Earnings Season: Wall Street Focuses on Fundamentals

Earnings Season: Wall Street Focuses on Fundamentals

Jason Cohn/Reuters

Fourth-quarter earnings season got off to a sorry start Monday when aluminum producer Alcoa (AA) reported results that were just as disappointing as the market had been expecting, including its first loss in more than a year.

But don’t get too distracted by Alcoa’s bleak results and outlook. True, it’s the first company in the Dow Jones Industrial Average to report, but that doesn’t mean that it’s a harbinger of bad news to come. And true, companies generally have been revising their earnings outlook downward, but that simply reflects the need for caution in turbulent times and leaves room for upside surprises. It’s also true that for much of last year, it was hard to generate long-term returns from stock-specific news events such as earnings releases, as the market focused on macro events such as the geopolitical events in the Middle East and Europe. Again, that doesn’t mean that there isn’t money to be made by keeping an eye open for those stocks and sectors where positive earnings surprises will generate at least short-term opportunities. And, as Fred Dickson, chief market strategist at D.A. Davidson & Co. told Reuters, earnings season may help return investor focus back to this side of the Atlantic: "I think this month we're probably going to break away and see the pattern of U.S. market trade on U.S. fundamentals rather than in reaction to the euro movement.”

Overall, the pace of earnings growth is likely to slow this year for companies in the S&P 500, and we are likely to see the first signs of this in the profits companies report for the fourth quarter. In the first three quarters of 2011, earnings posted gains of 17.5 percent to 19.7 percent; in the fourth quarter, S&P Capital IQ consensus calls for a relatively meager 7.2 percent advance. But as Sam Stovall, chief equity strategist at S&P Capital IQ, pointed out in a research note yesterday, positive surprises could turn that ho-hum figure into a more impressive 11 percent advance, assuming that those surprises come in at the same pace as in prior quarters. (Even financials are expected to post a gain in operating earnings in the fourth quarter, Stovall notes, thanks in part to a small growth in lending activity.) Meanwhile, Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch, believes earnings growth could hit 13 percent for the fourth quarter.

If earnings don’t surprise on the upside, it would be the first time in more than two years that earnings growth hasn’t moved into the double digits. But the real earnings story isn’t the broad trend, but the fact that not all earnings will rise in lockstep with the index. Just as some firms – like Alcoa and the banks – will disappoint, posting losses or minute gains, others will generate much higher earnings and likely will be rewarded for doing so as that growth becomes scarcer.

Subramanian notes that companies that earn a lot of their earnings overseas, particularly those with Euro exposure, will be hurt if the dollar remains strong. Avoid materials stocks like Alcoa, she urges, as well as financial stocks, and turn instead to utilities and consumer stocks. S&P Capital IQ’s memo points out that operating earnings in the energy industry are likely to climb 22.5 percent.

Even if earnings themselves don’t live up to bulls’ expectations, there is still hope that earnings-related news will help boost share prices of cash-rich businesses. Jeffrey Kleintop, equity strategist at LPL Financial, points out that most companies that initiate or raise dividends do it in the first quarter, after or concurrent with the announcement of fourth-quarter results. Even if earnings slide, cash balances remain at record levels, and the payout ratio for S&P 500 companies – the share of earnings paid out as dividends – has fallen to about 25 percent, down from 30 percent recently and a 30-year average of 40 percent.

Keeping an eye open for companies that boast a hefty supply of cash and that appear likely to deliver positive earnings surprises may prove to be a lucrative strategy throughout earnings season – at least for as long as European policymakers allow financial markets to stay focused on fundamentals, that is.