One thing was abundantly clear in the most recent earnings season: Quarterly results were often terrific as analysts had apparently underestimated the earnings strength of a wide range of companies in a wide swath of industries. And in many instances, analysts only boosted their estimates for subsequent quarters and years by a modest amount. For many, that means that more “estimate-topping” results lie in store.
But the folks that work as economists and market strategists have an entirely different view. They think that analysts are always far too optimistic, and they suspect that analysts are vastly over-estimating profits for 2011. Call it the battle of the “bottom-up” analysts versus the “top-down" strategists and economists.
It’s an important debate. The rate of actual profit growth will be the main determinant on whether investors should expect further upside or a retracement back down during the next 12 months. Everything else, from oil spills to partisan wrangling to M&A activity is just short-term noise for short-term traders.
History is on the side of the “top-down” crowd. As we have come out of recessions in the past, investors -- and the market -- have been fooled into prematurely calling for a sustainable rebound. Profit growth looks great at first, thanks to many costs cuts and revenue streams that rise back up after sinking especially low. But as revenue growth cools and cost cuts have been made, profit growth tends to fall back to earth, taking the market with it. For example, from the summer of 2001 to the summer of 2002, profits rebounded nicely, providing fresh confidence to investors. But profit gains were short-lived, and the S&P 500 ended down -22% in 2002.
So how could analysts be both overly-optimistic and also under-estimate near-term earnings strength? Simple, analysts tend to first raise forecasts after earnings estimates are exceeded, and then lower the bar again prior to the next period. That’s why it’s so important to look past companies that consistently beat estimates, and instead look for stocks that show consistently rising profit estimates during the last 90 days (which you can find on Yahoo! Finance and other financial websites).
From where I sit, the truth lies somewhere in between. Companies are now so lean that only modest sales gains will yield even higher profits. But it’s also increasingly likely that any analyst who is banking on more robust sales growth in 2011 for the companies they follow will need to ratchet down their forecasts. It’s a sad fact that many analysts derive their earnings forecasts from what management tells them. And most management teams are always blindly optimistic, acting as head cheerleader for their sales forces.
Action to Take --> Some companies will always issue conservative guidance and can always be counted on to beat forecasts when results are released. Just this morning, we saw Bed, Bath & Beyond (Nasdaq: BBBY) top quarterly estimates once again by a handy , while issuing seemingly cautious guidance. CarMax (NYSE: KMX) did the same thing Wednesday. These firms are leaving themselves some wiggle room in case sales results are disappointing.
But in many other instances, you’d be wise to refrain from simply extrapolating current results into the future. So many companies are seeing +15% or +20% year-over-year sales gains, while the economy is growing +2%. That’s not sustainable.
The best thing you can do in this environment is stick with low price-to-earnings ratio (P/E) stocks. If estimates need to come down, as the top-down crowd suspects, these stocks are likely to fall by a lesser amount. You may also want to stick with the cash-rich firms that can defend their stocks with buybacks if need be.
As noted above, history tells us that we may see the great profit rebound peter out next year. But history also tells us to prepare for more robust earnings after that. Even though the S&P slumped -22% in 2002, it rose a hefty +28% the next year as sales growth picked up again, and profit growth really took off.