A Major Shift Could Drive Stocks in Coming Years

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Many investors have been surprised by the steady advances in the stock market since it bottomed out three years ago.

They shouldn't have been. History predicted it would happen.

Exiting a major economic slowdown, companies cut costs fairly quickly, leading to a tremendous spike in profit margins. Consider this statistic: Companies in the S&P 500 boosted per-share profits by 38% in 2010, with roughly 80% of that coming from margin gains. Sales growth accounted for the remainder.

 

The margin gains posted by companies moderated in 2011, but were still good enough for the S&P 500's profits to rise by 16% on an aggregated basis. Yet in the just-completed fourth quarter, an ominous sign appeared: profit margins fell slightly from a year earlier, for the first time since early 2009.

Looking ahead, this should be "the new normal." Year-over-year profit margins are expected to fall slightly in the first three quarters of 2012 and rise only modestly in the fourth quarter. The clear takeaway: to boost profits, companies are increasingly relying on good old-fashioned sales growth. The good news: a moderate rise in the U.S. gross domestic product  should do the trick for a number of stocks such as banks, retailers and late-cycle industrial plays. The bad news: companies that see minimal sales growth may actually see profits slip back as labor and material expenses rise higher.

Analysts at UBS figure S&P 500 profits will likely rise roughly 5% this year. And thanks to a move up toward 3% GDP growth in 2013, profits could rise a more robust 9% in 2013. This pales in comparison to the gains seen in 2010 and 2011, but is probably good enough to keep the market from slumping badly. They also predict the S&P 500 will end the year at 1,475, roughly 5% ahead of current levels. (Most Wall Street firms have raised their S&P 500 price targets since I looked at their forecasts last month , but still see little further upside from current levels.

You'll occasionally come across market prognosticators that predict that the stock market will surge much higher in coming quarters, and a few have tossed off "Dow 20,000" predictions to garner some buzz. I think UBS and the other firms are closer to the mark.

They missed this rally with their year-end prognostications, but with the market's price to earnings (P/E) (14.6) now higher than its projected earnings growth rate (12.2%), further euphoria may be capped. That said, a drop in oil prices and an expected eventual pullback in the dollar could be a plus for corporate profits. As analysts at UBS note, "risks to our revenue and [earnings-per-share] EPS estimates are weighted to the upside."

Even if profit targets for the S&P 500 come in as expected, many individual stocks can rise appreciably higher -- it's just important you stay cognizant of the macro picture spelled out above regarding profit margins. It's crucial that you assume some margin slippage in your own earnings assumptions, and you'll need to gut check your sales growth assumptions as well. Europe remains challenged, so any S&P 500 companies with major European exposure could disappoint on the earnings front this year.

Roughly 90 companies in the S&P 500 are expected to boost sales at least 10% in 2013, according to Thomson Reuters . And roughly two-thirds of those companies -- or 12% of the S&P 500 -- should be able to do so again in 2014. Notably, almost all of those companies are also expected to boost EPS by at least 10% in 2013 and again in 2014.

But what if we tighten the noose, looking for companies that should see sustained sales and profit growth of at least 15% in 2013 and 2014? The group falls to just 15 stocks, representing 3% of the S&P 500.

 

There are some great growth stocks on this list, but it doesn'tmean investors will (or should) shun value stocks. Indeed, a number of genuine bargains still exist in the S&P 500, if you are willing to tolerate decent but not robust sales and profit growth. I went back and looked at the 90 companies that should see 10% sales and profit gains in each of the next few years, and found a 15 of them selling for less than 15 times projected 2013 profits.

 

Only Google (Nasdaq: GOOG ) and Sandisk (Nasdaq: SNDK ) make both lists, implying they hold appeal for both growth and value investors.

Of course, many other variables will be in play as the market digests sales and profit trends in the coming quarters. For example, natural gas firm Chesapeake Energy (NYSE: CHK ) will need to shore up its balance sheet if it is to fund its capital spending plans for 2012 that yield expected growth in 2013. Conversely, if natural gas prices manage to start rebounding, Chesapeake, Noble Energy (NYSE: NBL ) , Pioneer Natural Resources (NYSE: PXD ) and many other stocks could see huge share price appreciation in the years ahead.

You'll note auto parts supplier BorgWarner (NYSE: BWA ) in the group above. Many suppliers and auto makers -- including my favorite auto play -- Ford Motor (NYSE: F ) increasingly appear poised to exceed consensus sales forecasts, as monthly sales trends now imply a faster-growing U.S. auto industry. (I own shares of Ford in my $100,000 Real Money Portfolio .) Whether profit growth can follow suit will be a function of controlled expenses and a stabilized Europe.

Risks to Consider: The U.S. economy is expected to grow nearly 3% in 2012 and again in 2013. There are still enough headwinds in place to lead economists to lower their views, including a deepening slump in Europe -- our biggest trade partner -- and the negative effects of tax cut expirations expected at the end of this year. A spike in oil prices could also quickly derail the U.S. economy as consumers retrench anew.

Action to Take --> After stunning multi-year gains, it's time to lower expectations for the stock market. Focus on stocks that have moderate upside with considerable downside protection. It's exactly the kind of focus I take in my $100,000 Portfolio , and I wouldn't do it if I didn't think it was the absolute best way to approach the market right now. The "swing for the fences" approach may no longer be advisable now that profit margin pressures change the dynamic of corporate profits.

[ Note: Don't miss a single update. Whether a stock is up in a major way or I decide to sell a holding to raise cash for a fresh new pick, you won't want to miss a thing. Go here to get my updates delivered to your email, free for a limited time .]


-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of GOOG, CHK, F in one or more if its "real money" portfolios.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Investing Ideas

Referenced Stocks: BWA , CHK , F , GOOG , NBL

David Sterman

David Sterman

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