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Dancing Over Hot Coals
The pre-announcement earnings season always keeps investors hopping. Here's how to find the bargains and avoid getting burned.
By Jim Jubak
Is it just business as usual? Should we shrug our shoulders as one company after another warns that earnings aren't going to measure up to expectations next quarter? Should we buy on the dips from panicky fellow investors? Or is this the time to head for the hills?
Pre-announcement time -- those weeks when companies tell the world that reality has taken a big, big bite out of those rosy projections of revenues and earnings -- always has the potential to rattle an investor's nerves. But this year it's especially important to figure out how much damage the shock waves are likely to do. Corporate earnings growth does indeed look like it's slowing down. Some industries seem to be headed for real and prolonged slumps. Buying on the dips has worked magic for investors since the October1987 crash. Is it still a good strategy?
I think the answer is, "Yes, but . . . " This pre-announcement season isn't exactly business as usual. Some of the bad news that will be hitting the wires is signaling fundamental change in a few industries and at some companies. In this market, I think an investor has to separate the dips that are buying opportunities from the dips that signal long-term troughs. You can do that, I believe, if you keep four principles in mind.
You can learn a lot about this pre-announcement market by studying what happened to Intel (INTC) last Thursday. After the market closed on Wednesday, March 4, Intel dropped a bombshell. It said revenues would fall 10% from those recorded in the last quarter of 1997, gross margins would tumble by about 6 percentage points, and earnings would come in somewhere south of Tierra del Fuego. In the low-volume after-hours market, Intel fell about $10 a share.
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Once the market opened the next day, the stock quickly dropped through that price as investors looking to sell tumbled over analysts scrambling to downgrade the stock and cut earnings estimates. Morgan Stanley, for example, cut its projections for 1998 earnings to $3.25 a share from $4.00.
But two important things didn't happen. First, Intel's price didn't go into free-fall. After the frenzied markdown of the first hour or so, the stock stabilized as bargain hunters snapped up all the shares that sellers wanted to unload. The stock finished the day down a total of approximately $11 a share. Second, Intel's problems didn't take down the whole market. Oh, sure, it wasn't a great day for investors -- the Dow Jones industrials fell 95 points, or about 1%, and the technology-laden Nasdaq Composite Index dropped about 2.7% -- but considering that one of the market's bellwether stocks had just blown up, the damage was amazingly minor.
On Friday, March 6, the market even rallied, despite another earnings warning from a big technology stock. Motorola (MOT) announced that its earnings for the quarter ending in March would be 25% below estimates. Nonetheless, the Nasdaq index regained about 90% of its drop. Intel recovered $2.50 a share of its loss. And the Dow climbed 125 points.
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Friday's rally is even more significant because Intel and Motorola haven't been the only two companies to warn about earnings problems. Advanced Micro Devices (AMD), Disney (DIS) and Cabletron Systems (CS) all officially doled out the gloom days before Intel. Compaq (CPQ) officially lowered the boom just a day behind Motorola after hinting, for almost a week, of trouble to come.
The market is reacting as if each warning is company-specific and refusing to generalize the news to corporate earnings as a whole. When Motorola, for example, said that it was seeing weakness in Asia, that didn't set off another flight from the stock of every company that does significant business in Asia. When Motorola said that growth of sales of wireless phones in the U.S. was slowing, competitors' stocks didn't take huge hits. Instead, the market just shrugged. "Everybody knows Motorola has problems" just about characterizes the reaction.
That smacks of complacency to me. Corporate earnings growth is definitely slowing across the board. At the turn of the year, Wall Street analysts projected 15% earnings growth for the March 1998 quarter (from the year-earlier quarter) for the companies in the Standard & Poor's 500. By early February that estimate was down to 8%. Now it's 4%. Whether actual earnings come in at that level or at 8%, the rate of growth is definitely slower than it was a year ago. As a whole, the stock market, of course, is more expensive than it was a year ago. The S&P 500 now trades at about 26 times 12-month trailing earnings. A year ago, it traded at 20 times trailing earnings.
An investor generally should pay a higher multiple for a stock, or the market, only when the rate of earnings growth is climbing. While analysts are still calling for 11% earnings growth in all of 1998, that rate, even if achieved, would still be a slowdown from 1997. And making 11% will require some pretty robust growth in the rest of the year if the first-quarter growth turns out to be just 4%. To compensate, earnings would have to grow by 15% in each of the remaining quarters.
So what do I conclude from this, and what strategies do I recommend?
1. The "company-specific" attitude means that, while investors will still punish some stocks unfairly when a "similar" company reports bad news, the dip is likely to be pretty small. Big enough for traders. Too small to make long-term investors salivate. For example, when Intel warned, Cisco Systems (CSCO) took a dive. No particular reason -- the companies are in very different markets, don't sell similar products, don't even have overlapping customer lists to a great degree. Cisco fell simply because, like Intel, it's a technology stock.
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But the "discount" never got very big and it didn't last long. Cisco fell all of $3.44 a share on that Thursday, and rebounded $2.88 on Friday. So I'm not counting on being able to pick up the stock of my dreams the day after a not-very-closely-related company warns. You aren't going to get many big bargains on unblemished but unfairly shunned stocks this pre-announcement season.
2. The real dips are likely to come because of a barrage of bad news. Advanced Micro Devices warns and the stocks of other chip-makers don't budge -- but the news sets the stage. Intel warns and the pressure builds on chip-makers and the companies such as Applied Materials (AMAT) that make equipment for chipmakers. Compaq warns the next day. More selling of chip makers, equipment makers, and PC companies. The result: Compaq, which traded near $37 a share on Feb. 11, breaks below $27 a share on March 9, and Applied Materials, which had rallied from $28 in early January, starts a U-turn after climbing to $38.
Be patient when you see a pattern of bad news building in a group of related companies. This market is very slow to generalize, but it will get the point eventually. Intel, for example, moved lower yet on Compaq's warning. You could have bought Intel more cheaply the day after Compaq warned than on the day after the company announced its own bad news.
3. Make sure you're actually buying a bargain -- not just a cheap stock that should be cheap. For example, investors should be asking if they really want to invest in the PC industry at all for the next six months -- no matter how cheap stocks like Compaq and Intel get. Intel's revenue shortfall could be related to one-time problems such as inventory cutbacks at big manufacturers like Compaq. But it could also be a sign that demand for chips and PCs is slowing, or that the popularity of sub-$1,000 computers is about to permanently reduce Intel's gross margins. Compaq now admits that it stuffed the sales channel with PCs in the December quarter. Analysts believe that IBM (IBM) and Hewlett-Packard (HWP) did the same thing. That's likely to mean lower revenues at those PC companies too -- and, like Intel's announcement, could signal industry-wide growth problems.
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The stocks that are likely to take the biggest price cuts in these pre-announcement weeks will belong to companies with real problems that will take more than a month or two to work out. Investors will have to search through that pool to find the companies with real turnaround stories and be willing to hold on while those stories unfold. Compaq, Intel, Applied Materials, PRI Automation (PRIA), and other PC-related stocks are likely to become real bargains in the coming weeks. But I think in each case it will take until the end of 1998 for the turnaround in revenues and earnings to achieve enough visibility to move the stock up strongly.
4. Recognize that an atmosphere of earnings uncertainty changes the relative value of entire classes of stocks. With many companies -- including some rocks like Intel and Compaq -- issuing earnings warnings, and then delivering bad earnings as predicted, I'd expect that investors will bid the already-inflated prices of "guaranteed" earnings producers even higher. That's especially likely if analysts begin cutting earnings estimates for the second quarter as soon as the numbers for this period are officially in the bag. Investors could then reasonably conclude that steady earnings are worth a higher premium than they command even now. I know there is no way on the fundamentals to justify paying nearly 50 times earnings for a drug stock such as Pfizer (PFE) but I think the stock will head higher in the next six months, driven by a demand for predictable earnings.
I'd even suggest putting what I'd call a "reliable earnings strategy" in place after companies report in April. I'd buy a handful of big-name, highly liquid stocks that actually manage to deliver the earnings expected by analysts (beating projections by a penny or two would be my requirement) and that are showing 10% or better earnings growth.
You can name some of these right off the top of your head: Merck (MRK), Pfizer, Microsoft (MSFT) and Cisco (if they escape the technology meltdown), plus a few consumer names such as Home Depot (HD) and Gillette (G). Don't sell any of these names now if you own them -- but don't move on this strategy yet. It's important to wait to see who actually delivers the goods in April. I'll come back to this topic then and try to put together a list for you to consider. (Investor is published by Microsoft.)
Pre-announcement season rolls around once every quarter like clockwork. But that doesn't mean that each season is exactly the same. The stock market is so fascinating because it's always the same and yet always different. The trick is to find a strategy that builds on what is unchanging, yet is flexible enough to adapt to the endless variations of the moment.
(Full Disclosure: Of the stocks mentioned in this column, I own or have interest in Applied Materials, Cisco, Hewlett-Packard, Integrated Device Technology, Intel, Microsoft and PRI Automation.)
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