21 Jun 2002 Not ‘Til We See The Earnings
The economy is getting better, albeit very slowly and with some mixed signals. Investors now choose to concentrate individual company announcements waiting for proof at the company level that things are getting better. They are not yet willing to simply trust the government compilations alone. Corporations must begin to show improvement individually.
Yesterday, a Bloomberg Consumer Confidence survey suggested that consumer confidence might decline and a Goldman Saks analyst downgraded the growth prospects of General Motors and Ford. These two bits of news had a significantly negative impact on the market. One might have expected a more significant positive move in the markets when it was announced that the Leading Indicators and the Philadelphia manufacturing indices were twice better than economists expected. Investors are stuck in micro-view now. It shouldn’t be any surprise that auto sales cannot continue at the record pace they have exhibited in the past few months. How many cars can people buy? If confidence is declining, as the Bloomberg survey suggests, how can we reconcile the strong sales results reported almost daily by America’s top retailers? American consumers have consistently baffled pollsters and investors alike. There is little reason to think their confidence is waning.
There was more good news for the economy as the government reported that new houses started during the month of May jumped 11.6% to an annual pace of 1.733 million units, the largest gain since July of 1995. People are moving dollars out of the stock market and into real estate, as they seek better returns. The trend in housing should continue for months to come, as low inflation keeps mortgage rates low.
Meanwhile, consumer prices were reported unchanged as lower costs for gasoline, clothes and cars offset higher prices for medical care and air travel. Real earnings were up better than expected and initial jobless claims continue to slow their rate of growth. The macro economic indicators suggest continued improvement even if select individual companies continue to have problems. The view from the sky seems to be much better than the view on the ground.
As earlier mentioned, the Leading Indicators, released yesterday showed surprising strength. Likewise, the Philadelphia Federal Reserve Bank manufacturing index showed that manufacturing in that region expanded the most it had in four years. That’s the sixth straight reading greater than zero, signaling a majority of the companies surveyed reported an improvement in business.
Economic data are important for gauging the strength of the economic recovery, but investors say they want to see corporate profits improve, but do they really? On Tuesday, Best Buy reported that their first quarter earnings increased by 27%. The stock declined almost immediately and is now down 10% since that report. Because management was a bit more conservative with their outlook for the next quarter compared to what analysts thought they could accomplish, the stock fell rather dramatically.
How is Best Buy’s stock valued now? Its price to earnings ratio on next year’s earnings is 17x, considerably better than WalMart’s 32x or the S&P’s 43x. Its price to sales ratio is .59x compared to WalMart’s 1.14x. Best Buy is the category leader, in the right place and time for this economy, well-managed, and financially sound. The company is a great example of how inefficient the market is now at identifying valuable stock opportunities. Many stocks are trading in almost mechanical or technical patterns now, as short-term traders control much of the market volume.
I performed a screen of all U.S. stocks yesterday to find quality companies with price earnings ratios below their growth rates. The screen also included the following criteria: return on invested capital of at least 10%, low debt, high cash, and earnings growth of at least by 10% in the coming five years. The list included over 300 companies. It was encouraging to see that many of the companies we own were on the list. There were also some surprises that we will investigate for future purchase.
The point is there are many pockets of value in today’s market. It may be that the potential these companies represent is indeed known to investors, but because of fear and doubt they are not yet ready to commit funds to them. They may view the potential returns as too far out into the future or too uncertain in today’s uneasy times. Just over two years ago, investors were willing to bet millions and billions on the dreams of the latest dot commer. Today, they refuse to believe even managers of one hundred-year-old companies until they read the earnings with their own eyes. That’s a bear market.
But in the midst of all the gloom, a company like Bed Bath & Beyond can report an earnings increase of 54% and increase its outlook for next quarter by a penny (instead of dropping it by a penny as Best Buy did) and watch its stock rise by 7% in a day. Bed Bath proves there remain in this market investors who are looking for good investments, but fear keeps many others away. In time though, as the recovery continues, and more companies announce better-than-expected earnings, greed will overcome fear and buyers will come rushing back in herd-like fashion. Investors who make smart purchases today will be happy to sell their holdings when they become over-valued at the hands of a panicky buying ‘herd.’ We believe we own many Bed Bath & Beyond’s with value not realized by today’s timid investors. As fears of the bear market give way to confidence of the bull market, our patience will be rewarded with stock prices that recognize the value we see today.