 to 7% growth in 2012 wasn’t quite as disheartening as it sounded. The company was looking for a drop in global production that would support aluminum prices as about 1.1 million metric tons of production in China went idle and as the rest of the world kicked in another 700,000 tons of curtailments.

But it wasn’t exactly good news either since 531,000 metric tons of that global curtailment would come from Alcoa itself. The company confirmed those cuts announced in January on April 5.

And that's where we stand on April 10. I think what the stock market wants to hear from Alcoa isn’t whether first quarter earnings were 3 cents or 6 cents, but what the company now projects as global demand growth—is it still 7%?—and its projection of demand growth from China—is it still 12%--for the rest of 2012. That will drive the trend in the stock for 2012.

You can do the same kind of sensitivity analysis with stocks that you probably care about more than you do Alcoa.

For example, McDonald’s (MCD) is scheduled to report on April 20. The stock is coming off its first comparable store sales miss in months in February. Comparable sales climbed 7.5% when Wall Street was looking for 8.3%. Analyst earnings estimates are rock solid:  at $1.23 a share for the first quarter they haven’t changed more than a penny in the last 90 days. But Wall Street is looking for just 6.84% year on year growth in the quarter. That would be a big drop from the 15% year on year growth recorded in the fourth quarter. In the last couple of quarters McDonald’s has turned in a modest positive surprise—2 cents better than expected in the September quarter and 3 cents better than expected in the December quarter. Anything less than a few cents above $1.23 a share might be considered a miss and confirmation that slow economies in Europe and Japan, and a slowing economy in China are about to cut into the company’s growth rate. It won’t be fair, but investors could also decide to sell if McDonald’s shows a bit of weakness because long-time CEO Jim Skinner is retiring in June. His replacement is 22-year McDonald’s veteran and current COO Don Thompson. If McDonald’s shows any earnings weakness this quarter, some investors nervous about the CEO transition might sell. If I could buy McDonald’s at $95 on any of this quarterly earnings noise, I would with a 12-month target of $110.

(You might also want to keep on eye on Arcos Dorados Holding (ARCO), the largest McDonald’s franchise operator in Latin America if McDonald’s shares themselves dip. The stock is down 29% since I added it to my watch list on August 16, 2011, but I see some signs that the price--$18.48 at the close on April 6—might be starting to stabilize. The company itself doesn’t report first quarter earnings until May 5.)

Or how about Schlumberger (SLB)? The consensus among Wall Street analysts is looking for first quarter earnings of 99 cents a share, a huge 39.7% jump from the first quarter of 2011. But the consensus conceals a high degree or worry. The trend in estimates has been decidedly negative over the last 90 days going from $1.08 to 99 cents a share in that time. The worry is North America--where continued low natural gas prices have caused North American gas producers to shut wells and curtail exploration and drilling operations. As I wrote in my March 28 post on Schlumberger http://jubakpicks.com/2012/03/28/close-but-not-there-yet-id-put-schlumberger-slb-on-your-watch-list-now/ , the company has acknowledged the slowdown in North America, the source of 33% of Schlumberger revenues, and that it won’t be a one or two quarter problem. Investors will be waiting to hear when Schlumberger reports earnings on April 20 how big a problem the North American slowdown is. The company hasn’t been a model of consistency in the last few quarters, reporting an earnings miss for the third quarter and a positive surprise in the fourth. As I wrote in that March 28 post, I’d be a buyer on a pull back to $64 or $65 from the $68.42 close on April 6.

And finally, don’t ignore the chance to add to positions in stocks you already own on unjustified weakness this quarter. (Or to sell if the weakness is justified.) For example, Cummins (CMI), a Jubak’s Picks http://jubakpicks.com/ reports earnings on May 1. The stock has been volatile lately on news of an 11% drop in orders for Class 8 trucks, the big rigs, at North American manufacturers. This is the third consecutive month-to-month drop in Class 8 orders. The March numbers were 32% below the level of March 2011. Investors will want to find out from Cummins whether this is a sign that the truck cycle, which most of us believe still has quarters of upside ahead, is coming to an unexpected slowdown. Cummins has already shocked investors once in recent quarters with an earnings miss (granted, it was just 5 cents a share) in the September 2011 quarter. The truck engine maker came roaring back with a 15.8% positive surprise in the December quarter, but the $2.19 consensus projection for the March 2012 conceals a high degree of disagreement with the top estimates at $2.42 and the bottom at $1.99. With 60% of Cummins sales coming from outside the United States, I think it’s hard to predict what the slowdown in Europe and China will do to Cummins revenue. I’d look to add to positions on a drop in sales and earnings from those regions as long as the company convincingly testifies to the continuation of the truck cycle.

I’m sure you have your own list of stocks to watch this earnings season, but let me add one more. Middleby (MIDD) has been a member of Jubak’s Picks before and I’d be happy to return this maker of cooking equipment for fast food and casual dining restaurants to the portfolio if this earnings season gives me an opportunity.  I’m adding Middleby to my watch list http://jubakpicks.com/ with this post.

Now, let the earnings season begin!

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Cummins and Schlumberger as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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