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
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
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%
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:
top quarterly estimates once again by a handy margin , while
issuing seemingly cautious guidance.
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.
Stocks that come to mind include
Applied Materials (Nasdaq:
Charles Schwab (Nasdaq:
Best Buy (NYSE:
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.
-- David Sterman
Disclosure: David Sterman does not own shares of any security
mentioned in this article.
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