As the market wraps up first quarter earnings season, results have been undeniably good. More than three-quarters (78%) of the companies in the S&P 500 have beaten earnings expectations, the highest percentage since FactSet began tracking it in 2008.
Earnings growth for the index on a year-over-year basis is above 24%, making it the strongest quarter since 2010.
Stocks have rebounded from February lows, but sentiment has clearly shifted. Instead of the enthusiasm for growth and optimism for future earnings, investors seem hesitant to believe shares can go much higher.
Is the market’s lethargy a sign of exhaustion and a long-awaited correction or is it just consolidation as earnings catch up?
More importantly, how can you be ready for either scenario?
Is Investor Enthusiasm Starting To Swing The Other Way?
Despite the strength in earnings, the S&P 500 is up just 3% since earnings started coming out in early April.
Investors have a reason to be hesitant in their enthusiasm. Forward valuations are at 16.0 times expected earnings for the next year, a 12% premium on the 10-year average of 14.3 times multiple. That elevated forward valuation is on expected earnings growth of 20% for 2018, almost double the 11.7% growth booked in S&P 500 earnings last year.
Management has already been careful to talk the market down from earnings, with more than half (55%) of the companies issuing earnings guidance reporting that earnings next quarter may miss expectations. Higher rates, fears over prices, a trade war, and general economic growth are all hanging over sales to temper what should otherwise be a euphoric market.
But none of this means the market cannot keep marching higher. The rally has climbed the proverbial wall of worry almost since it started nine years ago from fiscal cliff to geopolitical worries and rising rates.
Against the valuation and investor hesitance, we find a global economy primed to expand by 3.9% this year, according to the IMF, and U.S. unemployment at its lowest in two decades. Wages finally seem to be putting more money in consumers’ pockets and confidence is strong.
Nothing has seemed to stop this bull market, and I don’t want to sit out for fear of a correction. But that doesn’t mean I want to be mauled when the bear comes out of hibernation.
How to Have Your Growth And Value, Too
In this environment, I like to switch to a GARP (growth-at-a-reasonable-price) strategy in stocks. Companies with solid earnings growth but for some reason that are trading at a discount compared to peers and their own historic multiples.
If the economy continues to grow, these stocks should provide solid returns. If the economy or investor sentiment plunges then these stocks have a cushion in their valuation compared to other growth names. They will likely see prices fall as well, but not as much and they should rebound quickly when growth returns to the market.
Beyond this reasonably-valued growth criterion, I also like to look for companies with a competitive advantage and potential upside catalysts that can maintain their growth credentials.
BioMarin Pharmaceutical (Nasdaq: BMRN) is a leader in the orphan drug category (drugs used to treat rare diseases), which gives it extended protection and a longer sales trajectory versus other pharmaceuticals. The company is expected to bring its PKU treatment Pegvaliase to market this year to add significantly to sales and blockbusters Vosoritide and Valrox could come to market within the next two years.
Management is guiding to 15% annual sales growth through 2020 as well as cost cutting which should improve profitability. Operating expenses have already been cut from 114% of sales to 92% over the two years through 2017, even as revenue jumped 22% over the period. Shares trade for 11.2 times sales, a discount of 31% over the five-year average of 16.2 times.
Expedia Group (Nasdaq: EXPE) has seen profitability weaken on an aggressive capital spending plan to develop the HomeAway platform, but growth from the segment is expected to drive sales for the next several years. Segment sales on the vacation rental marketplace grew 46% in the last quarter and now contribute 14% of overall bookings.
Global economic growth continues to support Expedia’s foreign bookings, growing 37% year-over-year last quarter. Overall sales have grown at a 20% annualized rate over the last three years, and a network effect among the company’s platform assets should help to continue the trend.
Perhaps as important as growth in bookings, the company’s cost-cutting and technology improvements continue to pay off in higher margins. Last year reversed a two-year downtrend in operating profitability and should continue to improve. Shares trade for 1.7 times trailing sales, a discount of 23% on the five-year average of 2.2 times sales.
Incyte Corp (Nasdaq: INCY) was dealt a blow on the failure of its IDO inhibitor trials last year, but the market is discounting a strong pipeline and the ability of its blockbuster myelofibrosis treatment Jakafi to provide cash flow. The drug doesn’t come off patent protection until 2026 and posted 25% sales growth in the last quarter.
The company has already been aasdaq: pproved for its JAK inhibitor Olumiant in Europe and U.S. approval could take sales well past $1 billion. Shares trade for a price-to-sales ratio of 8.8 times, less than half the five-year average of 20.8 times. Sales have grown at a 44% annual pace over the last three years and are expected 16% higher this year over 2017.
Risks To Consider: There may be nowhere to hide if the economy plunges into recession, but investing in best-of-breed names with growth potential will ensure you participate in the eventual rebound.
Action To Take: Take advantage of near-term valuation discounts in growth stocks to benefit from continued economic growth while protecting yourself from a market selloff.
Editor's Note: On the same day Elon Musk tweeted that Panasonic would be his only supplier of Model 3 cells, Panasonic added $800 million to its market value! Find out what Elon Musk is saying now to cause these three little-known stocks to skyrocket 10X by 2020. Full story here.