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Q1’s Mismatched Earnings Results: Opportunity in Disparity

Think the market makes sense? In some ways it does; in a lot of ways it doesn’t. That’s not a complaint - just a reality we as investors have to acknowledge if we’re to have any hope at beating the market.

This idea surfaced again as the Q1 earnings data and numbers were being crunched on a sector-by-sector basis. Let’s just say there were some standouts, some disappointments, some conclusions to be made, and a lesson to be learned.

Q1’s Mismatched Earnings Results: Opportunity in Disparity

What’s the ultimate driver of stock values? Most would say that earnings results (and growth) are the most important numbers to investors - and we wouldn’t disagree. A lot of factors can have an impact though….  and the size of their impact can vary with the mood of the market.

For that reason, let’s look at the market’s sectors in detail by looking at last quarter’s earnings, revenue growth, earnings ‘beats’ and shortfalls, P/E ratios - the whole shebang. We think you’ll find some surprising (and not always in a good way) numbers. More importantly, the numbers may have you rethinking your allocation as we head into the latter half of the year.

First Things First

First and foremost, know that the first quarter for the S&P 500’s stocks was much better than expected - the bar is set high. When you break it down by sector though, there were some spectacularly good and spectacularly bad relative performances.

The nearby table tells the tale, though it’s a complicated one.

The big buzz was that the financial sector’s earnings indicated that things were finally looking up here. That 201% improvement in earnings though? Keep in mind that we’re comparing Q1-2010 to Q1-2009….. the darkest hour of the recession. The meager 7% increase in total revenue trailed the average sales growth, suggesting that the sector still isn’t back to its old pace yet.

The surprises went the other way too. Take technology and consumer discretionary stocks as an example. The 90% and 93% earnings ‘beat’ rates, respectively, were by far the most significant victories in the minds of investors and the psychology of the trading crowd.

That was certainly helpful for consumer discretionary names - they’re up 7% year-to-date despite only a 9% increase in earnings, and despite this sector now being the most expensive on a projected P/E basis.

Technology, on the other hand, posted a much better 19% increase in sales, and these stocks are technically cheaper than discretionary stocks (and even cheap by tech standards, with a forecasted P/E of 12.1). Their reward? The technology sector is down 7% year-to-date. So much for “What’s good for the goose is good for the gander.”

Telecom was a big letdown, for obvious reasons. And despite the 12% loss for the year so far (the biggest among all sectors), the forward-looking P/E is still an expensive 12.3. We still contend telecom is under-rated and a budding opportunity, but we specifically feel it’s the small caps and wireless names that will do the leading here. AT&T and Verizon were the key reasons for the S&P 500’s telecom sector problems.

We could go on, but the data is right there - you can glean the clues for yourself. We’ll just part with this nugget of wisdom, and a couple of sector-specific calls built around it.

Expectations Are (Usually) as Important as Actual Results

While solid tech numbers (beats as well as absolute improvement) didn’t help its stocks, that may have been the exception to prove the rule.

Take a look at the discretionary sector and the industrials. From an earnings growth and revenue growth perspective, both were a little sub-par [keep in mind that the comparison to Q1-2009 for consumer discretionary names was an easy number to top]. Yet, those two groups are the only two to remain in positive territory for the year in terms of stock prices. How’d they pull it off? They saw a huge - and disproportional - number of positive surprises.

Conversely, the energy sector actually put up the healthiest (real) earnings and revenue growth, and they’re now the market’s cheapest stocks. Yet, they’re also almost the biggest losers year-to-date.

Lesson learned? Beating (or not) estimates can be just as important to finding strong stocks as actual earnings or revenue growth is. It stinks, but there’s your proof that being exclusively married to fundamental analysis can hurt as much as it helps. That’s why we take a half-fundamental, half-technical approach.

Eventually, analysts will get their bearings, and you’ll stop seeing a huge number of positive and negative surprises. It can take a couple of quarters to straighten those guesses out though, which can be really good or really bad for those stocks in the meantime.

The Next Best Bets

Any actionable clues buried in the Q1 earnings and stock performance chart? A few.

Eventually, the fact that energy is doing so well - despite nobody realizing it - will boost the sector’s value. If you’re truly a long-termer, now’s the time to go shopping for energy stocks. Just keep in mind it may take another quarter or two for the market to get past its fear of the energy group, and accept the fact that these companies did quite well in a pretty mediocre environment.

Another hidden gem in there is healthcare. Yes, the federal healthcare overhaul probably gets most of the blame for the weakness here - uncertainty is a stock torpedo. Now that it’s not an unknown anymore, investors should start to realize that (1) there’s been some real growth here, (2) the healthcare bill actually has more opportunity than liability for these stocks, and (3) there are some undervalued names in the group.

And finally, technology offers the best of aspects both healthcare as well as energy….. real growth of earnings and revenues, and depressed prices. And, if the number of positive surprises in Q2 is anywhere near the number we saw from the technology sector in Q1, we’d be willing to bet the result would be buying rather than selling the next time out.

Read the original blog entry...

More Stories By James Brumley

James Brumley is a freelance writer and registered investment advisor. He began his career as a broker with a major Wall Street firm, where fundamentals and long-term holding periods were core strategies. After that, he switched gears completely, becoming an analyst at a short-term trading newsletter that focused on technical analysis. He now manages client money using the best of both philosophies. His company, Bluegrass Portfolio Management, offers investors an opportunity to reap superior returns with minimized risk.

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