Analysts Tell Simple Story

3/16/2009


Sometimes you go with your gut.

In recent months, hundreds of companies have flooded the market with negative profit guidance, projecting weaker-than-expected results for the March quarter and full year.

Such news tends to make analysts lower their projections and investors become more cautious and brace for the worst. Avoiding companies with declining profit estimates — and those analysts don’t like — is instinctual. In these pages, we have told you many times to resist a natural inclination. We won’t do that today.

In the following paragraphs, we discuss two trends related to analysts’ estimates and recommendations investors cannot afford to ignore.

Steer clear of decliners
History suggests that when consensus estimates decline, stocks underperform. The Quadrix Earnings Estimates score, which considers such factors as revision trends and profit surprises, has proven effective at identifying outperforming stocks since we began tracking the data in February 2004. In rolling 12-month periods, the top one-fifth of S&P 500 Index stocks as measured by the Earnings Estimates score averaged a return of 7.1%, versus 3.4% for the average stock. While our data only go back five years, academic studies from earlier periods confirm the trend is not new — stocks with rising profit estimates tend to outperform.

Unfortunately, estimates for S&P 500 companies are not rising. As of March 10, the consensus projected per-share profits of $62.31 for the index this year, down 12% from year-earlier levels. Three months ago, Wall Street expected 2009 profits to increase. Since then, the profit estimate has fallen 26%.

 

Data for the index reflect trends for individual stocks. About 87% of S&P 500 companies saw 2009 profit estimates decline over the last 13 weeks, with the average company’s estimate down 18% during that period.

The data look bad, but not every stock has fallen into the estimate trap. Biogen Idec ($46; BIIB) has seen consensus estimates for both 2009 and 2010 rise steadily over the past six months. Wall Street expects per-share profits to climb 11% this year and another 6% in 2010.

Links to a deadly brain virus weigh on multiple sclerosis (MS) drug Tysabri. But while five Tysabri patients have contracted the disease and the drug’s growth has slowed, the number of people taking Tysabri still rose 6% in the second half of 2008. The biotech firm also has other growth avenues.

Biogen is reportedly in merger talks with Acorda Therapeutics ($25; ACOR), whose experimental pill has improved mobility for MS patients in clinical trials. Years of heavy spending on research and development could also pay off in coming years. Roughly six medications should advance into late-stage development over the next 18 months, and two new products are slated to launch in 2010. Biogen is a Focus List Buy and a Long-Term Buy.

Analysts’ picks outperform
The Forecasts prefers companies trading at appealing valuations and with the potential to outperform analysts’ expectations. So do many analysts. While analysts use estimates to project operating results, they show the love with Buy and Strong Buy recommendations. Researchers disagree on the usefulness of analyst recommendations as indications of stocks’ appeal. Some studies have found that Buy-rated stocks tend to outperform, while others have reached the opposite conclusion. The divergence in study results suggests the effectiveness of analyst ratings changes over time and varies based on factors such as the size of the stocks.

Rather than trying to determine which studies are correct or depending too heavily on data from before the tech bubble, we performed a study of our own, looking at five years of returns for stocks with different levels of analyst coverage. Our research leads to two main conclusions:

More is not merrier. In the S&P 500 and S&P 1500 indexes, stocks covered by fewer than 10 analysts outperformed stocks covered by more. This makes sense when you consider that if 25 analysts cover a stock, most of the information about that company has probably reached the public domain, leaving less room for the surprises that drive stock prices up.

Buys do better. Don’t misread this — we do not recommend that subscribers load up on Spacely Sprockets just because Cogswell Investments gives it a Strong Buy rating. But quality tends to shine through, and if a lot of analysts like a stock, there may be a good reason.

Most of the large-cap and midcap stocks we recommend draw heavy analyst coverage — all but four have captured the attention of at least 10 analysts. However, only six analysts cover utility/energy hybrid Energen ($25; EGN), which earns an average rating of Buy from those analysts.

In 2008, 88% of Energen’s net income came from producing natural gas and oil. Low commodity prices have weighed on most energy firms, and Energen is no exception. However, roughly two-thirds of Energen’s projected 2009 production is hedged at prices 30% to 55% above current rates. Energen also enjoys another type of hedge, namely the relative stability of a regulated natural-gas utility.

In January, Energen cut its 2009 capital-spending budget 24% and shaved $0.10 off an earlier target range for per-share profits. The consensus projects a per-share-profit decline of 20% in 2009, followed by a 23% rebound in 2010. Energen, a Long-Term Buy, seems capable of exceeding Wall Street expectations.

A word of warning
The economic slowdown will eventually end. That statement seems obvious, but given the level of panic in our subscribers and other investors, it bears mentioning. Wall Street analysts expect a strong profit rebound in 2010, with the consensus projecting an average increase of 16% for S&P 500 stocks and less than 10% posting lower earnings. But before we get all giddy about 2010, let’s travel back in time for a moment.

A year ago, consensus estimates for S&P 500 companies translated to per-share profits of $98.40 for the index in 2008, representing a 19% recovery from depressed 2007 results. Today, we are looking at 2008 profits of about $71 per share for the index, 14% down from 2007 levels and 28% below expectations a year ago.

Yes, the 2010 projections look good. But analysts tend to be optimistic. The U.S. Federal Reserve’s Beige Book, a survey from regional Fed banks, reports that conditions continue to worsen in 10 of the country’s 12 regions. While the Beige Book projects the economy will start growing by the end of this year or early next year, many economists expect a longer period of recessionary conditions, and even the optimists expect a gradual recovery rather than a sharp one.

What it means: Don’t waste your time trying to predict what the economy will do. And don’t assume anyone else’s estimates will prove accurate. Rather than try to “play” the recovery — a strategy that only works if you correctly guess both the timing of the recovery and the industries that take the lead — count on the market to react more quickly than you will. Typically, stocks begin to rally before the economy pulls completely out of its funk. Build an all-weather portfolio — like the Buy List or Long-Term Buy List — and trust in the combination of a forward-looking market and quality stocks to help you take advantage of the recovery.


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