By GREGORY ZUCKERMAN
November 4, 2007
Disappointing earnings news and fears of further write-downs at financial companies have investors wringing their hands.
Indeed, while some recent economic news has been quite good, and investors have cheered bang-up profit reports from technology companies like Apple and Google, lukewarm results elsewhere have given investors reason to worry about the economy and the markets.
That anxiety contributed to last Thursday’s 362-point swoon in the Dow Jones Industrial Average. The benchmark ended the week down 1.5%, despite an interest-rate cut by the Federal Reserve. So far in 2007, the Dow industrials are still up 9.1%.
End of a Streak?
The quarter ended Sept. 30 appears likely to end a streak of 21 straight quarters of improved earnings vs. a year earlier. Among companies in the Standard & Poor’s 500-stock index that have reported earnings for the July-September period, earnings are down an average 1.6% from last year’s third quarter, according to Thomson Financial. That’s the worst performance since the first quarter of 2002, the last year-over-year decline, when profits dropped 11.5%.
Results from big financial firms like Merrill Lynch (MER) and Bank of America (BAC) and from homebuilders have been especially poor. Financial companies in the S&P 500 have seen profits fall 16%. Builder Lennar (LEN) lost $3.25 a share in the third quarter, down from a gain of $1.30 last year.
The news isn’t all bad. Technology companies in the S&P 500 have seen profit gains of 15% and health-care companies, 13% gains, Thomson says.
Looking at the numbers another way, of the 388 companies in the S&P 500 that have reported quarterly results so far, 65% have beaten the estimates of analysts, and 22% came in below expectations, Thomson says. That’s about in line with recent quarters. But of those that have missed estimates, a large number have done so by a wide margin.
“Almost two-thirds of companies beat expectations. That’s a good sign. But the financial sector is dragging things down,” says John Butters, director of earnings research at Thomson Financial.
The earnings disappointments come as difficulties reappear in various lending and debt markets, troubles that could cause banks to curb their lending, some fear, putting a crimp on the economy.
Earnings expectations are coming down for the months ahead, but perhaps not fast enough, some say, given that the U.S. economy is expected to slow. That suggests stocks are not yet at bargain territory. Analysts surveyed by Thomson Financial expect fourth-quarter profits to be up a hearty 8.9%, and predict earnings will jump 13.2% in 2008.
An Assist From the Fed
Last Wednesday, the stock market was bolstered by the Fed cutting interest rates by one-quarter percentage point, a step that could help the economy by making it easier for businesses and consumers to borrow money. Also buoying the market: Friday’s news that payrolls climbed by 166,000 in October, more than double the predictions of analysts, suggesting that the overall economy is holding up nicely.
An initial estimate of third-quarter economic growth suggests that the U.S. economy grew by a healthy 3.9% from a year earlier.
But the Fed gave its own mixed message about the economy. In a statement accompanying the interest-rate move, it said “economic growth was solid in the third quarter,” but added that “the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.”
The lesson for investors: The economy is holding up, but risks are growing.
“The broad picture for U.S. growth excluding housing is still fine,” according to a recent report from Bridgewater Associates, a large investment firm. “The housing picture, however, adds clear downside risks for the economy. This is even more true now as the pace of contraction looks to be accelerating.”
Analysts say troubles for financial companies could continue, as they own up to debt-related losses in the months ahead. But the overall market is not at troublesome price levels. The S&P 500 trades at about 14 times 2008’s earnings expectations. Even if those estimates are cut, stocks don’t look especially expensive.
“While we do expect the stagnating home values and mortgage resets to certainly impact consumer spending next year…equity valuations are reasonable enough to warrant a full exposure to the market,” says Jack Ablin, chief investment officer at Harris Private Bank in Chicago.
Go for Growth
Some analysts say investors should stick to companies that are generating impressive results but are still reasonably priced. For example, Kinetic Concepts (KCI), a maker of hospital mattresses and therapeutic surfaces that treat wounds, said third-quarter net income jumped 21%, as revenue improved 17%.
Lawrence Keusch, an analyst at Goldman Sachs who has an “attractive” rating on the stock, noted that Kinetic has been able to grow its earnings at a rapid clip outside the U.S. Kinetic is expected to grow profits 21% in the next year, but its price-earnings multiple is 18, a reasonable figure.
Indeed, as the U.S. slows and the rest of the world continues to grow, companies that receive the bulk of their profits from foreign markets are expected to do best, some analysts say. Turkish telecom giant Turkcell Iletisim Hizmetleri (TKC in U.S. trading), is expected to see profits jump 30% in the next year, but the stock is still trading at a P/E ratio of 16. Analysts have raised their estimates on the company by 3% in just the past four weeks.
