How 3 Best-Of-Breed Stocks Fared In Q1 And What The Future Holds

First quarter earnings were a mixed bag for stocks. While companies in the S&P 500 reported a 24.6% increase in earnings from last year, the highest growth since 2010, the index is less than 2% higher since reporting began in March.

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Not only did companies report record earnings growth but management has been relatively optimistic on the second quarter with far fewer S&P 500 companies issuing negative guidance than is usually the case.

With analysts estimating nearly 20% earnings growth for the index through 2018, the market’s mood seems surprisingly pessimistic on share prices. This isn’t just “climbing a wall of worry,” it’s a larger failure to price stocks on fundamentals rather than on pure emotion.

#-ad_banner-#And that market failure could help calmer investors snap up some value plays primed for a rebound.

Investors Throw the Best Out with the Bathwater
The market rewarded very few companies this earnings season. Even companies that were able to beat investor expectations were hardly compensated with an average gain of just 0.2% from the two days prior to earnings through the two days after, according to Factset Research.

That pales in comparison to the average bump over the last five years of 1.1% for companies reporting positive surprises.

Even worse off were the companies that just met or missed expectations. Lofty expectations and investor irritability punished companies not able to beat on earnings and dazzle with a forward outlook. Shares of companies missing expectations plunged an average 2.3% in the four days around earnings.

Investors can no longer blame this knee-jerk reaction on high stock prices. Analysts see earnings growth for the index between 16.9% and 18.8% year-over-year for the remaining three quarters of the year. The 12-month forward price-earnings ratio of 16.4-times is only slightly above the 16.2 average over the last five years.

Neither can investors blame the stagnancy on a pessimistic forward guidance from corporations. Just 57 companies issued negative EPS guidance for the second quarter, well under the five-year average of 79 negative warnings.

Sometimes the market is just overly pessimistic, and we may never know why it doesn’t act more rationally to fundamentals.

What we do know is that the selloff in some names has created a buying opportunity for solid companies with upside catalysts.

Finding Beaten Best Of Breeds In The Selloff
While it’s no surprise that the market is quick to punish companies for short-term weakness, the theme has grown stronger over the last several quarters.

Exuberant investors sell off any near-term weakness in haste without looking deeper at a company’s long-term fundamentals. This means a lot of quality companies with solid outlooks have been sold off, offering an opportunity for investors able to see the broader picture.

Check Point Software Technologies (Nasdaq: CHKP) plummeted 6.4% when it only slightly beat Q1 expectations but guided lower for the year. Cybersecurity has gotten more competitive recently, and the company reported a 12% increase in marketing expenses through the first quarter. That spooked investors on the potential for slower sales growth and weaker profitability.

But cybersecurity and the $16 billion leader in network security still have some great tailwinds. Rollout of the company’s Infinity platform, which protects an enterprise’s entire IT infrastructure, has weighed on segment sales but could ultimately be a boon to the business with higher customer retention and overall revenue growth.

The company is still expected to increase earnings 4.8% to $5.70 per share over the next four quarters, and management may just be playing it safe to protect its perfect 12-for-12 streak of beating expectations. Shares are trading for just 17 times forward earnings, a discount of 24% from its high of 22.3-times forward earnings in November.

GlaxoSmithKline plc (NYSE: GSK) saw its shares drop 3.7% when it only met expectations for the first quarter. Weakness in pricing around the company’s respiratory drug — and broadly across the industry — is weighing on shares and investors are worried that the drugmaker’s tempting 6.5% dividend yield could be in jeopardy.

Free cash flow increased last year on strength in operational cash and the company was able to pay down nearly a billion in debt while still returning $3.9 billion to shareholders. An increase in marketing expenses should drive sales throughout the year and I doubt the dividend is in any real danger of being cut.

Earnings are expected to be flat at $2.92 per share in 2018 compared to last year, putting the shares at just 13.9 times forward earnings. The company has a solid pipeline in its respiratory segment and is more diversified than peers with just 10% of revenue coming from its largest product Advair.

AT&T (NYSE: T) dropped 6% when it missed expectations by 2.2% for Q1 earnings on lower revenue and margin weakness. While the company added 2.6 million wireless subscribers during the quarter, many were on connected devices for existing contracts which led to lower average revenue per user (ARPU).

Worries of declining subscription numbers in its DirecTV division are being allayed as the company’s streaming service DirecTV Now ramps up and drives net gains. Management has stumbled recently, both on growth and with some questionable moves around fighting for the Time Warner (Nasdaq: TWX) merger but the company is still fundamentally strong.

Earnings are expected higher by 8.5% over the next four quarters to $3.44 per share. That means investors can get a solid bellwether stock with a 6% yield at just 9.5-times forward earnings. Rollout of 5G services this year and next, combined with significant benefit from the tax cuts, could drive sales and an earnings surprise to the upside.

Risks To Consider: While these best-of-breed names have already sold off, a hit to broader market sentiment could drag them down further even on a strong outlook.

Action To Take: Take advantage of the market’s near-sightedness and a selloff in best of breed shares that couldn’t meet investors’ lofty expectations.

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