Earnings Revision Trend No Friend

1/28/2013


After 11 straight quarters of per-share earnings rising at least 8%, the S&P 500 Index grew profits a measly 0.1% in the September quarter. It likely won't get much better soon, with the consensus projecting 2.7% growth for the December quarter.

Wall Street once held high hopes for the quarter. Analysts expected growth of 13.9% on July 1 and 9.9% on Oct. 1. But 20% of companies in the S&P 500 issued warnings before Alcoa ($9; AA) kicked off earnings season Jan. 8 — the most for any quarter since the one that ended in December 2008.

It's becoming a familiar sight: Once-healthy profit estimates shrivel as earnings season draws near. For eight consecutive quarters, consensus profit estimates for the S&P 500 have declined during the period stretching from the start of a quarter to the arrival of earnings season, as marked by Alcoa's report date.

Estimates have proved especially erratic for the materials sector. In the last five quarters, the consensus targeted double-digit growth about nine months before the start of earnings season; by the time earnings season arrived, estimates called for negligible growth or contraction.

This observation about shrinking profit estimates may seem obvious, considering that analysts are a notoriously optimistic bunch. But as recently as the tail end of 2009 and all of 2010, consensus estimates tended to rise as earnings season approached.

With positive analyst revisions in short supply, investors have done fairly well in the past couple years by focusing on stocks with high Earnings Estimates scores. The only Quadrix category score to work in the last 12 rolling 12-month periods was Earnings Estimates, with the top one-fifth of S&P 500 stocks based on that metric outperforming the average stock in the index by an average of 0.8%. In the previous 12 periods, top Earnings Estimates scorers outperformed by an average of 3.4%, second best among Quadrix categories. But the Earnings Estimates score is also highly volatile, and over the last 60 periods it has performed poorly, with top scorers lagging by an average of 1.4%.

As shown below, Earnings Estimates and Value scores rarely perform well at the same time. But they do work well in combination. Stocks scoring in the top quintile for both categories outperformed by an average of 0.9% in the past 60 rolling 12-month periods and 2.0% since February 2004, when we introduced the Earnings Estimates rank.

EARNINGS ESTIMATES, VALUE TAKE TURNS
Quadrix Earnings Estimates and Value scores rarely perform well at the same time. Over the past six years, Earnings Estimates has worked when Value didn't, and vice versa. For instance, in rolling 12-month periods that ended in 2012, S&P 1500 stocks scoring in the top quintile for Earnings Estimates outperformed the average stock in the index by an average of 0.8%, while top Value scorers lagged by an average of 3.3%.
 
Over the last year, no Earnings Estimates factor has worked better than the percentage difference between high and low profit estimates for the current quarter. The tighter the spread, the better, and the top quintile based on that metric has averaged excess returns of 3.2%. Some of these factors were added to Quadrix in February 2004, others in June 2010.
Average Outpeformance
---- Of Top Scorers In ----
 
Average
Outperformance In
Rolling 12-Month
------- Periods -------
Rolling 12-
Mo. Periods
Ending In
Value
(%)
Earnings
Estimates
(%)
 
Top Scorers In
Ending
In 2012
(%)
Since
Inception
(%)
2005
5.7
5.0
 
Earnings Estimates
Category Score
0.8
0.0
2006
0.3
2.6
 
2007
(1.5)
0.2
 
Spread Between High,
Low EPS Est., Curr. Qtr.
3.2
1.7
2008
(4.1)
3.5
 
2009
7.1
(5.2)
 
Net EPS Revisions, Past 4 Weeks
2010
11.8
(9.5)
 
For Curr. Qtr.
1.1
2.0
2011
(2.2)
3.4
 
For Curr. Yr.
1.5
0.4
2012
(3.3)
0.8
 
For Next Qtr.
1.0
1.9

The most effective Earnings Estimates score over the past year has been the one that measures the spread between the high and low analyst estimate, rewarding stocks with tight spreads. See the table above for other effective factors.

Should this trend of declining estimates continue, the S&P 500 could be hard-pressed to deliver profit growth in the March quarter. The quarter began with what seemed like modest expectations, 4.3% growth, yet that target has already shrunk to 3.5%. Still, results from the recent past tend to unduly color future expectations. And perhaps this wave of low growth will reset expectations to the point that analyst revisions become positive again.

Unlike the rest of the S&P 500, the following recommended stocks enjoy encouraging trends for profit estimates.

Fifth Third Bancorp ($17; FITB) rallied after the regional bank said it earned $0.43 per share in the December quarter, up 30% and $0.02 above the consensus. Revenue from mortgage banking jumped 65%. Total deposits advanced 4%, while loans and leases rose 7% at the commercial business and 3% on the consumer side. Management attributed some of the quarter's growth to customers rushing to complete deals ahead of tax hikes that took effect in 2013. Credit quality also improved, a trend that should continue this year.

Heading into its earnings report, Fifth Third had an Earnings Estimates score of 96, partly reflecting rising analyst estimates for both the March quarter and full year. Nearly half of Fifth Third's loans come from rust-belt states Illinois, Indiana, Michigan, and Ohio — areas that should benefit from a rebound in U.S. manufacturing. For 2013, management sees loans growing at mid- to high-single-digit rates.

Fifth Third also scores in the top 20% of our research universe for Value. At 10 times trailing earnings, the stock trades 26% below its 3-year average. And at less than 10 times estimated 2013 earnings, Fifth Third trades 26% below its peer-group median. Yielding 2.4%, Fifth Third is a Buy and a Long-Term Buy.


The number of U.S. land rigs is down nearly 20% overall from its peak in October 2008 — but up nearly 30% for Helmerich & Payne ($61; HP). And despite weak domestic prices for natural gas throughout most of 2012, H&P's rig rates have held up. H&P's rigs, more technologically advanced than those used by many peers, offer the precision and flexibility to handle complicated drilling procedures often required for hydraulic fracturing. H&P plans to expand its total fleet 5% to 336 rigs in fiscal 2013 ending September.

H&P shares have advanced 12% since we first recommended the stock in early December. The next catalyst will likely arrive Jan. 31, when the driller reports December-quarter results. Wall Street calls for per-share profits to slip 1% to $1.28, but the consensus has risen by $0.11 in the past three months and by a penny in the past 30 days. Sales are projected to climb 13%, which would mark the 11th straight quarter of double-digit growth. The stock scores above 80 in Quadrix for both Earnings Estimates and Value. Helmerich & Payne is a Focus List Buy and a Long-Term Buy.


Wells Fargo ($35; WFC), with its strong presence in U.S. mortgages and huge deposit base, appears well-positioned for the long haul. Its short-term outlook is tied to the prevailing low interest rates, a double-edged sword. This environment has crimped net interest margins at Wells Fargo (and many other banks), providing lower returns on reinvested funds from loans and deposits. However, declining interest rates also drive homeowners to refinance their mortgages. Refinancing accounted for 72% of the bank's mortgage originations in the December quarter.

Looking ahead, Wells Fargo could face a new problem. While the Federal Reserve seems determined to keep interest rates low, it can't do much to reduce rates further. The lack of mortgage-rate declines could eventually weaken a key component of the bank's mortgage business. And at some point, nearly all of the homeowners capable of refinancing will have done so.

Still, Wells Fargo enjoys healthy loan growth and expects expenses to decline as the regulatory environment improves. The bank also raised its quarterly dividend 14% to $0.25 per share, payable March 1. The hike was part of Wells Fargo's 2012 capital plan — not part of the 2013 plan submitted to the Federal Reserve Jan. 4, meaning additional dividend growth could come later this year. Wells Fargo now yields 2.9%, above the 2.5% average for S&P 1500 banks. It pays out 30% of earnings in dividends, versus the 48% average for banks with yields above 2%. Wells Fargo is a Focus List Buy and a Long-Term Buy.

STOCKS WITH ROBUST PROFIT-ESTIMATE TRENDS
We screened for recommended stocks scoring at least 80 for three of the four most effective Quadrix Earnings Estimates factors, as described in the table labeled "Earnings Estimates, Value take turns." Consensus estimates have either held firm or climbed in the past 30 days for all eight stocks. For most companies, the current quarter refers to three months ended December. But Fifth Third Bancorp ($17; FITB) and Wells Fargo ($35; WFC) have already reported December-quarter results, so the current quarter is the March quarter. Oracle's ($35; ORCL) current quarter ends in February.
Quadrix
---- Scores ----
Current-Quarter
---- EPS Estimate ----
Next-Quarter
---- EPS Estimate ----
Current-Year
---- EPS Estimate ----
Total Return
Company (Price; Ticker)
Earns.
Ests.
Value
Curr.
Est.
($)
Est.
30
Days
Ago
($)
Implied
Year-
Over-
Year
Chg.
(%)
Curr.
Est.
($)
Est.
30
Days
Ago
($)
Implied
Year-
Over-
Year
Chg.
(%)
Curr.
Est.
($)
Est.
30
Days
Ago
($)
Implied
Year-
Over-
Year
Chg.
(%)
End Of
Fiscal
Year
Year-
To-
Date
(%)
12
Mo.
(%)
CVS Caremark
($52; CVS)
94
59
1.10
1.10
24
0.78
0.78
21
3.40
3.40
21
 Dec. 
8
23
Exxon Mobil
($91; XOM)
85
78
2.00
1.99
1
2.01
2.00
0
7.88
7.87
(6)
 Dec. 
5
7
Fifth Third Bancorp
($17; FITB)
96
81
0.39
0.38
9
0.41
0.40
14
1.64
1.60
3
 Dec. 
9
26
Helmerich & Payne
($61; HP)
97
83
1.28
1.27
(1)
1.22
1.20
8
4.96
4.86
(4)
 Sept. 
9
2
Magna International
($53; MGA)
86
83
1.15
1.12
(21)
1.36
1.30
(7)
5.23
5.21
11
 Dec. 
6
29
Oracle ($35; ORCL)
98
72
0.66
0.66
7
0.88
0.88
7
2.69
2.66
9
 May 
5
24
Qualcomm
($65; QCOM)
95
50
1.12
1.12
16
1.10
1.10
9
4.32
4.31
16
 Sept. 
5
13
Wells Fargo
($35; WFC)
75
89
0.88
0.87
17
0.91
0.90
11
3.63
3.62
8
 Dec. 
3
16
Note: Quadrix scores are percentile ranks, with 100 the best.

 

MORE S&P 500 COMPANIES SET LOWER EARNINGS HURDLE
Downward pressure on profit estimates partly reflects a rise in negative preannouncements. Entering the current earnings season, more S&P 500 Index companies had warned than any period since the December 2008 quarter.
----------------- 2010 -----------------
----------------- 2011 -----------------
----------------- 2012 -----------------
March
June
Sept.
Dec.
March
June
Sept.
Dec.
March
June
Sept.
Dec.
Negative/Positive
Preannouncements
72/61
71/60
77/34
91/48
82/45
83/33
86/33
99/30
83/29
95/29
94/22
100/29
Negative/Positive Ratio
1.2
1.2
2.3
1.9
1.8
2.5
2.6
3.3
2.9
3.3
4.3
3.4
Source: Thomson Reuters.

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