David Dreman - What Earnings Recovery?
, 07.08.02, 12:00 AM ET
Investors beware. Securities analysts are up to their old tricks, projecting wildly upbeat 2002 profits. This is their real sin, which Eliot Spitzer and the SEC aren't focused on.
Today's analysts have created their own alamo besieged by a large hostile force composed of New York State Attorney General Eliot Spitzer, the Securities & Exchange Commission and enraged investors. Then come legions of rabid trial lawyers.
The analysts may succeed in defending their fortress. But once their conflict of interest questions are settled and the headlines fade, the bigger problem will remain: They're simply too optimistic about earnings. Mandate whatever disclosures about underwriting relationships you want and set up watchdog committees galore--the outlook on Wall Street will remain sunny.
And if investors buy stocks now on the strength of rapturous S&P 500 earnings estimates for 2002, they have an unpleasant surprise ahead. The index is currently trading at a projected price/earnings ratio of 21, based on analysts' estimates of operating earnings for component companies. The 2002 P/E is 40% higher than the average multiple for the index over time and sharply higher than the S&P's multiple in other bottoming periods. In the 1990-91 recession the S&P 500 traded at a 14 P/E and in the 1973-74 bear market, at 7.
As we're painfully aware, the earnings performance for 2002's first half is a sorry one. Company after company has been forced to lower expectations or to restate past results downward. How can the consensus justify such a healthy-looking multiple for the year as a whole? By forecasting a second-half profit boom that gushes up from nowhere like a mad wildcatter's feverish dream: a 48% gain (from a year earlier) in the third quarter, 45.7% in the fourth, according to S&P analysts' forecasts. Included in the forthcoming profit explosion, as reported in First Call, are a 127% income increase in technology stocks in the third quarter and a 73% jump in the fourth, as well as a hardly modest nineteenfold rise in transportation earnings in the third quarter (mainly airlines), with an even larger gain forecast for the fourth.
It doesn't matter who is doing the forecasting--analysts who cover individual companies or market strategists who look at the economy overall. They're all Pollyannas. The company-by-company forecasts, assembled into a composite for the index, yield $51.15 in earnings for the S&P 500 this year. The big-picture fortune-tellers predict $45.01. These guys simply look at the operating earnings delivered last year and add a large growth factor plucked out of the optimism in the air.
Optimism is almost always in the air. A study I did of estimates between 1982 and 1997 (FORBES, Jan. 26, 1998) found that analysts' earnings growth forecasts on average were triple the actual earnings growth of the S&P.
To restore investors' confidence in earnings quality, Standard & Poor's in May brought out a stricter definition of its operating earnings, which is meant to capture profits from the ongoing business apart from one-time events like goodwill impairment. From now on S&P will treat employee stock options and restructuring charges as an expense and will no longer add pension gains to income. Trouble is, companies aren't required to use the S&P methodology and will keep on reporting earnings whichever way makes them look the best.
This doesn't mean you should stay out of the market completely. There are many first-rate companies that are cheap and do not have inflated estimates of earnings; under the S&P method, their earnings vary little from the GAAP results they've been reporting. Three such buys: Freddie Mac (nyse: FRE - news - people )(62, FRE), GAAP P/E 10, dividend yield 1.4%; tobacco outfit UST (nyse: UST - news - people ) (37, UST), P/E 12, yield 5.2%; and bookstore chain Borders Group (nyse: BGP - news - people ) (19, BGP), P/E 14.
Should all companies accused of aggressive accounting be shunned? No.
I recommended Dynegy (nyse: DYN - news - people ) (8, DYN) in my Mar. 18 column at 23, down from 50. Since then Dynegy has tumbled on news of offsetting trades, an SEC probe and threatened credit downgrades. Yet Dynegy, at a P/E of 8, with a major ownership stake in and management guidance from Chevron-Texaco, should be a survivor. I'd hold it here, and if you have high-risk dollars available, add modestly to your position. I also recommended Reliant Resources, Mirant and Williams Cos.--hold or add moderately.
An interesting play is El Paso Corp. (nyse: EP - news - people ) (21, EP), P/E 13, yield 4%, which has just offered new shares. Down sharply from its 12-month high of 58, the energy company's stock now trades much lower because of the skepticism about the sector, topped off by the recent suicide of its treasurer. All the same, the company appears to have less trading exposure than most in this field, as well as an investment-grade credit rating.
David Dreman is chairman of Dreman Value Management of Jersey City, N.J. His latest book is Contrarian Investment Strategies: The Next Generation. Visit his home page at www.forbes.com/dreman. |
