CWS Market Review – July 27, 2012

Now that the second-quarter earnings season is half over, we can say that the results aren’t so bad. Going into earnings season, we had many reasons to believe that it could have been far worse. Three such reasons were Europe, Europe and Europe. So far, 72% of the 255 companies in the S&P 500 that have reported earnings have topped estimates. But that’s against expectations. On a comparative basis, earnings are down 1.6% from a year ago. This the first quarterly earnings decline in three years.

In this issue of CWS Market Review, we’ll take a look at the flurry of Buy List earnings reports we had this week. Some were good and some were not so good. I’ll sort through the noise for you and highlight the best bargains.

I also want to discuss the market’s turn towards a defensive posture. This is a key point all investors need to understand. When the Street gets worried about the economy, sectors like Staples and Healthcare lead the way while Industrials and Energy stocks get left behind. Too many individual investors get blindsided by sector rotation. But first let’s look at why we already may be in the midst of an earnings recession.

How to Survive an Earnings Recession

The stock market has recovered quite well since early June, but there are a few ominous clouds on the horizon. For example, while nearly three-fourths of earnings reports have come in above expectations, only 43% have beaten their sales expectations. This suggests that companies are still relying on wider margins to grow their bottom lines. The problem with this strategy is that it can’t go on indefinitely.

The other trouble spot is that analysts are now ratcheting back their earnings forecasts for Q3. At the start of the third quarter, Wall Street expected Q3 earnings to grow by 3.1%. Now they see earnings dropping by 0.1%. While the economy is still growing at a very low but positive rate, the corporate world is probably in an earnings recession.

Wall Street is very sensitive to this shift and we’ve already seen a major sector rotation. Since February 3rd, the Morgan Stanley Cyclical Index (^CYC) is down by 12.2% while the S&P 500 is up by 1.1%. That’s a major divergence. The relative strength of the CYC just hit a three-year low. Key defensive sectors like Consumer Staples, Healthcare and Consumer Discretionaries have recently made all-time highs. The move away from cyclical stocks has held back some Buy List stocks like Ford ($F) and Moog ($MOG-A).

This defensive turn is matched by the tremendous surge in the bond market. The yields for long-term U.S. Treasuries are at all-time lows. It has never been cheaper for Uncle Sam to borrow money—and he’s been borrowing a lot.

Investors should stay far away from the ultra-low rates in the bond market. The 10-year Treasury gets you less than 1.5%, and the 20-year TIPs actually has a negative yield. There are plenty of stocks on our Buy List that yield more than that, and they have potential for growth.

This is also a good time for investors to get rid of overpriced stocks in their portfolio. A few weeks ago, I put together a list of stocks to avoid. I also caution investors to not be tempted by the dollar’s surge against the euro. The best part of that currency move has already happened. Investors should continue to focus on high-quality stocks, particularly some of the beaten down financials like JPMorgan Chase ($JPM) and Nicholas Financial ($NICK).

Dissecting Earnings from Ford, AFLAC and Others

I’m going to touch on the six Buy List earnings reports we had this week. Before I do, let me stress that with our style of investing, we don’t have to worry so much about a company earning precisely this or that. The earnings guessing game just ain’t worth playing. All of our Buy List stocks are high-quality companies. Just to make it here, they gotta be very, very good. With our earnings reports, we just want to see if business is going well. Missing by a penny or two…well, that doesn’t bother me at all.

Last Friday, Reynolds American ($RAI) reported earnings of 79 cents per share which was three cents more than estimates. I don’t care about that at all. The important news is that Reynolds reiterated its full-year forecast of $2.91 to $3.01 per share. They’re clearly on track to hit that. RAI yields 5.2%.

On Wednesday, Ford Motor ($F) reported earnings that were frankly rather blah. The automaker made 30 cents per share which was two cents better than Wall Street’s estimate. I’m not wild about these results but I’m comforted that Ford’s problems were due to weakness in Europe. Business in North America is still going very well. On Thursday, the stock closed at $8.96 which is a very low price. This is a good example of a cyclical company that’s been punished by an unforgiving sector rotation. Ford may be the cheapest major stock on Wall Street.

On Tuesday, AFLAC ($AFL) reported earnings of $1.61 per share which matched Wall Street’s estimate. Frankly, this earnings report was also disappointing, but just slightly. AFLAC has done a very good job of paring back on problematic investments in its portfolio. This seems to have caused Wall Street undue worry but I’m pleased with how the company has addressed the issue.

AFLAC said that it expects third-quarter earnings to range between $1.64 and $1.69 per share. The Street had been expecting $1.63 per share. AFLAC also narrowed its full-year guidance from $6.46 – $6.65 per share to $6.45 – $6.52 per share (assuming an average exchange yen/dollar rate of 80).

AFLAC is standing by its forecast that earnings growth will accelerate next year. That probably means that earnings will range somewhere between $6.80 and $7.00 per share. In other words, AFLAC is going for roughly six times next year’s profit. The shares pulled back this week, but my outlook hasn’t changed at all. AFLAC is a very good buy anytime the shares are below $50.

On Thursday, CA Technologies ($CA), our #1 performer on the year, reported quarterly earnings of 63 cents per share which was two cents above Wall Street’s consensus. This was a good quarter for CA in a difficult environment. The company shaved three cents off the top-end of their full year forecast (the June quarter is their fiscal Q1). That’s not a big deal. Once again, currency was a drag. CA is one of the most stable stocks on our Buy List. The stock currently yields 3.8% and is a strong buy up to $30 per share.

After the closing bell on Wednesday, CR Bard ($BCR) reported second-quarter earnings of $1.62 per share. The market wasn’t pleased as the stock dropped 4.7% on Thursday, but I think it’s a decent number. The company had given a range of $1.61 to $1.65 per share and Wall Street was expecting $1.64 per share, so Bard was in the ballpark. As with other companies this earnings season, Bard is running its business well. The problem is the economy in other parts of the world, especially Europe.

On the earnings call, Bard says it sees Q3 earnings ranging between $1.60 and $1.64 per share. Wall Street had been expecting $1.68 and I thought it could have been as high as $1.70 per share. Bard had previously said that it sees earnings growing by 3% to 4% for this year, and they reiterated that forecast. That works out to a range of $6.59 to $6.66 per share for this year. CR Bard remains a solid buy whenever the stock is below $112 per share.

Hold Hudson City

One of the Buy List stocks that I’m really having reservations about is Hudson City Bancorp ($HCBK). The other is JoS. A. Bank ($JOSB). Make no mistake, Hudson City is a fundamentally good stock, but I didn’t appreciate how much the business got squeezed by the low-rate environment. The stock ran out to a big gain for us early in the year, but HCBK has since given all of it back. This week’s earnings report was decent (15 cents per share, one penny more than estimates).

The best news is that Hudson City will keep its dividend at eight cents per share. If that payout holds for the following year, the shares will yield 5.4%. There’s no reason to sell HCBK, but I’m lowering it to a hold. I doubt Hudson City will be on next year’s Buy List.

This coming week, we’ll have earnings from Fiserv ($FISV), Harris ($HRS), Wright Express ($WXS), DirecTV ($DTV) and Nicholas Financial ($NICK). You can see an earnings calendar here.

Let me add a quick word about Wright Express. The stock got knocked down in May after the company guided lower for Q2. Yet Wright kept their full-year forecast the same. This shows you how short-sighted Wall Street can be. Less than a month after the earnings report, shares of Wright began a furious rally. Since early June, the stock is up more than 20% and it’s close to making a fresh 52-week high. Rational? No. But it’s not uncommon on Planet Wall Street.

That’s all for now. More earnings reports are coming next week. Then on Friday, all eyes will be on the July jobs report. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by on July 27th, 2012 at 6:34 am


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.