CWS Market Review – August 19, 2016

“To be an investor you must be a believer in a better tomorrow.” – Jason Zweig

I’ll briefly summarize this summer’s stock market:

Up, Down, Up, Down, Up, Down, Up, Down, Up, Down…

I exaggerate. But not by much. Here are some numbers. The last 14 times the S&P 500 had a down day, it closed higher the following day 13 times.

That’s the meanest mean reversion I’ve ever seen. It’s as if no trend can get itself going unless it’s a trend in not being a trend. Of the last 13 up days, ten have been followed by down days. Like I said, up, down, up, down, up, down.

This week, we just snapped an “alternating streak” of nine days in a row. This comes on the heels of an 11-day run in July. The Nasdaq Composite has now gone 37 days without posting back-to-back down days. What’s causing all this indecisiveness? In this week’s CWS Market Review, we’ll take a closer look.

We’ll also discuss our two Buy List earnings reports from this week, Hormel Foods and Ross Stores. Both stocks beat estimates and, more importantly, both stocks raised guidance. I’ll also preview HEICO’s earnings report for next week. The quiet little stock is our biggest winner this year (+36%). But first, let’s look at why low-quality stocks are suddenly popular.

The Low-Quality Rally

I was thinking of calling this “The Archie Bell Market” (ask your parents). The daily range has tightened up. The difference between the S&P 500’s daily highs and lows is at historically narrow levels. Despite the stock market’s aimlessness, I don’t believe it’s indicative of a larger theme, except that it’s summertime and there’s not much in the way of news. Rest assured, things will pick up after Labor Day.

Second-quarter earnings were pretty much what was expected. They mostly beat expectations, which had been pared back going into earnings season. That’s a classic Wall Street game—lower the bar until you can easily step over it. Then wait for applause. It looks like earnings fell 2.5% for Q2. If we exclude energy, then earnings rose by 1.8%. For Q3, Wall Street expects an overall earnings drop of 0.8%.

I think it’s interesting to see the growing diversion in the market’s rally. Goldman Sachs noted that stocks with weaker balance sheets have outpaced the market since the February low. That reflects the unwinding of the previous trend of favoring high-quality stocks. Since early July, the S&P 500 Dividend Aristocrats ETF (NOBL) has badly lagged the market. This is a group of blue chips that have raised their dividends every year for at least 25 years in a row. I like to use NOBL as a proxy for conservative stocks.

What we’re seeing is that investors are gradually becoming more tolerant of lower-quality names. It’s not a problem yet, but I encourage investors not to be lured by the illusion of easy gains. There’s a reason why those companies have weak balance sheets.

This week, the Federal Reserve released the minutes of its last meeting. For reasons not clear to me, the market took the minutes as evidence of a more dovish stance. I didn’t see that at all. I want to be careful not to overstate my position, but I think it’s possible that the Fed will raise rates in December or early next year. Futures traders aren’t so sure.

Now some Fed officials are moving to my side. This week, William Dudley, the top dog at the New York Fed, said there’s a chance the Fed could hike next month. I doubt that will happen, but it’s noteworthy that he said it publicly. John Williams, the head of the San Francisco Fed, went even further. He said the Fed ought to raise rates right now.

Fortunately, the inflation news continues to be favorable, but I’m not sure how much longer that will last. This week, the government said that consumer prices were flat last month. The “core rate,” which doesn’t include food and energy costs, rose by just 0.1%. The latest data indicate that workers are finally getting a wage increase, and that will work its way though the economy. For example, later on I’ll discuss the strong earnings report from Ross Stores. The deep discounter saw same-store sales grow by a healthy 4% last quarter. Ross was able to increase its operating margin.

One very favorable piece of information we got this week was a strong industrial production report. The Federal Reserve said that industrial production rose by 0.7% last month. That’s the biggest increase in nearly two years. This was especially good to see, since industrial production had sagged from November 2014 until March of this year. You can thank the strong dollar for that.

I was hesitant to say that the production slump was past us, but the last two reports have been quite good. The Fed said that industrial production rose by 0.4% in June. For July, manufacturing output rose by 0.5%. That was its biggest jump in more than a year. Now let’s take a look at this week’s Buy List earnings reports.

Hormel Foods Beat and Raised Guidance

On Thursday morning, before the opening bell, Hormel Foods (HRL) reported fiscal Q2 earnings of 36 cents per share. That beat Wall Street’s consensus by one penny per share. The Spam company’s quarterly revenues rose by 5.2% to $2.3 billion, which was a little better than expectations. This was Hormel’s 13th quarter in a row of record earnings.

I was pleased to see that Hormel had solid results across the board. Thanks to the inclusion of Applegate, Hormel’s Refrigerated Foods segment saw its profits rise by 24%. Their Jenny-O Turkey biz had a profit increase of 59%. Last year’s profits were impacted by the avian flu, so it’s nice to see a big increase here.

“We are pleased to announce exceptional results this quarter with three of our five segments delivering volume, sales and earnings growth. This is also our thirteenth consecutive quarter of record earnings, which is a testament to our balanced business model,” said Jeffrey M. Ettinger, chairman of the board and chief executive officer. “Excellent results in Refrigerated Foods were driven by the addition of the Applegate business, foodservice sales of OLD SMOKEHOUSE® bacon, HORMEL® BACON 1™ fully cooked bacon, and HORMEL® FIRE BRAISED™ meats, and retail sales of HORMEL® NATURAL CHOICE® meats. Jennie-O Turkey Store also returned to growth, posting strong double-digit sales and earnings increases,” stated Ettinger.

“Iconic brands such as SPAM® and SKIPPY® drove increased sales in our Grocery Products and International segments. We enjoyed strong growth from MUSCLE MILK® protein products led by innovative new items such as MUSCLE MILK® protein smoothies, though Specialty Foods did not show growth this quarter due to the sale of Diamond Crystal Brands,” commented Ettinger.

The best news is that Hormel is raising its full-year guidance. The old range was $1.56 to $1.60 per share. The new range is $1.60 to $1.64 per share. Shares of HRL rallied 1.9% on Thursday.

While Hormel’s stock had a great 2015, it pulled back sharply in April and May of this year. Fortunately, that rough patch appears to be over, and this earnings report should help calm any fears. Hormel Foods remains a buy up to $39 per share.

By the way, if you want to learn more about Hormel, I recommend this recent piece at Bloomberg. Whenever I tell someone I like Hormel, they invariable say, “Haha, Spam!” or worse, “Ewww, Spam!” The truth is that Hormel Foods is a great deal more than Spam.

Ross Stores Beat and Raised Guidance

Last week, I told you that “I expect to see an earnings beat” from Ross Stores (ROST). I wasn’t disappointed. After the closing bell on Thursday, the deep discounter reported fiscal Q2 earnings of 71 cents per share. That was a 13% increase over last year, and it was four cents more than expectations. They also beat their own expectation of 64 to 67 cents per share.

Looking through the report, I really like the numbers I see. Ross’s quarterly sales rose 7% to $3.181 billion, and same-store sales increased by 4%. Operating margins expanded from 13.9% to 14.4%. Maintaining margins is crucial in retail, especially for price-conscious consumers. Last quarter, Ross bought back 3.1 million shares of stock for $176 million. They plan to buy back $700 million worth of their own stock this fiscal year.

Ross’s CEO, Barbara Rentler, was confident enough to give optimistic guidance for the current quarter (fiscal Q3) and for next quarter.

Looking ahead, Ms. Rentler said, “For the third quarter ending October 29, 2016, we are forecasting a same-store sales gain of 1% to 2% on top of a 3% increase in the prior year, and earnings per share of $.52 to $.55, compared to $.53 in last year’s third quarter. For the fourth quarter ending January 28, 2017, we are also projecting same-store sales to grow 1% to 2% versus a 4% increase last year, with earnings per share expected to be $.73 to $.76, up from $.66 in the 2015 fourth quarter. Based on our first-half results and second-half guidance, fiscal 2016 earnings per share are now planned to increase 7% to 10% to $2.69 to $2.75, on top of a 14% gain last year.”

Last year, Ross Stores earned $2.51 per share, and they’re predicted to make $2.69 to $2.75 per share this year. Ross continues to be an outstanding business. This week, I’m raising my Buy Below on Ross to $67 per share.

Earnings Preview for HEICO Corp.

We have another Buy List earnings report coming next week. HEICO (HEI) is the third company on our Buy List with a quarter that ends in July. The company will report its fiscal Q3 earnings after the close on Wednesday, August 24. The conference call will come on Thursday morning.

Of all the stocks on our Buy List, HEICO is the smallest. The market cap is only about $5 billion. Wells Fargo is more than 40 times bigger, and Microsoft is nearly 100 times bigger. HEICO is also one of our quietest stocks. They rarely make the news, and most traders ignore them. You have to admit that replacement airplane parts isn’t the most exciting business.

Still, HEICO has managed to overcome this “handicap” of being a little dull by being our top performer this year. Through Thursday, HEICO is up more than 35% for us. That’s 13% more than our second-best stock.

What I like about HEICO is that it has a strong economic “moat.” That’s Warren Buffett’s phrase for a lasting competitive advantage. HEICO basically makes knock-off plane parts that are much cheaper than the originals. With lower oil prices, older airplanes have been flying longer, and that means more parts from HEICO.

The company has already raised guidance twice this year. Unfortunately, HEICO only provides guidance for net income and not earnings per share. Since the company earned $1.97 per share last time, we can infer a full-year EPS between $2.25 and $2.30 (assuming a stable number of shares). That’s seems very doable. HEICO has already earned $1.06 per share for the first half of this year. I’m expecting fiscal Q3 earnings of 60 cents per share.

Shares of HEICO are currently well above my $70 Buy Below. Don’t chase the shares. I want to see next week’s earnings report before I feel confident in adjusting our Buy Below.

That’s all for now. Next week, we’ll get reports on new- and existing-home sales (Tuesday and Wednesday). I’ll also be curious to see Thursday’s durable-goods reports. On Friday, the government will revise its report on Q2 GDP. If you recall, the initial report showed growth of just 1.2%. Also next week, the Federal Reserve holds its annual conference in Jackson Hole, WY. 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 Eddy Elfenbein on August 19th, 2016 at 7:08 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.